14.1 Time Value of Money in Capital Budgeting

Money's value changes over time, impacting investment decisions. Time value of money (TVM) concepts like present and future value help evaluate projects with varying cash flows. Understanding TVM is crucial for comparing investment opportunities effectively.

Advanced TVM concepts include selecting appropriate discount rates and considering compounding periods. These factors influence project valuations and help managers make informed decisions about long-term investments. Mastering TVM techniques is essential for successful capital budgeting.

Time Value of Money Fundamentals

Concept of time value of money

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• Time value of money (TVM) concept explains money's value changes over time due to earning potential
• TVM principle asserts a dollar today holds more value than a dollar in the future
• Significance in capital budgeting evaluates long-term investment decisions, considers cash flows at different time periods
• TVM enables comparison of projects with varying cash flow patterns
• Key TVM concepts include present value (PV), future value (FV), discount rate, cash flow timing

Present and future value techniques

• Present value (PV) technique discounts future cash flows to their current value using [PV = FV / (1 + r)^n](https://www.fiveableKeyTerm:pv_=_fv_/_(1_+_r)^n)
• Future value (FV) technique projects current cash flows to their future value using [FV = PV * (1 + r)^n](https://www.fiveableKeyTerm:fv_=_pv_*_(1_+_r)^n)
• Net Present Value (NPV) sums all discounted cash flows, accept projects with positive NPV
• Internal Rate of Return (IRR) calculates discount rate making NPV zero, accept projects with IRR exceeding required return

Advanced Time Value of Money Concepts

Discount rates in capital budgeting

• Discount rate selection influenced by cost of capital, project risk, inflation expectations
• Common methods include Weighted Average Cost of Capital (WACC) and Capital Asset Pricing Model (CAPM)
• Risk-adjusted rates apply higher rates for riskier projects, lower rates for less risky ones
• Opportunity cost considers rate of return on alternative investments (Treasury bonds, stock market)

Impact of compounding periods

• Compounding frequency varies (annual, semi-annual, quarterly, monthly, daily)
• More frequent compounding leads to higher future value
• Effective Annual Rate (EAR) accounts for multiple compounding periods using $EAR = (1 + r/m)^m - 1$
• Continuous compounding represents infinite compounding periods, calculated as $FV = PV * e^(r*t)$
• Adjusting for different compounding periods ensures consistent comparison of cash flows in capital budgeting