Define and discuss the importance of the time value of money

Define and discuss the importance of the time value of money concepts including compounding (future value), discounting (present value), and annuities. Why do organization leaders need to understand these concepts?

Solution

Time value of money is the impact of required rate of return on money over time. Concept of compunding and interest on interest are embedded in time value of money.

Future value : Determining the value of a cash flow by compounding it using the required rate of return to a particular time in the future

FV = PV * (1 + r) ^n

Present value: Determining value of a future cash flow today by discounting using the appropriate discount rate.

PV = FV/(1 + r)^n

Annuity : stream of equal cash flow occuring at equal interval of times.

Organization leaders need to understand these because it is essential when making capital allocation decisions. This is because cash flows occuring deep into the future are less valuable compared to those nearer to the present and allocation of resources to projects need to be done accordingly.