Time value of moneyTime value of money is a concept which shows that value of money diminishes day by day and there are many factors which contribute to this such as inflation, rising interest rates etc. Concept of time value of money is mostly used in capital budgeting techniques such as NPV, discounting pay back etc. without this concept it is not possible to evaluate capital budgeting projects, investment decisions etc. appropriately. To understand the concept of time value of money here is an example, Annual cash inflows from two competing investment opportunities are given below. Each investment opportunity will require the same initial investment. Investment X Investment Y

Year 1 $ 1,000 $4,000

Year 2 2,000 3,000

Year 3 3,000 2,000

Year 4 4,000 1,000

Total $10,000 $10,000

Determine the present value of the cash inflows for each investment using a 20% discount rate. This will help in understanding the time value of money concept.

Computation of Present value of Cash flows:-

Investment X

YearCash flowPresent value factor @20%Present value

1$1,0000.833$833

2$2,0000.694$1,388

3$3,0000.578$1,734

4$4,0000.482$1,928

NPV$5,883

Investment Y

YearCash flowPresent value factor @20%Present value

1$4,0000.833$3,332

2$3,0000.694$2,082

3$2,0000.578$1,156

4$1,0000.482$482

NPV$7,052

On the basis of above it can be said that investment Y is better than investment X because its present value is higher than that of investment X. Using time value of money concept we have easily determine as which investment should be chosen, therefore time value of money concept is very important.

References:-Horne James, Wachowica John, Fundamentals of financial management 2008, 12th Ed., Prentice Hall.Ross A. Stephen, Westerfield W. Randolph, Jaffe Jerrey, Corporate finance 2006, 8th Ed., McGraw-Hill.