a) Describe what is meant by the term 'the time value of money' and briefly describe the factors that ensure that monies received in different time periods will have different values

In appraising capital projects it must be kept in mind that €1 earned or spent sooner, is worth more than €1 earned or spent later. The earlier positive cash flows are generated, the sooner they can be used to make a further contribution to profit. Thus money ahs a time value and this plays an important role in appraising capital projects because the time lag between the initial investment and payback can be quite long. However the difficulty lies in comparing €1 cash flow received today with €1 received in the future, as the two cannot be equal to each other given they are received in different time periods. Thus to evaluate any project taking into account the time value of money, the cash flows received in the future must be reduced or discounted to a present value, so that all relevant cash flows are denominated in todays value (present value). This discount factor represents the cost of waiting, or the time value of money.

The reasons why cash flows received in different time periods have different values are:

q     Uncertainty:  Monies invested in projects run the risk of not being refundable. Ultimately, investors take this risk and profit is a payment for risk-taking. The greater the risk an investor takes, the greater will be the required return from the project to compensate for this risk-taking. The business world is full of uncertainty and risk, thus investors will require the promise of significant returns to entice them to take on extra risk. Although there might be a promise of future cash flows, it can never be certain that the money will be received. For example the massive investment in the ‘dot.com’ sector in the late 1990’s ensured massive valuations for these companies before they even made a profit. However as many investors will now testify, most did not make and never will make, a profit.

q     Interest or returns lost: Monies received earlier can be invested to earn extra income for a business. Monies received earlier can be used to reduce bank overdrafts and thus reduce the associated interest cost. Having to wait for cash results in this opportunity cost. DCF therefore takes into account the notional interest lost because of the time delay in receiving cash flows.

q     Inflation: General price inflation ensures that €1 now, purchases more and is worth more, than €1 received in the future. It is important to know that even if there was a period of zero inflation, the time value of money would still be a relevant concept and DCF would still be used for investment appraisal.

Uncertainty and risk, inflation, and the interest or return lost by not receiving cash earlier, all ensure that waiting for future cash flows has a cost and hence money has a time value. The difficulty for every business is to evaluate their cost of waiting or their time value of money, as it will be different for every business due to the following:

q     The differing levels of uncertainty and risk that applies to different business sectors, as well as to different businesses within a sector.

q     The inflation rate that applies to the specific business sector that the company operates in.

q     The opportunity cost of waiting is related to the interest foregone by not having the money earlier. This is certainly easier to evaluate than inflation or risk.

In reality, these three elements make up the cost of capital of a business and hence the discount factor to use in evaluating capital projects should be the cost of capital that applies to that business.

b) Compare the payback and net present value methods of investment appraisal

The payback method of investment appraisal focuses on how quickly will the cash flows arising from the project exactly equal the amount of the investment. It is a simple method, widely used in industry and is based on management’s concern to be reimbursed on the initial outlay as soon as possible. Its main disadvantages are it is not concerned with overall profitability or the level of profitability and it takes no account of the time value of money. Management can set a required payback period when appraising projects so that if the payback on any project looks to be longer than this set criteria then the project is rejected.

The net present value method of investment appraisal focuses on all the cash flows generated by an investment project. It focuses on discounting all the cash outflows and inflows of a capital investment project, at a chosen target rate of return or cost of capital. Thus cash flow are all based on a present or current value The present value of the cash inflows, minus the present value of the cash outflows, is the net present value (NPV).                              

q     If the NPV is positive, it means that the cash inflows from the investment will yield a return in excess of the cost of capital and thus the project should be undertaken, as long as there are no other projects offering a higher NPV.

q     If the NPV is negative, it means that the cash inflows from the investment yield a return below the cost of capital and so the project should not be undertaken. 

q     If the NPV is exactly zero, the cash inflows from the investment will yield a return which is exactly the same as the cost of capital and thus the project may or may not be worth undertaking depending on other investment opportunities available.

Its advantages include

q     It takes into account the time value of money.

q     Profit and the difficulties of profit measurement are excluded.

q     Using cash flows emphasises the importance of liquidity.

q     It is easy to compare the NPV of different projects.

The main disadvantages associated with the net present value approach are that it is not as easily understood as the payback and accounting rate of return. Also, the net present value approach requires knowledge of the company’s cost of capital, which is difficult to calculate.