Question

What is meant by the term time value of money?
- Why is the net present value method superior to other methods such as the payback and simple rate of return methods?

Answer 1

Time value of Money Shows Value of the Money with the Passage of the time. The Money You have now has more value than the future value due to potential earning capacity. Time Value of Money Gives investors Idea Value of Money You will receive in Future For eg. If you are Investing 10000 and You will receive after 1 year 11000 and 6 % is Discounted factor then Value of the money after one year = 11000 * 0.9434 (P.V Factor Value of 6% Discount rate ) =$ 10,377.Time Value of Money Helps Investor In Decision making.

NPV = Present Value of Future Cash Inflow – Present Value of Future Cash Out Flow.
If NPV is Positive Project shall be Accepted and if NPV is negative then Project shall be Rejected.
NPV Shall take into Account Discounting Rate that each cash inflow and outflow is deducted by Discounting Rate to make at present rate.

Under Payback Peiod Method It estimate how much year project should take to recover the amount of Cash invested. It Shows how much year project should take to make it at Breakeven or Create the profit.

Under Return of Investment Method , ROI = Cash Inflow / Cash outflow * 100

NPV is method is most accurate method then Payback and Return on Investment method.
It takes into Account Inflation and Capital Budget that Payback and return on investment not taking.
Payback period Not takes into account cash flow after Payback period their may be possible after payback period major change in cashflow statement.

Therefor net present value method superior to other methods such as the payback and simple rate of return methods.