Importance of Time Value of Money in Financial Management Decision Making

TASK 1
Importance of Time value of money in financial management decision making
a) Concept of time value of money (TVM)
The concept of time value is an economics concept also widely used in the discipline of
Financial Management for the purpose of decision making. The theory behind the TVM
is used to find out the future value of the money in present time period. In other words,
TVM is about finding the worth of a sum of money in present date as its equivalent in
future dates considering the effects of interest, inflation and other factors on the money if
it is kept until that future date. The assumption behind this concept is that, due to the
potential earning capacity a sum of money is worth more in the present than in the future.
TVM is also called as the discounted value of the money or the Net Present Value
(NPV). As a matter of fact a rational investor would want to receive a sum of money in
the present date as compared to a future date because the sooner the money is received
the more value it gives. It gives quantitative value to an assumption or plan which makes
it easy to make decisions.The five variables that are used for the TVM are;
 Present value(PV) or the amount in hand
 Future value or the equivalent of the PV in future
 Time period or number of periods money is to be held
 Interest rate or the discounting rate
 Payment or installments (Woodruff 2018)
The formula for calculating the TVM based in the above variables is;
FV = PV x [ 1 + (i / n) ] (n x t)
b) Discounting VS Compounding process
Discounting:
Discounting is the indirect assessment of the present value of a sum of money to be
received in future. It can also be used to assess the amount to be invested in present so as
to receive certain amount at a later date. The concept is futuristic and helps to make

decisions for future by determining the value of sum receivable or current value of sum to
be invested (Keythman 2015)
A denomination of money is worth more as of today than at a specified future
date or even tomorrow. Discounting helps in ascertaining the worth of future cash flows
in the present date and gives a clear idea whether or not the target is going to be achieved.
Another use of the process of discounting is that it helps in the valuation of financial
assets. For example, the current value of a bond is the present value and the value of the
same bond in some future date is the future value. The net present value is determined by
finding out the difference between the two values using a discounting rate.
Compounding:
Process of compounding presents a stark contrast to the process of discounting. This is a
direct concept of the time value of money. It helps in determining the future value of the
current investment i.e. to say the potential amount that will be received in a future date if
we invest today. Also it can be used for the purpose of calculating the payments to be
made at a future date for an existing loan or a loan to be taken.
Unlike discounting here we know the present value of money and the future value
is to be ascertained. Compounding occurs when the earnings to an asset in the form of
interest or capital gains are invested again. The result will be additional earnings in the
form of compound interest on the reinvested amount and the original amount.
Discounting over compounding:
Discounting is the most favored process in the concept of TVM for the purpose of
financial decision making because it gives an overview on the current value of money
considering all the factors that can come to play in future. It is a comprehensive method
of calculating the worth of an asset which considers the inflation, interest rates,
depreciation for depreciable assets and taxes. It provides better insights into the present
so as to make informed decisions for the future (Sanders 2017)It is wise to use
discounting in place of compounding since decisions are made as per the targets to be
achieved and the target in the form of future value is known in the discounting process
and the current course of action can be decided in the form of a present value (Surbhi
2015)

c) Discount rate and its components
The discount rate is the rate of return used to calculate the present value of the future cash
flows in the discounted cash flow analysis. The rate of discounting considers two
elements for calculation of an appropriate discount rate; one is the risk free rate and the
other being the risk premium. Risk free rate means the receipt that has no chance of
default like the rate of return in the government securities. So to construct a suitable rate
for discounting, risk free rate is often extracted from the rate of return of the government
securities (Dalfard 2016) The risk premium, however, is the risk that the business is
exposed to during its operation. The risk factor could differ as per the instrument of
investment as it is mentioned earlier that each investment has a unique risk element
attached to it. While calculating the premium inflation is often considered as a part of
risk. The risk premium is calculated upon consideration of the following factors
 Size of the company
 Industry specific risk element
 Inflation attribute
 Company specific risk element.
The formula for calculating the discount rate is:
d) Use of different rates for different investment decisions:
It is important to use different rates for different investments because every investment is
exposed to unique risk factor(s) and they will have different returns. For a specific
investment the risk and return associated with that particular investment must be
considered to make the correct decisions otherwise if an incorrect rate is used the
decisions will automatically be incorrect. For example, an equity investment must
consider the risk premium of the company and industry from which the equity is to be
bought and the rate meant for any other company cannot be used to make an informed
decision. One decision affects the series of operations and other decisions as well, so for
everything to fall in a line it is important to use the relevant discount rate.

e) TVM in valuation of financial instruments
Financial instruments such as bonds, equity and preference shares are the most common
forms of investment. To find the worth of each financial instrument and deciding the
most beneficial course of action before investing into any of them the concept of TVM is
very helpful. This is in reference to a household investor (Larson 2015)
The valuation of an instrument is a very crucial decision for any company. TVM
can help find the valuation or pricing to be fixed for the instrument in question. The
pricing is decided based on the factors like taxes, interest, scrap value, repairs and other
cash flows. Financial instruments are carried at fair value and the fair value is nothing
else but the time value of the investment on the financial instrument. The yield of an
instrument is calculated based on the market scenario and assumptions for the future and
that yield is then used to calculate the present value.
f) Capital budgeting decisions and TVM
TVM can help in finding out whether an investment will yield positive or negative result.
The concept is technical but worth the complication and it can be done in the spreadsheet.
The business unit wishes to forecast the viability of an investment in a project, expansion
or buying an asset. An investment made now will fetch returns after a few years. Time
value concept will accurately tell the worth of the investment in terms of the present
value for helping the business unit decide on whether or not to invest in the project. For
making capital budgeting decisions the company calculates the cash flows in the form of
inflows and the outflows. Then the net cash flow is discounted to estimate the current
worth of a future project in the form of the net present value thus found. It can be
represented in a formula as under (Merittt 2015)
NPV = C x {(1 - (1 + R)-T) / R} − Initial Investment (Freedman 2018)
g) Other issues in TVM
The following are the issues when it comes to the use of TVM in financial management
decision making:
 The method of finding the present value involves technicality and expertise. It is
in itself a process to be learned to be applied.