Question

We have learned three rules of time values, and established various formula to evaluate different cash streams. Someone may argue that all these formulas are unreliable because it assumes a lot, and many other factors influence its computation. Do you agree or disagree? If you agree, which factors may affect (or break) the formula, and why? If you disagree, why not? Please specify your opinion, some factors, and reasons clearly.

Answer 1

I agree with the statement because of the following points

Selecting a Discount Rate

How does an investor know which discount rate to use? Accurately pegging a percentage number to an investment to represent its risk premium is not an exact science. If the investment is safe with a low risk of loss, 5% may be a reasonable discount rate to use but what if the investment harbors enough risk to warrant a 10% discount rate? Because time value calculations require the selection of a discount rate, they can be unreliable if the wrong rate is selected.

Determining Cost of Capital and Cash Flows

The cost of capital is the rate of return required that makes an investment worthwhile. It helps determine whether the return on an investment is worth the risk. When a company decides on whether or not to make an investment, it has to set an appropriate cost of capital. If it aims too high then it may determine an investment is not worth the risk and have a missed opportunity. Conversely, if the cost of capital is too low, it may be making investment decisions that are not worthwhile.

Investment Size

A higher time value doesn't necessarily mean a better investment. If there are two investments or projects up for decision, and one project is larger in scale, the NPV will be higher for that project as NPV is reported in dollars and a larger outlay will result in a larger number. It's important to assess the returns from an investment in percentage terms to get an accurate picture of which investment provides a better return.

Additional Costs

Time valuei islimited in that it only takes into consideration the cash flows of a project. It fails to include other critical costs that can have an impact on the true value of the investment. These costs include opportunity costs and any other costs not included in the preliminary outlay of capital.