How is the concept of the time value of money important to a company?

Aug 17, 2015

Incorrectly evaluating the time value of money could lead to over-investment or under-investment.

Explanation:

Time value of money is a critical concept in most financial decision making, both for firms and for households. For most investment decisions, the costs occur "up front", in the early time periods, with benefits hoped for as a future result.

Sophisticated cost-benefit analysis requires discounting -- or calculating the net present value of all cash flows estimated for both costs and benefits. If we invest in a large-scale project that will take several years to complete, for example, we have lots of costs in the first few years with very few benefits until the later years.

Imagine a project where the costs all occur in year 1 -- let's say, $1,000,000. Let's say that the benefits occur in years 2 and 3, and the benefits are$100,000 in year 2 and $950,000 in year 3. Without using the time value of money, it is tempting to say that the total benefit is$1,050,000 vs. the cost of $1,000,000. So, with this simplistic analysis, we might say that the benefits outweigh the costs. By this analysis, we should undertake the project, because the net benefit is$50,000.

If the time value of money is equal to 5% per year -- actually, a somewhat low interest rate -- we would calculate the net present value of the benefits in year 3 as:

NPV = CF(3)/(1-r)^2, where CF(3) is the cash flow in year 3. So ...

NPV = $950,000/(1.05)^2 =$950,000/1.1025
= $861,678 Similarly, for year 2, the present value of the benefits is: NPV = CF(2)/(1+r) =$100,000/1.05
= $95,238 When we add all the benefits, we get a total, net present value of the benefits =$956,916

Since all the costs occurred in year 1, we do not need to discount those cash flows. We can see now that this project has a cost of $1,000,000 and benefits of only$956,916. Using this analysis, we would reject the project, since the costs outweigh the benefits.