Application of Time Value of Money in Investment Decisions

BUSINESS FINANCE
Part 1

Introduction
The concept of time value of money holds higher significance in the process of financial
management as it is significantly used by the finance managers in making investment decisions.
It is important for making investment decisions by providing an analysis of relative worth of an
investment at present and its total value in future. In this context, the present essay is developed
for depicting the application of time value of money concepts in investment decisions. It has
examined the fundamental of time value of money, discounting and compounding process and
discount rate and its main components.
Fundamentals of time value concepts
The basic concept of time value of money is that an amount available in future is not the
same at the present time as its value in present period will be more as compared to value in
future. The difference in value of money in present and future is due to the earning capacity in
future period of time. The core principle of finance states that money has the potential capacity
to earn interest if it is invested in the market. For example, if $100 is invested for period of 1
year for 1 year than future value at the end of 1 year is $110. It means value of money in present
time is $100 and value of same money is $110 in future, it is only because of earning potential of
money over the period of time. It is the reason why time value of money is regarded as present
discount value (Brigham and Michael, 2013). Time value of money is very important concept
and it can be applied in every business transaction. The money value differs according to time
due to various factors and some of them are discussed below:
 Risk and uncertainty: The future of anything is uncertain and unpredictable. Cash
outflows and inflows in future are not certain as no one knows about the future. This is
the reason why every individual wants to receive money today due to the uncertainty in
the future to receive the money. It is reason why values of money today will definitely
more as compare to value of same money valued in any time in future (Arnold, 2013).
 Inflation: The global economy is affected by the inflation and due to this reason money
received today will have more purchasing power as compare to money received at any
point in future.