Question

Why is the understanding of the time value of money important to a firm’s top management? Be sure to explain your answer with principles from the textbook as well as an example scenario.

Answer 1

Time value of money forms the basis for any investment decision. The top management while making an investment decision will have to consider the costs and benefits of the investment. These costs and benefits do not occur at one point in time, rather they expand into the future as well.

The general principle of time value of money is that a dollar today is worth more than a dollar in one year's time. Assume a project has an initial investment of $1,000 and it produces a cash flow of $100 for the next 10 years. Even though we get back our initial investment of $1,000 in 10 years, this is a bad investment because of the time value of the money principle. When the future cash flows are discounted at a rate to bring them to the current time period, the value of those cash flows is less than $1,000.

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