Question

Defin breifly time value of money?

Why Is It So Important in Investment Decisions? why is so important in budgeting decision?

explain with details

Answer 1

Solution : The time value of money concept explains that the value of money changes with time. This means that the $ 100 worth today is more than the $ 100 worth tomorrow.This is because of infaltion. if you have invested that $ 100 , you could have earned interest on that $ 100 and the total worth in your hand will increase.So a dollar today will grow to a dollar more than a dollar later.

Capital budgeting or investment decisions refers to decision making process for accepting or rejecting projects.For example if we need to make investment in any one of the three different projects ,which of the investment proposal we are going to consider.The decision is based on time value of money only.  

Suppose you have three proposal :

1. Take 100000 today .

2. Take 200000 after 2 years .

3. Take 300000 after 3 years.

And let us suppose that the interest rate in the market is 10%. Which of the options you want to choose. Definetely you will say that 100000 today. But see selecting 100000 could be a wrong decision. What we have done is compared 100000 value today with the other values which we are going to receive in future. First of all what we have to do is bring all the money value at the same particular point of time. Either we have to bring 200000 and 300000 value in todays period or we have to take the value 100000 and 200000 after 3 years. When all the values we consider at one point of time then only the comparison is possible. This is done only with the help of Time Value of money.

Let us bring all the money value to today's time period and see which of these alternative is having highest worth.

So 100000 will be 100000 only today

200000 value two years from now will be= 200000 /(1+0.1)^2= 165289 today

300000 value three years from now will be = 300000/(1.1)^3 = 225394 today.

So what do you think which is the highest one . Offcourse highest one is 225394. We will be making a proper decision only if we know the time value of money concept. Similary in the capital budgeting lot to techniques are there which will make use of time value of money and help you in selecting the investments which worth is really high. So of the methods involving time value of money concepts are :

1. Net present value : UNder this we need to find out the net worth of an investment in today's period. For example if we investment 100000 today and we are getting 200000 after one year what is value of the investment.

NPV = -100000 + 200000/(1+0.1) = -100000 + 181818.18 =81818.

So the value of investment today is 81818. In the similar way if we are given two investment projects and we have to select any one of them then we need to calculate the NPV of both the projects and consider the investment which will have more NPV.

Some time we may find those projects which will have negative NPV. So we need to consider the investment proposal which is having a positive NPV.

Here also the role of time value of money conceot comes into play.

2. Discounted payback method also use the concept of time valuye of money .

3. Internal rate of return also considers the concept of time value of money.