The concept of Time Value of Money:

“A rupee is now worth full than a rupee to be received after a year” why ?

Do you prefer a 1000 rupees today or a 1000 rupees one year from now? why?

– Consumption forgone has value

– Investment lost has opportunity cost

– Inflation may increase and purchasing power decrease

Now,

Do you prefer a 1000 rupees today or 1100 rupees one year from now? Why?

You will ask yourself one question:

– Do I have any thing better to do with that 1000 rupees than lending it for 100 rupees

extra?

– What if I take 1000 rupees now and invest it, would I make more or less than

1100 rupees in one year?

Note:

Two elements are important in valuation of cash flows:

– What interest rate (opportunity rate, discount rate, required rate of

return) do you want to evaluate the cash flow based on?

– At what time do these the cash flows occur and at what time do you need

to evaluate them?

Example:

What return is needed to double money?

The present value formula can be rearranged to determine what rate of return is

needed to accumulate a given amount from an investment. For example, £100 is invested today and £200 return is

expected in five years; what rate of return (interest rate) does this represent?

The present value formula restated in terms of the interest rate is:

In addition to Time value of Money, let us also discuss, what is Opportunity cost?

Definition:

Opportunity cost is the cost of a foregone alternative. If you chose one alternative over another, then the cost of choosing that alternative is an opportunity cost. Opportunity cost is the benefits you lose by choosing one alternative over another one. The opportunity cost of choosing one investment over another one.

Example:

There is an opportunity cost over choosing an investment in bonds over an investment in stocks.