Question

Post your thoughts and personal experience with Time Value of Money. expand with further examples of Time Value of Money in a real life. Indicate how this can apply to corporate finance. 

Answer 1

Lets start with what is time value of money, The concept of time value of money states that money available today or at the present moment is worth more than the same amount of money available on a future point of time because of the earning potential of money available at the present moment. What it means is that if you have an option of getting X amount of money today and the same X amount of money in a year, the value of the X amount of money today will be higher than the value of X amount of money in a year because you can invest that money anywhere you want to earn an additional return in the time of a year. This is a very basic concept in the field of finance and I think everyone should have a thorough understanding of this concept because it will help us make better financial decisions.

Lets take a real life example of time value of money.

Suppose you are going to buy a $18,000 car and the dealer gives you two options,

Option A - Pay $16,000 cash and get a $2,000 cash discount

Option B - Purchase the car for $18000 loan for 36 months at a zero percent interest rate with monthly payments.

Market interest rate is 4%. Which option from the two is cheaper?

Now a normal person with no understanding of time value of money can go for the Option B thinking he will be paying $500 a month and it is better than paying $16,000 upfront today. But that is wrong, Option A is cheaper than Option B if we calculate the present value of each payment made in those 36 months.

Why to calculate the present value?

In finance, "the key thing to understand is that you need to compare the costs always at the same point in time".

So, if we calculate the present value of each payment we will find that it is cheaper to pay $16,000 today, than paying $500 each month for 36 months.

How this can apply to corporate finance?

When a company is making an investment decision, they forecast how will the project perform and how much cash flow they can generate if they make that investment. After making all the future cash flow forecasts according to their research, they compare the present value of the future cash inflows the project can generate to the initial investments they are going to make today in the project. This is called calculating the Net Present Value.

If their calculated Present value for the future cash inflows is more than the initial investments required in the project, the net present value will be positive, which means the project will increase the wealth of the company if the investment is made.

This is a very important part of corporate finance and investment decisions and is used by every company before making future investment decisions.