FINANCIAL THEORIES & STRATEGIES
Time Value of Mon
Time Value of Money Theory & Net Present Value Analysis
The underlying premise of the time value of money theory is that money in hand today is worth more than money that will be in hand at some future date. An additional premise that is associated with the time value of money theory is that the more distant the future time when money will be held is the lower will be the present value of the money held at the future date (Brealey & Myers, 2002).
A simple way to conceive of this concept is to consider the time value of money in relation to the rate of inflation. An annual inflation rate of five-percent means that for a stable product (no design changes, no new production efficiencies, and so forth occur) one will need to pay $105 for a product that can be bought today for $100. For a company considering an investment, the time value of money also relates to risk. If the company can put $100,000 in highly secure government treasury bills and earn five-percent per year in interest, it will not commit that $100,000 to a riskier investment unless there is a good chance that the alternative investment will earn more than the nearly risk-free investment. Therefore, the company will discount the future earnings of the alternative investment by an appropriate interest rate factor to assess the riskier investment alternative in relation to the nearly risk-free investment (Reilly & Brown, 2002).
A common tool applied by financial managers (a) to assess the feasibility of a proposed investment or (b) select between two potential investments in relation to the time value of money is net present value (NPV) analysis. The NPV of an investment is defined as the difference between the capital cost of an investment and the discounted future cash flows from that investment. For practical applications of the NPV procedure, tables providing the discounted value of one-dollar for specific periods into the future for specific interest rate…