Example Of Time Value Of Money Essay

Abstract

The time value of money concept is one of the most important in finance. The money in a firm’s possession today is of higher value than the same amount of money received in the future. This is because the money that the firm has today can be invested to earn higher returns in the future. The time value of money analysis principles has multiple applications, ranging from capital investment decisions to setting up loan repayment schedules. This paper attempts to discuss the discounted cash flow analysis, its importance and how it is relevant to financial managers. The paper also analyses the DCF methods of NPV and IRR. In conclusion the rule of 72 which is a based on time value of money concepts is also discussed.
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Discounted cash flow (DCF) is founded on the time value of money principle in finance. DCF has to do with the concepts of risk and time in regards to cash flows. The fundamental principle in the time value of money concept is that the value of a dollar today is greater than the same value received in the future. Discounting cash flows refers to the concept of determining the present value of future cash flows. Discounting cash flow analysis is a technique used in capital budgeting to asses and quantify the cash outflows and inflows from a particular project, activity or business venture. Some of the factors that affect the discount rate to be used include; size of the company, the risk associated with the project, the time horizon, the debt/equity ratio and the income tax considerations.
DCF analysis is an important technique since it enables financial managers to determine what the worth of a project or venture is today based on the future cash flows. Finance managers can use it in cases of determining which project to invest in, which securities to buy. It is a great technique used by companies in making investment decisions. In the DCF analysis it is important to determine the proper discount rate.
According to Hilton, the two primary DCF analysis methods are the internal-rate-of-return (IRR) method and the net-present value (NPV) method. NPV is the difference of the present value of future inflows and the present value of future outflows (Hilton, 1994, pp.157). Whereas, IRR is the discount rate at which NPV=0. Both methods can are used in capital budgeting. However, each has its strengths and weaknesses. The net present value method is used by investors in evaluating the value of securities such as stocks in a company or bonds in the stock market, also in making capital budgeting decisions the NPV method is very important. This method is used to rank projects in cases of capital rationing scenarios. A positive net present value for a given project implies that the firm will increase its value by increasing investing in the project. A negative NPV implies that investing in such a project will decrease the firm’s value. A zero NPV on the other hand, implies that the return from such a project just equals to the shareholder’s required return. The general rule in comparing the projects to invest in is, a project should be undertaken if it has a positive NPV. Projects with negative NPVs should be avoided.
The Rule of 72 is a simple but useful technique used in many financial aspects. It is frequently used to calculate long it would take to double the amount invested. However, it can also be used to assess an investment strategy or in making forecasts about the inflation impact. In this rule the number 72 is taken and divided by the annual desired (or estimated) rate of return. The resulting answer is the approximate duration in years it will to double your money. The rule can also be used for inflation. It works by taking 72 and dividing it by the inflation rate to determine how long it will take for the price of commodities to double. However the rule of 72 has its limitations such as, it gives an estimate not the exact value of the duration it takes to double your money. The rule assumes that the rate of return is constant over time whereas in reality it changes from time to time.
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References

Hilton, Ronald W. Managerial Accounting. New York: McGraw-Hill, 1994. Print.