TIME VALUE OF MONEY

Time value of money can be described as the value of a unit of money at different time periods.  It involves that the value of a unit of money is not same at different time periods. That is, the value of a sum of money received today is more compared to the similar sum of money received after some time.  On the other hand, the total amount of money received in future is less in value than it is today. The time value of money is also identifies as time preference of money.  Time preference of money is an individual's favorite for possession of a given amount of money now, rather than the similar amount at some future time. There are three reasons for this behavior. They are - i) Subjective preference for consumption ii) Risk due to the uncertainty of cash flows and iii) Availability of investment opportunities.  The time preference for money is generally expressed in terms of a rate of return or discount rate. The expected rate of return (ROR) as also the time value of money will change from individual to individual depending on his/her perception.  In order to develop meaningful comparison between future cash flows at different time periods, it is essential to convert them to a common point in time.  This is completed through two popular approaches -

i)                    Compounding technique and

ii)                   Discounting technique.