Question

Discuss the concept of time value of money and what it means. Explain how the time value of money is used and who it is used by. ( 200 - 300 words please )

Answer 1

Time value of money simply states that a $ in hand today is worth than a $ that would be received in future.

The reasons for this phenomenon are:

*Preference for current consumption

*Money in hand has earnings potential--also opportunity cost of getting money later

*Inflation reduces the value of future dollars

*There is risk attached to the receipt of future dollars

All the above reasons go to make a dollar in hand worth than a dollar to be received later.

These elements are built into what is called the 'discount rate' which is used to convert future dollars into their worth today that is to their present value.

The TVM concept is used by all rational decision makers where they have to deal with cash flows that occur at different points in time. For instance, if a project costing say $1000 is to be evaluated against cash inflows to be received at the end of years 1 and 2 of $750 and $500 respectively and if the discount rate representing the TVM is 10%. then the PV of the cash inflows would be 750/1.1+500/1.1^2 = $1095. As the PV of the cash inflows is more than the initial investment, the investment is worhtwhile. It is said to have a Net Present Value of $95.

This technique of finding the NPV of investment projects is used by all decision makers. It will also have use in ones personal invesmtne decisions also.