MEANING AND REASONS FOR THE TIME VALUE OF MONEY CONCEPT

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The time value of money is the concept that the value of money today exceeds its value at some point in the future.

The time value of money is an important concept when making financial decisions and it is one of the core principles of finance.

According to the time value of money concept, an investor will favor receiving a lump sum of money now over receiving the same amount in the future because the lump sum received today can be invested and its value will grow over time.

In other words, the time value of money means that the money available at the present time is worth more than the same amount in the future due to its potential earning capacity.

To illustrate, N10,000 today will be worth more than the same N10,000 received in 3 years. 

The reason is that if we invested the N10,000 we received today, interest would have been added to it in three years, increasing its value compared to what it would have been if we received it three years' time.

The time value of money basically states that, because the real or economic value of money decreases over time, it is preferable to receive money now rather than wait for some time in the future.

The time value of money concept is the reason why most individuals value the opportunity to receive money now rather than wait one or more years for the same amount of money.

Reasons for the time value of money concept

1. Inflation: Inflation is a persistent rise in the average prices of goods and services.

Inflation is a common phenomenon in our economic life that make money lose its value over time.

Generally, if the rate of returns of an investment is lesser than the inflation rate, then such an investment will be worthless to the investor.

Because the inflation rate is generally rising, a rational investor would prefer to receive a certain amount of money now than wait to have the same amount of money sometime in the future.

2. Risk or uncertainty: Another common reality in our economic life is risk and uncertainty.

We live in a world of uncertainty, where an individual may not be certain about future cash receipts and as a result, may prefer cash now.

Therefore, such individuals would appreciate the chance of receiving a particular sum of money now rather than wait to receive it at some time in the future, as per the time value of money concept.

3. Investment opportunities:  The idea of time money may also be explained by the investment opportunity that comes with a present sum of money for the holder.

The majority of people prefer present cash to future cash because present cash may be invested in the current investment opportunities that are currently available, whereas future cash cannot be invested in the current investment opportunity because it will be received at a later date.

To illustrate, 10,000 now would be preferred to N10,000 in the future because the N10,000 now can be invested in an investment opportunity that may earn N500 between now and the nearest future.

Therefore, if someone wishes to increase their available cash, the chance to earn, say, N500 on their investment would make them prefer N1,000 now rather than N1,000 in a year's time.

READ ALSO: CALCULATING THE FUTURE VALUE OF A LUMP SUM

4. Preference for consumption: Most consumers subjectively prefer to consume goods and services now rather than in the future.

This might be owing to the pressing nature of one's immediate needs, the danger of not being able to enjoy future consumption due to illness, death, or because of inflation.

People may prefer to obtain money now rather than wait later in the future because money is the means by which they acquire goods and services.

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