What Is the Time Value of Money (TVM)?

‘A bird in hand is worth two in the bush’ – this adage applies to financial
transactions too. Say, someone borrowed a certain amount from you and it is due.
Just as you are expecting the money to be credited to your account, you get a call
from the borrower saying that he will pay you after 3 months. You are not happy
about this. This is because you are aware of time value of money or TVM, albeit
subconsciously.
The time value of money (TVM) is the concept that money available at the
present time is worth more than the identical sum in the future due to its
potential earning capacity. This core principle of finance holds that, provided
money can earn interest, any amount of money is worth more the sooner it is
received. TVM is also sometimes referred to as present discounted value.
The time value of money draws from the idea that rational investors prefer to
receive money today rather than the same amount of money in the future because
of money's potential to grow in value over a given period of time. For example,
money deposited into a savings account earns a certain interest rate and is
therefore said to be compounding in value.
There is no reason for any rational person to delay taking an amount owed to him
or her. More than financial principles, this is basic instinct. The money you have
in hand at the moment is worth more than the same amount you ‘may’ get in
future. One reason for this is inflation and another is possible earning capacity.
The fundamental code of finance maintains that, given money can generate
interest, the value of a certain sum is more if you receive it sooner. This is why it
is called as the present value.
Basically, the time value of money validates that it is more beneficial to have
cash now than later. Say, if you invest a Rs. 100 today – the returns will be more
compared to the same investment made 2 months from now. Moreover, there is
always a risk that the borrower might delay even more or not pay at all in the
future.

Further illustrating the rational investor's preference, assume you have the
option to choose between receiving Rs.10,000 now versus Rs.10,000 in two
years. It's reasonable to assume most people would choose the first option.
Despite the equal value at time of disbursement, receiving the Rs.10,000 today
has more value and utility to the beneficiary than receiving it in the future due to
the opportunity costs associated with the wait. Such opportunity costs could
include the potential gain on interest were that money received today and held in
a savings account for two years.
Future is uncertain. As an individual is not very certain about future cash
receipts, he prefers receiving cash now. What is available at present is preferable
to what may be available in the future. The more distant the future is, the more
uncertain it is likely to be. Most people have subjective preference for present
consumption over future consumption of goods and services because of risk of
not being in a position to enjoy future consumption that may be caused by illness
or death. The main reason for time preference for money is to be found in
reinvestment opportunities for the funds which are received early. The funds
received earlier can earn a rate of return, which would not be possible if they are
received at a later date. The time value of money is therefore generally expressed
in terms of a rate of return or more popularly as a discount rate.
 Compounding Technique

The time preference for money encourages a person to receive the money at
present instead of waiting for future. But he may like to wait if he is duly
compensated for the waiting time by way of ensuring more money in future. For
example, a person being offered Rs.1000 today may wait for a year if he is
ensured of Rs.1100 at the end of one year, taking his preference for an interest
rate of 10 % per annum. The cash flow of Rs. 1000 at present or Rs. 1100 after
one year will be the same for this person.

We have only considered the future value after one period. But we may need to
calculate future values over longer periods. For example, what will be the value
of Rs.100 after two years at 10% per annum rate of interest if neither the
principal sum of Rs.100 nor interest is withdrawn at the end of one year?? The
answer to this question lies in understanding that the second year’s interest will
be paid on both original principal and the interest earned at the end of first year.
This paying of interest on interest is called compounding.
In simple words, when interest is paid on principal amount only, it is known as
simple interest, but when interest is paid on aggregate amount, i.e. principal
amount plus the amount of interest, it is known as compound interest.
Compounding is the method used in finding out the future value of the present
investment. The future value can be computed by applying the compound interest
formula which is as under:
Where n = number of years
R = Rate of return on investment.

Discounting Technique

Suppose a person wants to invest Rs.1000 for one year at 10% per annum. Here,
he will get interest of Rs.100 and principal of Rs.1000 at the end of first year. So,
here the aggregate amount is Rs. 1100. If, Rs.1000 is given at present and Rs.
1100 at the end of one year the value of both will be the same. It can be said that
Rs. 1100 received at the end of first year is equivalent to Rs.1000 received today.
It means Rs. 1000 is the present value of Rs.1100 to be received at the end of the
year at 10 % discount.

In discounting technique, the amount of future cash flows is translated into their
present values. The present value of future cash flows is translated into their
present values. The present value of a future cash flow is the amount of current
cash that that is equivalent value to the decision maker. In discounting approach,
money is received at some future date and will be worth less because the interest
for the period is lost.

Discounting is the process of converting the future amount into its Present Value.
Now you may wonder what is the present value? The current value of the given
future value is known as Present Value. The discounting technique helps to
ascertain the present value of future cash flows by applying a discount rate. The
following formula is used to know the present value of a future sum:

Where 1,2,3,…..n represents future years

FV = Cash flows generated in different years,
R = Discount Rate
For calculating the present value of single cash flow and annuity the following
formula should be used:

Where R = Discount Rate

n = number of years
You can also use discount factor to arrive at the present value of a future amount
by simply multiplying the factor with the future value. For this purpose, you need
to refer the present value table.
 Conclusion
Compounding and Discounting are simply opposite to each other. Compounding
converts the present value into future value and discounting converts the future
value into present value. So, we can say that if we reverse compounding it will
become discounting. Compounding Factor table and Discounting Factor table is
taken into consideration for the quick calculation of the two. In the table, you
will find the factors, concerning different rates and periods. The factor is directly
multiplied by the amount to arrive the present or future value.
 What is Capital budgeting?
Capital budgeting is the process of making investment decisions in capital
expenditures. A capital expenditure may be defined as an expenditure the
benefits of which are expected to be received over period of time exceeding one
year.
The main characteristic of a capital expenditure is that the expenditure is incurred
at one point of time whereas benefits of the expenditure are realized at different
points of time in future. In simple language we may say that a capital expenditure
is an expenditure incurred for acquiring or improving the fixed assets, the
benefits of which are expected to be received over a number of years in future.
Charles T. Horngreen has defined capital budgeting as, “Capital budgeting is
long term planning for making and financing proposed capital outlays.”

According to G.C. Philippatos, “Capital budgeting is concerned with the

allocation of the firm’s scarce financial resources among the available market
opportunities. The consideration of investment opportunities involves the
comparison of the expected future streams of earnings from a project with the
immediate and subsequent streams of earning from a project, with the immediate
and subsequent streams of expenditures for it”.

Richard and Greenlaw have referred to capital budgeting as acquiring inputs

with long-run return.
In the words of Lynch, “Capital budgeting consists in planning development of
available capital for the purpose of maximizing the long term profitability of the
concern.”
Capital budgeting is a process of evaluating investments and huge expenses in
order to obtain the best returns on investment.
An organization is often faced with the challenges of selecting between two
projects/investments or the buy vs replace decision. Ideally, an organization
would like to invest in all profitable projects but due to the limitation on the
availability of capital an organization has to choose between different
projects/investments.
Capital budgeting is a predominant function of management. Right decisions
taken can lead the business to great heights. However, a single wrong decision
can inch the business closer to shut down due to the number of funds involved
and the tenure of these projects.
The following are some of the examples of capital expenditure:
(1) Cost of acquisition of permanent assets as land and building, plant and
machinery, goodwill, etc.
(2) Cost of addition, expansion, improvement or alteration in the fixed assets.
(3) Cost of replacement of permanent assets.
(4) Research and development project cost, etc.

Capital expenditure involves non-flexible long-term commitment of funds. Thus,

capital expenditure decisions are also called as long term investment decisions.
Capital budgeting involves the planning and control of capital expenditure. It is
the process of deciding whether or not to commit resources to a particular long
term project whose benefits are to be realized over a period of time, longer than
one year. Capital budgeting is also known as Investment Decision Making,
Capital Expenditure Decisions, Planning Capital Expenditure and Analysis of
Capital Expenditure.
Objectives of Capital budgeting
Capital expenditures are huge and have a long-term effect. Therefore, while
performing a capital budgeting analysis an organization must keep the following
objectives in mind:
1. Selecting profitable projects
An organization comes across various profitable projects frequently. But due to
capital restrictions, an organization needs to select the right mix of profitable
projects that will increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main objective of capital
budgeting. However, controlling capital costs is also an important objective.
Forecasting capital expenditure requirements and budgeting for it, and ensuring
no investment opportunities are lost is the crux of budgeting.
3. Finding the right sources for funds
Determining the quantum of funds and the sources for procuring them is another
important objective of capital budgeting. Finding the balance between the cost of
borrowing and returns on investment is an important goal of Capital Budgeting.
 Capital Budgeting Process
The process of capital budgeting is as follows:

1. Identifying investment opportunities

An organization needs to first identify an investment opportunity. An investment
opportunity can be anything from a new business line to product expansion to
purchasing a new asset. For example, a company finds two new products that
they can add to their product line.
2. Evaluating investment proposals
Once an investment opportunity has been recognized an organization needs to
evaluate its options for investment. That is to say, once it is decided that new
product/products should be added to the product line, the next step would be
deciding on how to acquire these products. There might be multiple ways of
acquiring them. Some of these products could be:
Manufactured In-house
Manufactured by Outsourcing manufacturing the process, or
Purchased from the market
3. Choosing a profitable investment
Once the investment opportunities are identified and all proposals are evaluated
an organization needs to decide the most profitable investment and select it.
While selecting a particular project an organization may have to use the
technique of capital rationing to rank the projects as per returns and select the
best option available.
In our example, the company here has to decide what is more profitable for them.
Manufacturing or purchasing one or both of the products or scrapping the idea of
acquiring both.
4. Capital Budgeting and Apportionment
After the project is selected an organization needs to fund this project. To fund
the project it needs to identify the sources of funds and allocate it accordingly.
The sources of these funds could be reserves, investments, loans or any other
available channel.
5. Performance Review
The last step in the process of capital budgeting is reviewing the investment.
Initially, the organization had selected a particular investment for a predicted
return. So now, they will compare the investments expected performance to the
actual performance.
Importance of capital budgeting
(1) Large Investments:
Capital budgeting decisions, generally, involve large investment of funds. But the
funds available with the firm are always limited and the demand for funds far
exceeds the resources. Hence, it is very important for a firm to plan and control
its capital expenditure.
(2) Long-term Commitment of Funds:
Capital expenditure involves not only large amount of funds but also funds for
long-term or more or less on permanent basis. The long-term commitment of
funds increases the financial risk involved in the investment decision. Greater the
risk involved, greater is the need for careful planning of capital expenditure, i.e.
Capital budgeting.
(3) Irreversible Nature:
The capital expenditure decisions are of irreversible nature. Once the decision for
acquiring a permanent asset is taken, it becomes very difficult to dispose of these
assets without incurring heavy losses.
(4) Long-Term Effect on Profitability:
Capital budgeting decisions have a long-term and significant effect on the
profitability of a concern. Not only the present earnings of the firm are affected
by the investments in capital assets but also the future growth and profitability of
the firm depends upon the investment decision taken today. An unwise decision
may prove disastrous and fatal to the very existence of the concern. Capital
budgeting is of utmost importance to avoid over investment or under investment
in fixed assets.
(5) Difficulties of Investment Decisions:
The long term investment decisions are difficult to be taken because:
(i) Decision extends to a series of years beyond the current accounting period,
(ii) Uncertainties of future and
(iii) Higher degree of risk.
(6) National Importance:
Investment decision though taken by individual concern is of national importance
because it determines employment, economic activities and economic growth.
Thus, we may say that without using capital budgeting techniques a firm may
involve itself in a losing project. Proper timing of purchase, replacement,
expansion and alternation of assets is essential.

Limitations of Capital Budgeting

Capital budgeting techniques suffer from the following limitations:

(1) All the techniques of capital budgeting presume that various investment
proposals under consideration are mutually exclusive which may not practically
be true in some particular circumstances.
(2) The techniques of capital budgeting require estimation of future cash inflows
and outflows. The future is always uncertain and the data collected for future
may not be exact. Obliviously the results based upon wrong data may not be
good.
(3) There are certain factors like morale of the employees, goodwill of the firm,
etc., which cannot be correctly quantified but which otherwise substantially
influence the capital decision.
(4) Urgency is another limitation in the evaluation of capital investment
decisions.
(5) Uncertainty and risk pose the biggest limitation to the techniques of capital
budgeting.
Capital Budgeting Techniques
To assist the organization in selecting the best investment there are various
techniques available based on the comparison of cash inflows and outflows.
These techniques are:
1. Payback period method
In this technique, the entity calculates the time period required to earn the initial
investment of the project or investment. The project or investment with the
shortest duration is opted for.
2. Net Present value
The net present value is calculated by taking the difference between the present
value of cash inflows and the present value of cash outflows over a period of
time. The investment with a positive NPV will be considered. In case there are
multiple projects, the project with a higher NPV is more likely to be selected.
3. Accounting Rate of Return
In this technique, the total net income of the investment is divided by the initial
or average investment to derive at the most profitable investment.
4. Internal Rate of Return (IRR)
For NPV computation a discount rate is used. IRR is the rate at which the NPV
becomes zero. The project with higher IRR is usually selected.
5. Profitability Index
Profitability Index is the ratio of the present value of future cash flows of the
project to the initial investment required for the project.
Each technique comes with inherent advantages and disadvantages. An
organization needs to use the best-suited technique to assist it in budgeting. It
can also select different techniques and compare the results to derive at the best
profitable projects.