Question

Explain why the concept of time value of money important to long-term project decisions.

Answer 1

Time Value of Money is a concept which focuses on the value of money with different period of time. Value of money is not absolute. It changes with time. The value of 1000$ in 2010 was different than today and it will be different in future. It is affected by economic condition of the country and no a day global economy. In simple terms it is affected by the rate of inflation and rate of interest at the point of time.

For long term projects, the business person has to borrow the money from bank or other means. For that the borrower has to pay interest. So when the project ends it is costlier. Let’s take simple example, for a project which will be completed in 5 years, Mr. X (Project owner), borrows 100,000 USD at the rate of 10%. The owner will pay 161,051 after 5 years. Here the interest is compound interest and calculated yearly. So when the project will be completed it will cost around 1.5 times of the loan amount. Due to this when a project is taken time value of money is considered.

Apart from this cash inflow and cash outflow is also determined. For example for 100,000$, after 1 year the cash inflow is 75,000 then net cash flow will be -25,000(-100,000+75000). As per project lifespan such calculations are done.

Apart from this Net Present Value, Internal Rate of Return and other concepts are also taken into consideration.

So to identify how much the project is profitable, the Time Value of Money concept is taken into consideration.

Hope this will help. Provide your feedback.