Factors Affecting Time Value of Money Notes for the UGC-NET Exam (2024)

The time value of money is stated by two factors such as- opportunity cost and also interest rates. The time value of money refers to the concept that money today is worth more than the same part in the future due to its likely of earning interest. Various financial and economic factors influence how we calculate and assess the time value of money. Concerns about interest rates, inflation, opportunity costs, risk, liquidity and asset horizons all shape the time value principle and how it affects financial decisions involving funds at different points in time.

Factors affecting the time value of money are very vital to be studied for the UGC-NET Commerce Examination.

In this article, the learners will be able to find out in detail about the factors affecting the time value of money.

Read about Time Value of Money in Financial Management.

Time Value of Money-Meaning

The time value of money refers to the idea that a dollar today is worth more than a dollar in the future due to its likelihood to earn interest. It recognizes that money has a greater value when it can be invested and start earning a return sooner rather than later.

The time value principle broods that most people like receiving money now rather than later. The further into the future a charge is made, the less it is worth today after accounting for interest and inflation.

Read about Economic Fiscal Policies.

Factors Affecting Time Value of Money

The factors affecting the time value of money have been stated below.

Interest Rates

Interest rates as a factor affecting the time value of money have been stated below.

• Higher interest rates raise the likely returns that can be made on funded funds. This makes current dollars more useful.
• When interest rates are low, future dollars are ignored less heavily since the opportunity cost of waiting is lower.
• Higher interest rates raise the value of current funds by allowing them to grow faster when invested. This makes money today more useful than the same amount in the future.
• At higher interest rates, $1 invested today will be worth more in the future due to earning higher returns over time. This gives current funds a greater value.
• The longer the period money is invested, the bigger the impact of pilling returns at better interest rates. This makes current funds worth substantially more compared to future amounts.
• When interest rates are low, future cash flows are discounted at a lower rate. This means the difference between present and future values is smaller. So money in the future is discounted less heavily when rates are low.
• In summary, higher rates provide greater likely returns on funded funds via pilling over longer periods. This raises the value of money available today compared to future cash flows.
• Lower interest rates reduce the opportunity cost of waiting to receive future cash amounts. This means the money in the future is discounted at a lower rate and is worth more than current funds.
• Interest rates reflect the likely returns public on investments. Higher rates make current funds more useful since they can earn larger returns through pilling, while lower rates reduce the value of current funds close to future amounts.

Also, read about Inflation Accounting.

Inflation

Inflation as a factor affecting the value of money has been stated below.

• Future dollars will typically buy fewer goods and services due to inflation, which erodes their purchasing power over time.
• Inflation lowers the value of money received in the future, giving current dollars a higher close value.
• Inflation reduces the future purchasing power of money by causing prices to rise over time. This erodes the value of future cash flows, giving current funds a higher relative worth.
• Future dollars will typically buy fewer goods and services due to inflation. So money available today has more purchasing power and is worth more.
• Higher inflation rates mean prices will rise more quickly, further devaluing future cash amounts. This makes current funds preferable since their purchasing power remains stable.
• With 2% inflation, $100 today will only be worth around $95 in purchasing power after 5 years. But at 4% inflation, that same $100 loses about $10 of value, dropping to around $90 after 5 years.
• Over longer periods, the cumulative impact of inflation significantly reduces the worth of future cash flows. This enhances the value of having funds available for spending or investing today.
• Inflation reduces the real value (after accounting for purchasing power) of money received in the future. This gives current dollars a higher relative value.
• Higher expected inflation rates mean larger reductions in the future purchasing power of money. This raises the time value of current funds since their real value remains stable.

Also, read about Macro and micro economic policy.

Opportunity Cost

• The returns that could be earned by investing funds elsewhere convey the opportunity cost of not investing now.
• The higher the likely returns that are forgone, the greater the time value of having funds available for investment today.
• The returns that could be earned by investing funds elsewhere represent the opportunity cost of not investing them now.
• When higher returns are available from alternative investments, the opportunity cost of delaying investment is greater. This raises the value of current funds.
• For example, if you could earn 8% investing now but will only earn 3% in the future, you are giving up 5% returns by waiting. This large opportunity cost makes current funds more useful.
• Lower likely returns in the future mean a lower opportunity cost from delaying investment. This reduces the value of current funds close to future cash flows.
• The longer the period, the bigger the impact of forgone returns on the value of current funds. Even a small difference in returns can make a large difference in total returns over longer periods due to pilling.
• In outline, the opportunity cost associated with not investing funds immediately represents the returns offered by delaying investment.
• The higher the likely returns are, the less useful future cash flows are close to current funds. This is because current funds could start earning a return right away.
• Opportunity cost is one factor that contributes to the higher value of money available today rather than in the future. It reflects the returns that could be generated from investing current funds.

Read about Economic Monetary Policies.

Risk and Return

• Higher expected returns account for the risk of investing funds and impact how useful those funds are at different times.
• Riskier investments tend to have a higher time value of money due to their prospect for greater returns.
• Riskier investments offer higher likely returns to compensate for a greater chance of loss. These higher expected returns raise the time value of investing funds now.
• Why? Because investments with higher returns likely allow current funds to grow faster via pilling over time. This makes money today worth more than the same amount in the future.
• For example, an investment with 8% expected returns has a higher time value than one with 4% returns, taking both carry similar risks.
• The larger likely gains from investing in assets with higher risk and reward today raise the opportunity cost of slowing investment. This makes current funds more useful close to future cash flows.
• Over longer periods, even small disparities in expected returns between investments can restate into greatly extra total returns due to pilling up. This magnifies the impact of risk and returns on the time value of money.
• Higher returns that pay for greater investment risk reflect the added value caused by giving capital to its most productive uses. This further raises the worth of funds open now versus those received in the future.
• In summary, risk and return reviews form part of the opportunity cost of delaying an investment. They reflect the greater likely gains from giving capital today rather than in the future.

Understand about Budgetary control.

Liquidity

• More liquid assets can be more quickly invested or converted to cash, earning a return sooner.
• This provides more value from pilling over time, increasing the dollar value of liquid assets today.
• More liquid assets can be invested or altered into cash more quickly, allowing funds to start earning a return sooner. This provides additional value from pilling over time.
• Why? Pilling the smaller initial returns caused by investing liquid funds will make a bigger contrast to total returns over a longer period.
• For example, $100 invested for 5 years at 8% will earn $54 in returns. But slowing investment by just 3 months will reduce total returns by around $5.
• Illiquid assets that cannot be quickly invested have a lower time value since they cannot yield returns for some time. Their value rises only after they evolve liquid.
• The longer the period an illiquid asset cannot be funded, the larger the impact on its time value close to liquid assets. Compounding returns over this holding period cannot be made.
• Even a small contrast in the lengths of time that liquid versus illiquid funds can be invested has a magnified effect on total returns earned over longer investment horizons due to pilling.
• In summary, liquid assets have a higher time value as they can immediately be put to effective use and start generating returns. Illiquid assets have lower value since they cannot earn returns after purchase or maturity.
• The stability and predictability of cash flows from liquid assets also gives them a higher worth since returns can be well counted and earned sooner.

Read about Human Resource Accounting.

Time Horizon

• The longer the period, the greater the likely effect of compounding interest.
• Compounding gives current dollars a higher equal value reached to future dollars.
• Shorter time frames have less of an effect due to fewer compounding years.
• The longer the time horizon over which funds can be invested, the greater the likely impact of compounding returns on their total value.
• Why? Because compounding the smaller initial returns forged over longer periods can make a big contrast in total returns earned. Even a small disparity in rates can magnify due to compounding.
• For example, $100 earning 8% yearly for 5 years totals $162. But earning the same rate for 10 years compounds the value to $260 - $98 more due to the extra 5 years of returns compounding.
• The impact of compounding returns over longer time horizons greatly raises the total worth of funds known for asset now compared to the same amount in the future.
• Shorter time frames have a less scenic impact on the total returns that can be forged and the time value of money. Even with higher interest rates, shorter Buy horizons yield less extra value for current funds.
• For example, investing $100 for just 1 year at 8% yields only an $8 return. Over 5 or 10 years, the impact of compounding that 8% return creates higher total returns.
• In outline, longer time horizons allow compounding returns to forge higher total returns over time. This magnifies the value of investing funds directly versus waiting investment into the future.
• The likely impact of compounding is a key factor donating to the higher worth of money available today as fought to the same cash flows obtained at later points in time.

Conclusion

Many concerns shape the time value of money principle and how it impacts financial decisions affecting cash flows at different times. Factors related to interest rates, inflation, opportunity costs, risk and return, liquidity and investment horizons all donate to the higher value placed on receiving funds now versus later. Higher likely returns, greater inflation risk, larger opportunity costs, shorter holding periods and greater liquidity give current dollars a relative benefit that makes them worth more than an equal amount in the future.

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