Question

Time value of money is one of the most important concepts in Finance. It is applied very frequently by finance professionals in corporate finance, investment management, retirement planning etc... Give an example of the application of Time Value of Money in one of these professional situations.

Answer 1

An example of time value of money application can be in capital budgeting in Corporate finance when a finance manager wants to understand the feasibility of a five year investment given that the cash flows for the next 5 years are known and the discount rate is also known.

Assuming that the investment is $ 100 and the cash flows over the next 5 years are $ 50, $50, $20,$20 and $10  and the discount rate is 10%, then the feasibility of the project can be found using NPV(Net present value) of the project.

NPV of the project = - 100 + PV of future cash flows

= -100+ 50/(1+10%) + 50/(1+10%)^2 + 20/(1+10%)^3 + 20/(1+10%)^4 + 10/(1+10%)^5

if NPV>0, then project is accepted or if NPV<0, it is rejected