The act of committing money or capital to an endeavor with the expectation of obtaining an additional income or profit is termed as investing. Investing has become important due to the following reasons:
- Inflation is eating away your returns
- You are going to live longer
- You have a substantial standard of living to maintain
- Your families are getting smaller and nuclear
- Planned expenses
Concept of Time Value
Money has time value. In simpler terms, the value of a certain amount of money today is more valuable than its value tomorrow. It is not because of the uncertainty involved with time but purely on account of timing. The difference in the value of money today and tomorrow is referred to as the time value of money.
Money has time value because of the following reasons:
Risk and Uncertainty
Future is always uncertain and risky. Outflow of cash is in our control as payments to parties are made by us. There is no certainty for future cash inflows. Cash inflows are dependent on our Creditor, Bank etc. As an individual or firm is not certain about future cash receipts, it prefers receiving cash now.
In an inflationary economy, the money received today, has more purchasing power than the money to be received in future. In other words, a rupee today represents a greater real purchasing power than a rupee a year after.
Individuals generally prefer current consumption to future consumption.
An investor can profitably employ a rupee received today, to give him a higher value to be received tomorrow or after a certain period of time. Thus, the fundamental principle behind the concept of time value of money is that, a sum of money received today, is worth more than if the same is received after a certain period of time. For example, if an individual is given an alternative either to receive Rs.10,000 now or after one year, he will prefer Rs. 10,000 now. This is because, today, he may be in a position to purchase more goods with this money than what he is going to get for the same amount after one year.
Thus, the concept of time value of money is a vital consideration in making financial decisions.