Question

How would you weigh the time value of money? Is there something in your life, financial or otherwise, that you would have paid in advance for a better return later? How much? How long would you be willing to wait for that return? What would be an acceptable return?

Answer 1

From a financial standpoint, the time value of money refers to a comparison of how much value an amount of money has presently vs. its similar value in the future. The importance of the time value of money comes in considering whether a business decision that results in $20,000 in revenue in one year is potentially more favorable than one that results in $21,000 in revenue in five years, for instance.

While $21,000 is greater, you could easily end up with more money by making $20,000 and investing it further over the five years. You would only need a 1 percent or higher annualized return to benefit, which is quite achievable even based simply on putting the money in an ordinary bank account.

2

Another important factor in assessing time value of money is the level of debt you carry. If you have significant, costly debt, it is more advantageous to get money in hand quickly. If you make payments on a 12 percent loan, generating revenue quickly can help you expedite payments on the debt. This reality warrants strong consideration of investments with quick returns.

If you anticipate a 5 percent annualized return on an alternative investment when weighing a long-term option, it makes more sense to take the earlier revenue and pay off the debt. Because of considerations like what debts businesses carry and what types of investments are available to them, time value of money calculations will differ from business to business.

3 Required Rate of return is the minimum acceptable return on investment sought by individuals or companies considering an investment opportunity.

Investors across the world use the required rate of return to calculate the minimum return they would accept on an investment, after taking into consideration all available options. When calculating the required rate of return, investors look at overall market returns, risk-free rate of return, volatility of the stock and overall project cost. The required rate of return drives the type of investments that can be made. For instance, someone requiring a higher rate of return would necessarily have to look at riskier investments. Finance professionals routinely calculate the required rate of return for purchasing new equipment, new product rollouts and potential mergers. For example: an investor who can earn 10 per cent every year by investing in US Bonds, would set a required rate of return of 12 per cent for a riskier investment before considering it.

Formula for Required Rate of Return Required Rate of Return = Risk Free Rate + Risk Co-efficient (Expected Return - Risk free return)