Why Is the Time Value of Money So Important in Capital Budgeting

Decisions?

When a business chooses to invest money in a project -- such as an expansion, a strategic

acquisition or just the purchase of a new piece of equipment -- it may be years before that
project begins producing a positive cash flow. The business needs to know whether those
future cash flows are worth the upfront investment. That's why the time value of money is
so important to capital budgeting.
The time value of money is important in capital budgeting decisions because it allows small-
business owners to adjust cash flows for the passage of time. This process, known as
discounting to present value, allows for the preference of dollars received today over dollars
received tomorrow. Understanding some common capital budgeting techniques that use
the time value of money can help you understand why this concept is so important in capital
budgeting decisions.
Net Present Value
The net present value method uses the time value of money to determine whether a project
is profitable, even after adjusting for the time value of money. To perform this test, a small-
business owner would first determine the cash inflows and outflows required for the
project. Once identified, these figures are adjusted to present value and their difference is
determined.
If the project's net present value is greater than or equal to zero, the project is acceptable,
as it provides a return greater than or equal to the company's acceptable rate of return. If
the owner does not use the time value of money to discount cash inflows and outflows,
projects with a long time horizon or in periods of a high discount rate could be mispriced,
and the owner could make an unprofitable decision.
Internal Rate of Return
The internal rate of return method applies the net present value method in reverse. This
method finds the discount rate, given the undiscounted cash flows of the project, which
results in a net present value of zero. The zero point represents the break-even point of
project profitability.
To apply this method, a manager divides the investment required by a project by the net
annual cash inflow the project is expected to produce. This calculation yields the internal
rate of return factor. This factor can be looked up in a net present value table to discern the
appropriate internal rate of return. This internal rate of return is then compared with the
company's minimum acceptable rate of return. If the project promises a higher return, it is
accepted.
Total Cost Approach
The total cost approach allows small-business owners to evaluate multiple projects at one
time. In this method, the manager adjusts all cash inflows and outflows for each competing
alternative and then compares them. All projects with positive net present values are
acceptable; however, the project with the greatest net present value is the most profitable.
This method can be time-consuming, because costs that do not differ across competing
projects are calculated, even though they are irrelevant.
Project Profitability Index
When funds available for projects are limited, a small-business owner can calculate the
project profitability index, or PPI, to determine which project is preferred. By dividing the
net present value of a project by the investment preferred, the owner is calculating a value
of net present value obtained per dollar invested. This is known as the PPI. Higher project
PPI values imply more desirable projects.
Time Value

Simply put, the time value of money is the idea that a particular sum of money in your hand
today is worth more than the same sum at some future date. For example, given the choice
between receiving $1 today or $1 a year from now, you should take the money today. You
could invest that $1, and even if you only earned a 2 percent annual return on your
investment, you still would have $1.02 a year from now -- more than the $1 you'd have
gotten if you waited. If you didn't invest that $1 at all but simply spent it, you'd still be better
off; because of inflation, the $1 usually will have more buying power today than in the
future.
Discount Rate

An essential consideration in the time value of money is the discount rate. That's the rate a
business uses to convert future amounts into today's dollars. Multiple factors affect the
discount rate, including the interest rate at which the company can borrow money, the
return the company could earn from investing money, the return demanded by the
company's own investors, inflation and the risk of the project itself. Setting a discount rate is
as much an art as a science, but it's critical that a company come up with a reasonably
accurate figure. Using a rate that is way off means making bad capital budgeting decisions.
Converting Values

To make capital budgeting decisions using the time value of money, a company first
estimates all the cash flows involved with the project, positive and negative. It then converts
all of those cash flows into their present value -- how much they're worth in today's dollars.
Consider a project that requires a $100,000 investment today (a negative cash flow) and will
return $25,000 a year for the next five years (positive cash flows). On paper, it looks as if the
project produces a $25,000 profit. But those future cash flows must be converted to present
value. If the company uses a discount rate of 10 percent, the present value of those cash
flows actually comes out to $94,769.67. That's less than the $100,000 cost, so the project
actually will lose money. However, if the company is using a discount rate of 7 percent, the
present value is $102,504.94, meaning the project is profitable. This underscores the
importance of accuracy in setting a discount rate.
Methods

Companies apply the time value of money in various ways to make yes-or-no decisions on
capital projects as well as to decide between competing projects. Two of the most popular
methods are net present value and internal rate of return, or IRR. In the first method, you
add up the present values of all cash flows involved in a project. If the total is greater than
zero, the project is worth doing; the higher the net present value, the better. In the IRR
method, you start with the cost of the project and determine the rate of return that would
make the present value of the future cash flows equal to your upfront cost. If that rate --
called the internal rate of return -- is greater than your discount rate, the project is worth
doing. The higher the IRR, the better.