Organizations and individuals usually prefer to receive money on an earlier date than receiving an equal sum on a later date. It is considered that the value of money goes through erosions with passing periods of time. That is why organizations try to receive payments as soon as possible.
Note − Organizations seek to receive payments now than in the future if the amount is the same.
Time Value of Money refers to this philosophy and considers the value of money received now to be superior to the same amount of money on a later date. It is based on three factors −
Risk − There is a risk associated with the passing periods to get the same amount of goods with the same amount of money in the future.
Preference for consumption − Consumption in the present is worth more value if it is done on a future date.
Investment opportunities − The money received earlier can be invested and returns could be generated from it. The later we get the money, the more loss we will incur in terms of interests earned.
Referring to Investment opportunities, a person would like to receive Rs 100 today in contrast to receiving it one year later. If the interest is 5% in investment, the value of the money would be Rs 105 after one year. So, the person would seek to obtain the money now rather than a year later.That is not all, both risks and consumption are also in favor of the current receipt than receiving the same amount of money later.
Note − Risk, consumption, and investments lead us to rely more on the time value of money.
Organizations' interest in time value for money lies simply in the investment opportunities. Although there is uncertainty whether investments would fetch extra profits, corporates usually rely on funds paid by clients for expenses of various nature. This dependability of cash inspires the corporate to prefer the time value of money more than a deferred payment. The uncertainties can be handled by some statistical tools as well as via a decision tree.
It is usually known to all that although returns from investment are not guaranteed, still everyone tends to believe in the time value of money. It is also more relevant to bigger organizations than the smaller ones.
Note − The time value of money is related to corporate goals in terms of investments and returns more than anything else.