Share
Explore BrainMass

The Time Value of Money in Economic Decisions

Hi,

Please explain why the time value of money is important in an economic decision and how NPV and payback period are used in business to incorporate the time value of money into operational decision. Explain the three basic concepts that are used for estimating the cost of ownership for a single option or in comparing multiple options, as well as the relationship between these cost estimation concepts and a company's financial statements.

Solution Preview

It is relevant to acknowledge that the time value of money is important in the economic decision due to several reasons. The time value of money is one of the corner stones of economic decision making. Both businesses and individuals utilize the time value of money to decide how to plan things. The time value of money is also utilized to bring about the future economic development. In several situations, evaluating investment opportunities and allocating cash will need the time value of money calculations (The time value of money, 2013). Furthermore, the time value of money is a crucial tool utilized in project appraisals to compare several investment alternatives. The related concept is also utilized to solve the problems comprised in leases, mortgages, loans, annuities, and savings. A major concept behind time value of money is that a series of equal or single sum of money, evenly spaced receipts or payments in the future, can be converted to an equal value today (Time Value of Money, 2002).

Moreover, the time value of money is an economic concept, which accounts for the difference in value. A definite sum of money is based on the time comprised in receiving or losing it. Significantly, the time value of money is a manner of recognizing the difference between being paid presently and being paid at some future time. It is noticeable that money has a time value (Time Value of Money, 2002). For instance, if company A has the opportunity to realize $10,000 from an asset today, or two years in the future, in this situation, the time value of money permits the company to calculate exactly how much more that $10,000 has importance if it is obtain today, as opposed to in the future. It is significant to know how to measure the time value of money because it means a person can distinguish between the values of the investment opportunities, which offer returns at different times (Time Value of Money, 2009). Apart from this, the time value of money has functions in several areas of the corporate finance comprising bond valuation, capital budgeting, and stock valuation. For instance, a bond typically pays interest regularly maturity at which time the face value of the bond is repaid. Thus, it is obvious that the value of the bond in the current time depends upon the future cash flow. Significantly, the time value of money is categorized into two areas. These two areas are the present value and future value. Present value explains the process of deciding what a cash flow to be received in the future is crucial in dollars of today. Thus, it can be stated that the time value of money is the value of money figuring in a given inflation or interest earned over a given amount of time (Time Value of Money, 2009).

Here, we will focus on the Net Present Value, which is an important tool utilized in business to integrate the time value of money into operational decision making. Besides, the formula of NPV will also be ...

Solution Summary

The time value of money in economic decisions are examined.

$2.19