Question

Time Value of Money

What is the time value of money and why is it important? Describe the net present value (NPV) and internal rate of return (IRR) methodologies and their use in capital budgeting decisions. What is NPV when the discount rate (hurdle rate) equals IRR?

Project Management

Answer 1

The concept of time value of money plays an important role in finance and in majority of capital budgeting decisions. The concept is based on the idea that money that we have today is worth more than money we receive some time later. The difference in the value of money exists because there exists an opportunity cost of holding money. Money can be invested and interest can be earned from the investment. Therefore the value of money keeps changing with time. The value of money depreciates over time if money is left idle without making any investment. The depreciation of money is due to inflation which is the general increase in the price level of all goods and services. Therefore the quantity of goods or services that money can buy now will be more than what the same amount of money can buy 1 year later. Thus the idea of change in the value of money over a period of time is known as time value of money.

Net present value is a capital budgeting technique which makes use of the concept of time value of money to decide if investment must be made or not in a particular project. The technique discounts the projects cash inflows to its present value using a minimum acceptable rate of return (MARR) and subtracts it from the initial investment. If the result obtained is greater than the initial investment, then the project is acceptable. If the present value of projects cash inflows is less than the initial investment, the net present value will be negative and therefore the project is not viable for investment. Thus the net present value technique helps in deciding whether an investment in a project should be made or not.

The internal rate of return (IRR) is another useful capital budgeting technique that makes use of time value of money to make investment decisions. The IRR is the discount rate that makes the present value of cash inflows of a project equal to its initial investment. If the IRR is greater than the MARR, the project produces returns greater than the initial investment.

When IRR equals the discount rate ( hurdle rate) the NPV of the project is zero. This is because the IRR is the discount rate that equates the projects cash inflows with the initial investment.