Question

Q#5) a) A Dollar Today Is Worth More Than A Dollar Tomorrow. Elucidate

b) Why is Present Value considered an Opportunity Cost?

c) Are these mutually exclusive or independent projects? i) Deciding between repairing a machine or replacing it and ii) Deciding which market to enter next.

Answer 1

Q5a A dollar today is worth more than a dollar tomorrow

You have $1 then what can you do with it ? You can either spend $1 today or save $1 for tomorrow.

Situation 1 - You have spend $1 in purchasing 15 chocolates.

Situation 2 - You have saved $1 to purchase chocolates in future.

After a month, You want to use $1 to purchase chocolates but now you can get only 12 chocolates for $1.

Over time, on average, things get more expensive due to inflation. Inflation is real and is eating the value of our money. Money has a time value because it can be invested to make more money. To increase the value of your money, make investments. The present value of money differs from its future value because of inflation.

Thus a dollar received in future has lesser value than a dollar received today. In other words, a dollar today is worth more than a dollar tomorrow.

Q5b

Opportunity cost is the cost of next best alternative.

Example : You have two options - to spend $1 or to invest $1 in savings account with 5% interest rate.

Here if you choose to spend $1 then the opportunity cost will be the interest income lost on deposits.

How to calculate present value?

It is calculated by discounting the future series of income (cash flows).

The discounting rate is the minimum rate of return ,i.e, the rate of return of the next best alternative. (say 5%)

The present value in the example will be discounting the interest income to be received in future with 5% discounting rate. The answer will be $1.

Thus Present value is considered as opportunity cost.

Q5c

Mutually Exclusive projects - Acceptance of one project rejects the other projects

Independent Projects - Acceptance of one project does not affect cash flows of other project.

i) Deciding between repairing a machine or replacing it

It is mutually exclusive project because either you can repair a machine or replace a machine. It means acceptance of one option leds to the rejection of another.

ii) Deciding which market to enter next.

It is an independent project. Decision regarding next market to enter is an independent decison because the cash flows of other project are not affected by this decision.