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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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View Full Documentsome 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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 Spring '11
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 Time Value Of Money

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