Principles of Finance: Understanding the Time Value of Money

BUSINESS FINANCE
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Financial management is a key task not only in modern businesses but also in personal life.
There are various principles of finance that are pivotal for financial management. One of
these principles is the time value of money. The core concept is that money that is available
at the present has a higher worth than money available in the future owing to the earning
potential of the money (Lasher, 2017). This can be understood using a small example. For
instance, I win a lottery and the sponsor offers me two choices. Under one of the choices, I
would be given $ 1 million today while in the other the same amount of money would be
received after one year. The appropriate decision between the two can be made by
considering the earning potential of money. If I am able to obtain the winnings of $ 1 million
today, then the same money can be used to earn interest by keeping the money in a bank
account or invest in some asset. However, if the $ 1 million is received after one year, then I
would be at loss of the potential earnings that I could have made with the money. As a result,
in order to compensate for the loss of potential earnings, I would demand higher money if my
winnings would be paid after one year (Damodaran, 2015).
Another key input that is required to implement the time value of money is reality is the
discount rate. This discount rate is not constant varies from situation to situation. One of the
key parameters is the underlying risk associated with the underlying project whose cash flows
are being evaluated. Yet another factor would to be the underlying opportunity cost involved.
For instance, if in the lottery example, the funds can be deployed in a bank with 5% p.a.
interest rate, then the discount factor should be 5%. While finding the opportunity cost, it is
essential that the underlying risk should be similar. This concept can be extended and used
for corporate decision making (Petty et. al., 2015). This is because the companies need to
make a plethora of decisions and most of these involve present investment with estimated
profits in the future. Thus, there are situations where there are many opportunities available
for the firm to make an investment but the amount of capital is rather limited and only one of
these projects can be funded. In such a scenario, it is essential the firm must compute the
present value of all future cashflows so as to understand which investment is better (Brealey,
Myers and Allen, 2014).
Instead of discounting the future cash flows the firm can also do compounding of the money
and then compare the returns. Using the concept of compounding, the future value can be
attained which can be compared to the current value of investment based on which the
decision can be made. However decision makers tend to prefer the discounting concept owing
to the underlying ease with this can be computed and along with ease of interpretation. In