Time value of money is a widely used concept in literature of finance. Financial decision models based on finance theories basically deal with maximization of economic welfare of shareholders. The concept of time value of money contributes to this aspect to a greater extent. The significance of the concept of time value of money could be stated as below:
Investment Decision
Investment decision is concerned with the allocation of capital into long-term investment projects. The cash flow from long-term investment occur at different point in time in the future. They are not comparable to each other and against the cost of the project spent at present. To make them comparable, the future cash flows are discounted back to present value.
The concept of time value of money is useful to securities investors. They use valuation models while making investment in securities such as stock and bonds. These security valuation models consider time value of cash flows from securities.
Financing Decision
Financing decision is concerned with designing optimum capital structure and raising funds from least cost sources. The concept of time value of money is equally useful in financing decision, especially when we deal with comparing the cost of different sources of financing. The effective rate of interest of each source of financing is calculated based on time value of money concept. Similarly, in leasing versus buying decision, we calculate the present value of cost of leasing and cost of buying. The present value of costs of two alternatives are compared against each other to decide on appropriate source of financing.
Besides, the concept of time value of money is also used in evaluating proposed credit policies and the firm's efficiency in managing cash collection under current assets management.
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