Concept of time value of money with examples

By | April 16, 2014

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The concept of time value of money quantifies the value of a given amount of money through time (Baggini 2008, p. 484). This concept is widely accepted in not only the accounting practices but also in the project evaluating practices. The interest rate used to derive the present value of the cash flows, known as the discount rate, is important to reflect where the value of the cash flows brought by a project and how the return is perceived by the market (Choudhry 2010, p. 4). For example, project KCC Pearl has a discount rate of 15% while Bridgetown has a discount rate of 8%, this means that KCC Pearl need to have more cash inflow in the future than the other project in order to have similar current value, such difference could be due to the market perceives that project KCC Pearl have greater risks than the project of Bridgetown. Below we calculate project KCC Pearl’s NPV.

 

KCC Pearl

Year

Cash Flow

Discount

PV

 0

$-3,000,000

1.0000$-3,000,000

1

0

0.86960

2

0

0.25000

3

0

0.15300

4

0

0.40960

5

$18,000,000

0.4907$8,832,190.60

 

NPV:                          $5,832,190.60

c. Discount rate