Question

1. Explain and discuss the importance of time value of money when evaluating different investments or capital expenditures. 2. What are the components of "Required Rate of Return" and why is it an important calculation?

Answer 1

1. Time value of money is based on the idea that the present worth of same amount of money will be more than the future worth of same amount if money. Interest rate is always positive so discounting reduces the value of money in future. This is based on the principle that investors prefer to receive amount sooner and if the amount is received later they would want higher returns on that amount. If the amount is received in future investors would want to receive higher amount in future due to the risk undertaken by the investor .
Time value of money concept is used to calculate present value of annuities, cash flows and perpetuity . It is also used to calculate future value of a present investment .Time value of money is used to calculate annuity and annuity due of present investment or for future payment. It also helps to calculate the number of years for an investment to grow if the interest rate is known.
Time value of money is important in banking industry when interest rates are decided taking into factor the risk involved, inflation, etc. The loan and savings deposit both work on the principle of time value of money. Industries and companies value their future projects through calculation of NPV which borrows from the concept of time value of money. Here it helps in identifying more beneficial projects and also helps to accept or reject a project by checking whether NPV is positive or negative. Other concept like MIRR also uses discounting or time value of money in deciding about project.