Question

what the meaning of "time value of money". Why it is important financial concept? How to apply it to a financial decision. Tell some pros and cons of payback analysis(break even point) ROI, and net value (NPV) and give an example how these might be used to evaluate competing business project proposals?

Answer 1

Time value of Money =

The time value of money means that, ''worth of a rupee received today is different from the worth of a rupee to be received in future''. The preference for money now,as compared to future money,is known as time preference of money.

Important in financial concept

• Risk : There is uncesrtainty about the receipt of money in future.Hence present money is preffered.
• Preference for present consumption: Most persons / companies prefer present consumption than future consumption than future consumption e.g. due to urgency of need (say,consumer durable) or otherwise
• Investment opportunities : Present Money is preferred due to availability of investment opportunities for earning additional cash flow e,g 1000 in hand earns interest at the bank rate.
• Inflation : Due to inflation there is general rise in price therefore future money has less purchasing power,hence present money is preffered.

Methods of apply / analysis : The concept of time of money helps in arriving at the comparable value of the different rupee amount arising at different points of time into equivalent values of a particular point of time (present or future).This can be done by either:

• Compounding the pre out future value sent monet to a future date.i.e findind out Future value of present money;or
• Discounting future money to the present data.i.e finding out present value of future money.

Payback analysis

Payback period referes to the period in which the project will generate ther necessary cash to recoup the initial investment.

Payback period = initial investment / Annual cash inflow

Pros / advantages

1. This method is simple to understand and easy to operate.
2. it clarifies the concept of profit or surplus,surplus arises only of the initial investment is fully recobered.hence,there is no profit on any project unless the payback period is over.
3. When funds are limited,projects having shorter payback periods should be selected,since obsolescene is very high and hence only those projects which have a shorter payback period should periods should be financed.

Cons / Disadvantages :

1. It stresses on capital recovery rather than profitab.
2. This method become an inadequate measures of evaluating two projects where the cash inflow are uneven.There may be projects with heavy initial inflows and very less infloe in later years,Other projects with moderately but uniform CFAT may be rejected because of longer payback.
3. This method ignores the time value of money.cash flow occurring at all points of time are treated equally.this goes against the basic principle of financial analysis which stipulates compoundind or discounting of cash flow when they arises at different points of time.