TIME VALUE OF MONEY

There is an adage that says that a bird in hand is worth more than twice in the bush. That seem to be the reality here whenever the issue of time value of money comes up. This concept is very clear around the way time determine all things, not only things that are monetized but even abstract things like knowledge for example. The concept of time value of money has been able to stand the test of time and economic analyst has used this concept in their work and their prediction of economic indices.

What then is this concept of time value of money. Put it simply, it means that a unit of money today is worth more than the same unit in the future. When analyst do a forecast, they tend to do this forecast into the future and a better way to report their result in the present terms is to find a way to bring those cashflow projected into the future to present day reality. This means that the projected cashflow must be “discounted” to the present to arrive at the “present value”.

The present value of future cashflow is the amount of future worth in today’s value. This means that we are looking at the future amount in terms of today’s value and that is the time value of money. You may then be wondering where the time comes from? Two factors play a very significant role in the time value of money. Those factors are the time and the discount or what some people refer to as the interest rate. These factors are very important as they act in the same magnitude on the cashflow. The longer the time of the future cashflow into the future, the lower the present value will be and vice versa. With the discount rate, the larger the discount rate, the lower the associated present value.

Present value is a very important consideration that an analyst must consider especially in valuing investment that are into the future. The fact that these investments are into the future, analyst must be able to find the monetary value impact and report that the in the present day. The interplay of discount rate and time on the future cashflow will then enable us to be able to report the future cashflow in its “discounted state”.

The discounted amount basically take into consideration the risk inherent in holding cash. The value of cash is determined by what that cash can afford. Therefore, a future amount is of less value than the current cash held and the further into the future the less valuable the future amount will be. The time value of money can then be conclusively defined as the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim. Being a core finance concept, a sum of money in the hand has greater value than the same sum to be paid in the future.

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