The value of Indian rupee does
not remain same always. The money available presently is worth more than the same
money in future since it has potential to earn returns. Here are the options
Receiving Rs.100 now
Receiving 100 after one month
All investors would prefer to
cashflow received now versus wait for a month though the amount to be received
has the same value. This is due to following reasons.
Instinctive preference for
current consumption over future consumption
Ability to invest Rs.100 for a
month in a bank account or deposit and earn a return so that it grows in value
to more than Rs.100 after one month
Cleary Rs.100 available now is inequivalent
to Rs.100 received after a month. The value associated with same sum of money
received at various points on the timeline is called the time value of money.
The time value of money received in earlier periods as compared to that
received in later time periods will be higher.
In financial markets, the time
value of money is always considered. It is thought that if an investment
provides a series of cash flows, they can be reinvested to earn a positive
return. Alternatively, an investment that does not have intermediate cash
flows, is assumed to grow at an annual rate each year, to be compounded every
year to reach the final value.
Time value is the excess price a
buyer of an option is ready to pay over and above intrinsic value of that
option.
Courtesy – NISM