Question

Convinced that time value of money is an essential concept, you try to understand the weaknesses associated with the method we use to discount or compound money in different time periods. Explain three weaknesses associated with the time value of money concept and the methodology we use.

Answer 1

Time value of money is an important concept in the finance world. The three major weakness associated with this method are:

· The discount rate being used is subjective and it can be biased towards the one party and that party will be at disadvantage.

· Inflation expectation is one very important part of discounting rate being used and inflation in reality can vary significantly from the expectation leading to different value than expected.

· When we are discounting cash, we have to match the cash flows with the discount rate, that is the discount rates can be real rate or nominal rate otherwise the value derived would not be reliable.