Essay on Time Value of Money and Retirement Planning

BAO 5534 BUSINESS FINANCE
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Task-1: Essay on Time Value of Money
The concept of time value of money is the basic premise of financial decisions. The
concept of time value of money confers that the value of money reduces with the efflux of time.
This means that the value of one dollar today will not be the same after 1 year from today (Drake
and Fabozzi, 2009). The purchasing power of one dollar today will reduce over the period of
time due to inflation and other economic changes. For example, a man who bought suppose one
KG bananas in one dollar today would not be able to do so after one year. After one year he
might has to pay 1.5 dollar to buy one kg bananas. The consideration of time value of money is
of utmost importance in the financial decisions. If a firm deciding on to invest in a project does
not consider the time value of money, it will end up evaluating the project’s financial viability in
wrong way (Drake and Fabozzi, 2009).
There are four basic factors which lead the consideration of time value of money concept.
These four factors are risk and uncertainty, inflation, consumption, and investment opportunity.
It is important to consider the risk and uncertainty involved in an investment decision (Silver,
2011). As the future is uncertain and hence the receipt of cash flows can not be guaranteed with
certainty, therefore, the firm makes provision for this uncertainty by adjusting the discount rate.
The inflation refers to increase in the price of goods and services over the period of one year.
The increase in the price of goods and services affects the cash flows of a firm and hence it is
important to consider inflation when assessing financial viability of the project. The discount rate
is further adjusted on account of inflation after being adjusted for risk and uncertainty (Silver,
2011).
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Consumption and investment opportunity leads encourages a person to receive money
today rather than tomorrow. The person would always prefer to consume today rather than
consuming tomorrow. Further, the dollar money received today could be invested to earn income
for the future (Halpin and Senior, 2011). Thus, a person receiving money in future would like
have incentive or some extra charge. For example, a person receiving $100 today would not like
to defer this payment for one year if he does not receive anything greater than $100. If the person
defers the payment of $100 for one year, he would be deprived of consumption of goods or
services which he could have availed by utilizing $100 today. He would also loose opportunity to
invest money. So, he would be happy to defer it if say the payment after one year becomes $110.
In such a case, there would be some incentive to the person deferring payment for one year
(Halpin and Senior, 2011).
There are two techniques being emerged from the concept of time value of money
namely discounting and compounding. Discounting refers to bringing the value of money to be
received in future to the present times while compounding means determining the future value of
money (Baker and English, 2011). An example of discounting technique:
Value of $100 receivable after one year at discount rate of 10% would be $90.90. This is
arrived at as under:
PV = FV/(1+r)t
Here, PV = Present value
FV = Future value
R = Rate of discount
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= 100/(1+.10)1
= 90.90
On the other hand, if we calculate let say value of $100 invested at the rate of 10% after
one year, it would amount to $110, this is called compounded value. This value has been arrived
at as under:
Fv = PV (1+r)n
= 100(1+.10)1
= $110
In capital budgeting decisions, the discounting technique is used instead of compounding.
The discounting technique provides computation of the present value of future cash flows which
is compared with the investment amount to arrive at the decision. The compounding technique in
the capital budgeting decisions can not be applied as it would be difficult to determine the rate of
return that the project would generate over the period of time. However, the future cash inflows
can be estimated with reliability. With the help of discounting technique, the present value of the
future cash flows can be determined (Shapiro, 2008).
It is to be noted that a discount rate is used in computing the present value of future cash
flows. This discount rate is determined having regards to the investor’s desired rate of return
(Shapiro, 2008). The discount rate could also be said to be the approximation to the cost of
capital of the firm. A firm may use its weighted average cost of capital as the discount rate. The
weighted average cost of capital of the firm comprises the cost of different components of the
capital such as equity, debt, and preference shares. In an all equity firm, the CAPM return could
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