Concept of Time Value of Money in Financial Management

Concept of Time Value of Money in Financial Management

Have you ever paid for something with monthly payments? Suppose you wanted to buy a $10,000 car and were told the payments would be $273.11 per month for 48 months. How would you know whether you were being offered a great deal, a fair deal, or a bad deal?
The Time Value of Money

Now suppose you have $10,000 to invest for a long time and someone tells you about an investment that will double your money, without any risk: Invest your $10,000 now, and you'll get back $20,000 in 15 years. How does this compare with other no-risk investments?

This and next coming posts will teach you how to answer such question; it's devoted entirely to the Time-Value-of-Money Principle. You'll learn how to value at one point in time cash flows that actually occur at other points in time. We develop the logic underlying these calculations and show you procedures for solving problems using a financial calculator. We urge you, however, not to use these calculator procedures like cookbook recipes. Understanding the logic will prepare you to apply the Time-Value-of-Money Principle in the business world to new types of problems, ones that don't fit neatly into classroom examples.

Like you, companies also have to choose among investments and borrowing alternatives. In fact, their success depends on those choices. Financial decisions are measured by their net present value (NPV). Recall that NPV is the present value of the expected future cash flows minus the cost. The NPV is the value created or lost by a decision. Therefore, to be successful, companies must find positive-NPV opportunities and avoid negative-NPV choices.

The Time Value of Money and The Principles of Finance

• Time-Value-of-Money: Note that the value of a cash flow depends on when it will occur.
• Two-Sided Transactions: Be specific about the timing of cash flows to be fair to both sides of a transaction.
• Risk-Return Trade-Off: Recognize that a higher-risk investment has a higher required return. Therefore, the time value of money is especially important to the profitability of long-term investments.
• Capital Market Efficiency: Use efficient capital markets to estimate an investment's expected and required returns.