Question

Explain what is meant by the time value of money, and discuss its relevance to the capital budgeting process. View Instructor posts

Answer 1

The concept of time value of money says that a $ received toady is of more worth than $ received after one year. This is because

1) money has capability to earn interest

2) Probability of default ,i.e not paying $ after one year does not arisis

For Example: lets say one is to receive 100$ today and 100$ after one year, interest rate is 10%

Now value of $100 received today will be = 100$ + interest

=100$ +(100 x 10%)

= 100$ + 10$

=110$

Thus $110 is more than value of $100 received after one year

Time value of money plays an important role in capital budgeting. In capital budgeting one need to determine whether a project should be accepted on basis of its cash flow

Time value of money help us to find cash flow at year 0 and helps us to compare it with initial cash flow.

If present vale of future cash inflow is more than initial expenditure than project is selected otherwise it is rejected

Thus Time value of money is important while making capital budgeting decisions