TIME VALUE OF MONEY

Businesses invest in the current opportunities in return for future cash flows.However, cash flows are worth more today than they could be in the future.This concept of giving preference to present instead of future is known as Time Value of Money.Now, the question arises, why is money worth more now to a business than in the future?Cash tied up in investments  is a cost to  a business because of the given factors:

*The business could have earned interest on the money if the money was kept in a bank account.
*The business will be paying interest if it has to borrow the money   for the investment..
*Inflation erodes the value of future cash flows compared to their current value.\
*The business could have potentially earned higher returns from alternative investment opportunities.
*Until the cash from the investment is actually received there is a risk that it may not  be received, or less may be  received than expected.

This cost is known as the “cost of capital”.A good starting point to put a value on this cost is the level of return required by a business”s investors, such as banks or shareholders.
Let’s say the cost of capital (or return required by investors) is 10% per year. this means that Rs 100 invested now should generate at least Rs 10 a year and be worth Rs 110 in a year’s time, to satisfy investors.Looking at this another way, if the cost of capital is 10%, receiving Rs 110 in a year’s time is equivalent to receiving Rs 100 now, in monetary terms.Accounting for the time value of money means essentially discounting future cash flows back to their   equivalent present value i.e. what they are worth now versus future.

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