Unsourced material may be challenged and removed. Time value can cash flow analysis example pdf described with the simplified phrase, “A dollar today is worth more than a dollar tomorrow”.
Here, ‘worth more’ means that its value is greater. A dollar today is worth more than a dollar tomorrow because the dollar can be invested and earn a day’s worth of interest, making the total accumulate to a value more than a dollar by tomorrow. Interest can be compared to rent. Just as rent is paid to a landlord by a tenant, without the ownership of the asset being transferred, interest is paid to a lender by a borrower who gains access to the money for a time before paying it back. By letting the borrower have access to the money, the lender has sacrificed the exchange value of this money, and is compensated for it in the form of interest. When deciding between projects in which to invest, the choice can be made by comparing respective present values of such projects by means of discounting the expected income streams at the corresponding project interest rate, or rate of return. The project with the highest present value, i.
The traditional method of valuing future income streams as a present capital sum is to multiply the average expected annual cash-flow by a multiple, known as “years’ purchase”. For a riskier investment the purchaser would demand to pay a lower number of years’ purchase. The standard usage was 20 years’ purchase. Time preference can be measured by auctioning off a risk free security—like a US Treasury bill. 100 a year from now.