Question

What is the time value of money concept and why is it important to consider when making decisions about capital budgeting?

Answer 1

Time value of money concept - this concept indicates that the money we received today have more value than if we receive it in future. This is due to the earning capacity of money in form of interest on deposites, dividends on investment etc.
For example - we gets $1000 today, we deposited it in bank at the interest of 10% for one year, then after one year we gets $100 as interest and total money on that date is $1,100. which means money have earning capacity so money received earlier have more value than later in future.

Why Time value of money concept important to consider when making decisions about capital budgeting -

In Capital budgeting management have to decide the acceptance of projects, for this management have to consider the profitability of the different proposed projects. For this NPV, IRR etc techniques are used to consider the profitability of different projects. NPV, IRR etc are depend on the Time value of money concept.

In Net Present Value (NPV), Internal Rate of Return (IRR) etc Capital Budgeting techniques , as per Time value of money concept, we calculate Present value of Cash inflows and cash outflows and compare them to know the accptability of the projects.

So Time value of money concept is very much important to consider when making decisions about capital budgeting.