Question

Time value of money

How useful are the PV and FV for the firms? What do you think?

Answer 1

The concept of Time value of money refers to the fact that the value of money received today is different in its value from the money to be received after one year. The money receivable after one year is less in value than the money received today. If it is received today it can be reinvested and the value will become more after one year. The preference for current money as against future money is known as time preference for money or Time value of money.

Future value may be defined as the value of the the present amount if it was made at time in future. For example if $ 100 is deposited in bank today, and suppose the interest rate is 10 %, the future value of $100 will be $110.

Present Value may be defined as the value of the money if it is received today. For example PV of $110 receivable after one year at 10 % interest rate is $100.

Future value and present value is useful for a firm in determining the worth of a project. This can be explained with help of below example.

Suppose a project has initial investment of $10,000 and it will provide $12,000 after 4 years. Discount rate is 10 %

If we don't compare the present value of future cash inflow with the present value of outflow, the investment proposal is good one as it will provide $2,000 benefit on $10,000 which is 20 % returns.

But when we take Time value of money into consideration, we get to know the present value of cash inflow is $8196 (12000 / (1 + 0.10)⁴ )

---> ( PV = FV / (1 + r)ⁿ )

So it turns out to be a bad proposal as the present outflow is more the the present value of cash inflow.

Therefore, the firm has to take into consideration the time value of money before taking a decision about a proposal. The future value of cash outflow should be compared with the future value of cash inflow or present value of the cash outflow should be compared with the present value of cash inflow before taking decision about a project.

Hope it clarifies!