Question

7:29 LTE (Notes Examine the concept of the time value of money in relation to corporate managers. Propose two (2) methods in which time value of money can help corporate managers in general.

Answer 1

Time Value of Money (TVM) is the effect of application of interest. An amount received today is worth more than the same amount received on a future date. Because the money received or paid today will earn interest for the interim period and will grow in volume during that period. Inversely, the amount received or paid on a future date is equivalent to a lesser amount today, the difference being interest during this period.

Two applications in which TVM is used to help corporate managers are as follows:

1. Net Present Value (NPV). It is the measure of how much the future cash flows (net) is worth today. This is the sum of discounted values of cash flows, both positive and negative, discounted by the appropriate rate. The rate employed is called discount rate and is akin to the interest rate in calculating future value in the inverse direction. Discounting takes place at appropriate intervals as decided, like monthly, quarterly, semi annually or annually.

2. Internal Rate of Return (IRR). It is the rate of return implied in an investment or project. Mathematically, it is the discount rate at which NPV or sum of present values of all cash flows associated will become zero. This metric generates the yield expected from the investment or project but takes care of only the internal factors and not external factors like cost of capital or rate of inflation.