The time value of money is critical to the decision-making process of capital budgeting. Both individuals and businesses use the time value of money to best determine how to plan for and bring about future economic growth. In many situations, allocating cash and analyzing investment opportunities will require the use of time value of money calculations. Understanding how the time value of money works and the reasons this concept is important helps make these budgeting decisions easier.
The time value of money is an economic concept that accounts for the difference in value a certain sum of money has based on the time involved in gaining or losing it. In essence, the time value of money is a way of acknowledging the difference between being paid today and being paid at some future time, requiring a wait. For most people, waiting for money is much less desirable than having it immediately. This is because waiting involves the potential for an opportunity cost.
An opportunity cost is a loss that results from a missed opportunity. Opportunity cost is conceptually related to the time value of money. If a person receives money sooner rather than later, they can invest or spend it and enjoy the money's value. If they must wait, however, the money is of less value to them because they will miss out on any opportunities between the present and the time they receive the money. By determining the value of this opportunity cost, it is possible to compare the difference in the value of money lost due to waiting. Capital budgeting decisions necessarily involve the choice of one opportunity cost over another.
Present Vs. Future Value
The time value of money is usually expressed as the difference between the present value of a sum of money and that same sum's future value. The present value is usually the outright value of the money, if paid immediately, while the future value is the amount of money plus interest. This is because receiving the same amount money in the future means the loss of an opportunity to earn interest.
Use in Capital Budgeting
Present and future values of money are critical to capital budgeting. Budgeting requires individuals and businesses to decide how to allocate or invest money. By opting to place money into an investment, an individual or a business will be denying themselves the use of that money until the investment pays off. If the investment's value at maturity exceeds the calculated future value of the investment's principal, this could be an excellent choice. But if the future value of the money exceeds the value of the investment, it might be better to choose another investment or keep the money in cash. As a concept, time value of money provides a means to analyze the opportunity costs of capital budgeting decisions. Using the time value of money allows these decisions to take place with a better understanding of whether or not a particular choice in allocating money is better or worse than other available choices.