Time Value of Money – The time value of money is an important consideration in capital budgeting decisions. Whenever a capital project is accepted for investment, it constitutes an outflow of cash. It is compared with the estimated annual cash inflows (net cash benefits) from the project.
Buts it is important to note that a Dollar received immediately is preferable to a Dollar received at some future date. For example, if a project requires US $10000 to be invested. Estimated average annual cash flows from it are US $3,000. Estimated economic life is 5 yrs. Now, it is true that this project will contribute total US $15000 but as a matter of fact US $3,000 of first year are more valuable than the US $3,000 of fifth year.
Hence, the average annual cash flows must be discounted at present value factors. The concept of time value of money is described as the present value of estimated cash benefits from the project. The value of money today is called its present value. The present value of US $1/- that is not available today, but that will be available at some future time will be certainly less than US $1/- How much less, it will depend upon the present value factor.
The discounted cash flow method of capital budgeting takes full care of this fact. One such discounted cash flow technique is called the “net present value method” or sometimes simply the ‘present value method.’ To implement this approach, we simply find the present value of the expected net cashflow of an investment, discounted at the rate of the cost of capital and then subtract from it the initial cost outlay of the project.
By definition, “
The present value of an amount that is expected to be received at a certain time in the future is the amount which if invested today at a designated rate of return would accumulate to the specified amount.
For example, the present value US $100 to be received one year from now at a rate of return of 10% is US $90.91.
The Formula for Time Value of Money
The formula for this calculation is as follows :
Present Value (PV) = 1/(1 + r)n
So, P.V. of US $100 @ 10% after one year will be :
100/(100 + 10)n =100 /110= US $90.91. [Here n=1]
However, this calculation becomes very complicated for a number of years, hence, present value tables can be used for it. They are very valuable aid in such calculations. A present of these tables reveals two fundamental points about present value.
(1) The present value decreases as the number of year in the future in which the payment is to he received increases.
(2) The present value decreases as the rate of return increases.