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Time Value of Money is an important concept for making good investment decisions. It’s based on the principle that the timing of payments is important. You’ll need this at work if you’re a project manager, proposing a new idea to your boss that costs money. You’ll also need this for evaluating different options or choices of investments. We can calculate this “time value of money” easily in Excel. In fact in this video, I’ll show you an Excel template you can use to calculate the time value of money for any investment decisions.
Question: If a customer asks you if instead of paying $10,000 in cash now he could pay $10,800 over 4 years. Is that a good deal for you?
The answer depends on several factors:
1. Opportunity Costs – Money has an earning capacity. So, instead of waiting for the money, you could invest it and hopefully make more out of it. By getting the money later, you lose the opportunity to make an additional income.
2. Inflation – Prices increase over time. So, the same item will probably cost more in a couple of years.
3. Risk – Payments in the future always carry a certain risk. Will you really get the money then?
The combination of these factors defines the time value of money and is expressed as a discount rate. For instance a discount rate of 5% means that in each successive year the same amount of money is going to be worth 5% less than in the previous year.
You’ll learn how to calculate Present Value (PV) manually and then we’ll use the Excel NPV formula to calculate the Net Present Value in one go. Input values is the discount rate and the future cash flows.
In order to compare alternatives with different timing of payments we need to calculate their present value. In other words we need to discount future payments.
Companies often use their Weighted Average Cost of Capital (WACC) which is their average cost to get equity and debt. By applying their WACC as discount rate, any project that results in a NPV greater than zero is worth doing.
– The further in the future the payments are, the lower their present value will be
– Think of the discount rate as a hurdle. The higher the hurdle, the more difficult it will be to get a high present value
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