FINANCIAL THEORIES & STRATEGIES Time Value of Mon

Time Value of Money Theory & Net Present Value Analysis

The underlying premise of the time value of money theory is that money in hand today is worth more than money that will be in hand at some future date. An additional premise that is associated with the time value of money theory is that the more distant the future time when money will be held is the lower will be the present value of the money held at the future date (Brealey & Myers, 2002).

A simple way to conceive of this concept is to consider the time value of money in relation to the rate of inflation. An annual inflation rate of five-percent means that for a stable product (no design changes, no new production efficiencies, and so forth occur) one will need to pay $105 for a product that can be bought today for $100. For a company considering an investment, the time value of money also relates to risk. If the company can put $100,000 in highly secure government treasury bills and earn five-percent per year in interest, it will not commit that $100,000 to a riskier investment unless there is a good chance that the alternative investment will earn more than the nearly risk-free investment. Therefore, the company will discount the future earnings of the alternative investment by an appropriate interest rate factor to assess the riskier investment alternative in relation to the nearly risk-free investment (Reilly & Brown, 2002).

A common tool applied by financial managers (a) to assess the feasibility of a

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t with a means of selecting between investment alternatives. It is essential for management to have an effective and an efficient means of selecting between alternative investment proposals, because capital is scarce in most organizations. Efficient Markets Theory & Capital Assets Pricing Model Efficient markets theory, more generally known as the Efficient Market Hypothesis, holds that at any given time, financial asset prices fully reflect all available information. The hypothesis implies, thus, that all investors have access to all relevant information and that all investors use that information (Brealey & Myers, 2002). If the efficient market hypothesis is true then asset bubbles and subsequent crashes should not occur. The fact that such events do occur, however, reflects the real world in which (a) all investors do not always have access to all relevant information and in which (b) not all investors with access to all relevant information use such information. The earlier random walk hypothesis held that stock price changes were similar to a random series. Portfolio-selection theory developed by Markowitz (a) demonstrated the importance of diversification in terms of reducing the overall risk of a portfolio, (b) deri

Category: Economics - F