The time value of money: The underlying principle is that a dollar worth today is worth more than a dollar in the future simply because, we can invest that dollar and earn a return on it. When financial managers make key operating decisions, it is certainly important for them to worry about the time value of money simply to understand the worth of a financial decision made by them. It is actually a key metric for the discounted cash-flows model which allows organizations to declare the value of an investment today, based on the expected return from the investment in the future. Importance: The fact of the matter is that capital budgeting is directly linked to time value of money, by that I mean, any investment that the firm intends to make has strategic objectives behind it. All of the ...view middle of the document...
There are multiple factors that can affect the discount rate some of them are; the interest rate at which a company can borrow money, investment returns on projects, inflation, and the risk of the project itself and so on. This is evidence enough that strategic considerations are directly linked to the time value of money. Many companies need to understand the future worth of their organizations and use such calculations to substantiate to investors in order to raise funds for the organization. Time value of money concept is often used in private equity to understand the risk of investment and to measure whether the risk and the return on investment is appropriate. A method that incorporates time value of money is the Internal Rate of Return (IRR) method. Since the early days of private equity, the IRR has served as the industry’s prime metric. The IRR is the annualized implied discount rate, i.e. the effective compounded rate, that equates net present value of outflows with its net present value (Gupta, 2012, p. 6). In essence, time value of money and the related calculations are indispensable to financial managers who in turn make appropriate strategic decisions and to advice the management about whether or not to make investments. Such assessment is vital to the board and the management so that any plans for strategic acquisition of a company or expansion is not justified by mere impulsiveness and to show corporate power, but it is indeed substantiated by evidence that the corporation and its shareholders ought to benefit from such investments. This allows for adherence of appropriate corporate governance as well.
Gupta, V., 2012. Benchmarking Private Equity. [Online] Available at: http://www.russell.co.nz/resources/russell-com-nz/_pdfs/research/1206_BenchmarkingPrivate-Equity.pdf [Accessed 18 July 2014].