Investment Appraisal Method: Understanding Time Value And Present Value Of Money

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In my earlier articles on Payback and Accounting Rate of Return, we noticed that those two investment appraisal methodologies do not take into consideration the time value of money.
So what really is the time value and present value of money and why is so important?

1. Let’s understand the concept of time value of money.

It means that a dollar in the hand today may be invested to earn a return and therefore has a greater value than a dollar to be received one year from today. The difference between a dollar received now and its value from one year from today is the time value of money. It’s the reward for waiting and not having use of your money for that time period.

1. Next why is it so important in investment appraisal.

Time value of money concept is very important because for most investment appraisal, the costs and benefits involve a series of cash inflows and outflows that occur at different times over the life of the project.

1. What is the present value of money?
   

Present value is the opposite of future value of a present sum of money. Future value is based on the compound interest concept.
Whilst, present value is the amount that must be invested now so as to reach a given sum at a given point of time in the future, assuming that it is compounded at a specified rate of interest. Present value is obtained by discounting the future value cash flows to a present value equivalent.
With the basic understanding of the time value and present value, we should next proceed to two other investment appraisal techniques using this basic concept.