FREE online courses on Investment Appraisal - Basic Concepts of Investment Appraisal - Time Value of Money

 

If an individual behaves rationally, then he would not equate money in hand today with the same value a year from now. In fact, he would prefer to receive today than receive after one year. The reasons sited by him for preferring to have the money today include:

1.                  Uncertainty of receiving the money later.

2.                  Preference for consumption today.

3.                  Loss of investment opportunities.

4.                  Loss in value because of inflation.

 

The last two reasons are the most sensible ones for looking at the time value of money. There is a 'risk free rate of return' (also called the time preference rate), which is used to compensate for the loss of not being able to invest at any other place. To this a 'risk premium' is added to compensate for the uncertainty of receiving the cash flows.

 

Required rate of return = Risk free rate + Risk premium

 

The risk free rate compensates for opportunity lost and the risk premium compensates for risk. It can also be called as the 'opportunity cost of capital' for investments of comparable risk.

 

To calculate how the firm is going to benefit from the project we need to calculate whether the firm is earning the required rate of return or not. But the problem is that the projects would have different time frames of giving returns. One
project may be giving returns in just two months; another may take two years to start yielding returns. If both the projects are offering the same %age of
returns when they start giving returns, one which gives the earnings earlier is preferred.

 

This is a simple case and is easy to solve where both the projects require the same capital investment, but what if the projects required different investments and would give returns over a different period of time? How do we compare them? The solution is not that simple. What we do in this case is bring down the returns of both the projects to the present value and then compare. Before we learn about present values, we have to first understand future value.