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In: Accounting

What is time value of money? Whu problems may arise if time value of money is...

What is time value of money? Whu problems may arise if time value of money is not taken into consideration while making transactions? Explain theoretically how can these problems be dealt with?

Solutions

Expert Solution

Time Value of Money: means money has its time value. A rupee today is more valuable than a rupee a year hence. To express the time value of the money rate of interest plays a very important role.

The following problems may arise if the time value of money is not taken into consideration while making transactions:

  • Inflation: When there is inflation, the value of currency decreases over time.
  • Risk: Risk of Uncertainty in the future lowers the value of money.

In the absence of time value of money, while making transactions the major effective factors like inflation, risk will get neglected. Hence, we will not able to make an accurate conclusion.

We can deal with this problems by applying the time value of money

Suppose you are offered the choice between having Rs.10,000 today and having Rs, 10,000 at a future date, you will usually prefer to have Rs, 10,000 now. Similarly, if the choice is between paying Rs. 10,000 now or paying the same Rs. 10,000 at a future date, you will usually prefer to pay later.

In the first case by accepting Rs. 10,000 early, you can simply put the money in the bank and earn some interest. Similarly in the second case by deferring the payment, you can earn interest by keeping the money in the bank.

Therefore, the time gap allowed helped us to make some moey. This incremental gain is time vlaue of money.


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