Time Value of Money
The notion of the Time Value of money (TVM) states that an amount of money is worth more now than it will be at a later period due to its earning potential in the interim. The time worth of money is a fundamental financial notion. A sum of money in one’s hand is worth more than the identical sum paid in the future. The present discounted value is another term for the time value of money (Fernando, 2022).
The time value of money is based on the known fact that the value received now is more than the value obtained in the future due to the existence of inflation in the economy; the higher the rate of inflation in the economy, the less the future value of money is less than its present value (Fernando, 2022). Fernando (2022) added that financial decisions may be made by determining the worth of cash flows at the same time point using present value, such that the ideal financial decision is the one that achieves the greatest future value or present value of the greatest possible alternatives.
Net Present Value (NPV)
The net present value (NPV) approach adds the present value of all cash inflows and subtracts the current value of all cash outflows when assessing assets (Heisinger & Hoyle, n.d). There are three steps to calculating the NPV:
- Step 1: Determine the quantity and timing of the cash flows necessary over the investment’s life.
- Step 2: Calculate the interest rate that will be used to evaluate the investment, also known as the necessary rate of return.
- Step 3: Calculate and analyze the investment’s net present value (NPV).
The following formula is used to calculate NPV:
NPV=∑t=1nRt(1+i)
Rt=Net cash inflow-outflows during a single period
I=Discount rate or return that could be earned in alternative investments
t=Number of times periods
PV = Net cash flows / (1+ r)^ years
References
Fernando, J. (2022, September 28). Time value of money explained with formula and examples. Investopedia. Retrieved November 23, 2022, from https://www.investopedia.com/terms/t/timevalueofmoney.asp
Fernando, J. (2022, June 13). What is present value in finance, and how is it calculated? Investopedia. Retrieved November 23, 2022, from https://www.investopedia.com/terms/p/presentvalue.asp
Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html
Note:
This article is written based on University of The People Financial Management (BUS 5111) written assignment by Fristy Tania in November 2022
