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B-Time Value of Money

# B-Time Value of Money - Part 1 Time Value of Money Cash...

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Part 1: Time Value of Money, Cash Flows, and Incremental Analysis Time Value of Money What is meant by the term time value of money? Let’s consider an example. What is better, \$500 today or \$500 two years from now? You probably would agree that receiving \$500 today is superior. You are happier having money in your hands now rather than hoping to receive money sometime in the future. You also encounter the time value of money when you work with interest. Interest, of course, is the charge paid for a loan. The longer it takes you to repay a loan, the more interest you pay. Even the interest rate is higher on longer loans. Consider another example. You borrow \$1,000 for one year at 10% interest. The money borrowed is principal. At the end of one year you own \$100 in interest as well as still having the obligation to repay the principal of \$1,000. If you do not repay the principal, nor the interest, but keep the money for a second year, the interest continues to accumulate on the unpaid interest as well as on the principal so that you owe \$1,210. This phenomenon of interest growing on itself is called compounding or compound interest. This is the snowball effect of interest. When analyzing investments, you can base your analysis upon any point in time or upon a series of recurring payments. To keep this discussion as simple as possible, we will consider investments exclusively from the point of view of the present moment. Because we will translate all future income and costs to the present, this type of analysis is called present value analysis. Most investors follow this convention. We will adhere to this rule. But be aware that other methods exist. Reiterating what we just considered, present value analysis converting all money into present dollars, and present dollars represent the present value of money you expect to receive in the future. Generally the present time is the moment when an investor makes an investment decision. We call this point time zero. Most analysts consider time zero to be of short length, such as several days or a few months. In

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some instances, time zero can be a full year; however, time zero never exceeds one year and typically runs much less than a full year. Note that present value analysis brings all future money back to the present using compound interest. Investors often use the term discount rate or discount factor, but it is nothing more than compound interest. We will talk about the discount factor a bit later, but first let us discuss another important term, cash flow. Cash Flow Cash flow is the movement of money in and out of a business or an account. Examples include: A personal checking account A company’s cash flow statement The tabulation of a project’s costs and revenues Business analysts call the cash generated by a company the operating cash flow. It is the firm’s net earnings tallied after the company pays taxes and adds back in depreciation. Business people also talk about other types of cash flows, such as the cash flow from assets, the cash flow to
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