The concept “the time value of money” is vital to understanding Net Present Value. The time value of money basically is that a dollar received today is worth more than a dollar received in the future.
A hundred dollars given up today is not worth $100 upon its return in three years because there is an opportunity cost of forgoing the use of that money for those three years. If I invested $100 this year for three years at an annual rate of 4%, that $100 would be worth about $112.33 at the end of year three (given compounding). So if I was to forgo that $100 now and receive it in three years, I would want to receive at least $112.33 at term. Similarly, if someone said I will pay you $100 in three years I would not give them $100 now – it would be less!
For capital budgeting decisions, the issue is how to value future cash flows in today’s dollars. The term cash flow refers to the amount of cash received or paid at a specific point in time. The term present value describes the value of future cash flows (both in and out) in today’s dollars.This resource provides an introduction to the time value of money. It is important to understand the basics of time value of money.