- December 31, 2019 at 9:01 am
I am a bit confused with the reasons behind time value of money. In almost all sources they say that the reason for time value of money concept is opportunity costs i.e. the value of money increases over time due to, for example, interest that could have been earned if the money were deposited in a bank or return from other potential investments missed.
In just a few other sources they mention inflation i.e. that purchasing power decreases over time and so to have at least the same purchasing power as today you need to get more money in say a year.
From my old studies inflation was the main reason for time value of money for me. To be honest it made perfect sense to me. When I started to prepare for CIMA P2 I realised that as I said inflation was mentioned just in a few sources and the main reason for time value of money seemed to be opportunity costs.
As a result I got confused and lost while studying for P2 as inflation was mentioned so rarely that I started to doubt whether it is a reason for time value of money at all. Could you please clarify what the actual reasons for time value of money are and whether inflation is one of them?
Thank you in advance.January 2, 2020 at 9:15 pm
Hi, Thanks for your message & first of all dont panic!
Your understanding of the time value of money relating to inflation is a sensible one.
Time value of money – basically recognises that one dollar today is worth less in future. This is because of inflation – but also due to opportunity cost.
The idea of this is that if I were to borrow $100 from you today to be repaid in 3 years time – you’d expect MORE than $100 back in 3 years. This is to account for
inflation ( $100 will have lot less purchasing power in 3 years time)
lost Interest ( you could’ve invested that $100 in a savings account for 3 years so you want compensation for the lost interest you could’ve earned)
risk ( the longer away the more chance of not getting money back)
Therefore these are the reasons why we discount future values for the time value of money – with inflows & outflows being more heavily discounted if the interest rates are higher ( more risk/ more opportunity cost/ more inflation) and if further away in time duration.
Hope this explains ok
CathJanuary 9, 2020 at 3:39 pm
Thanks for such a good explanation! I would now like to ask a few questions about cost of capital.
1) Some sources state that cost of capital consists of cost of debt and cost of equity which are in short are money received by a company from someone (bank, shareholder, other creditor etc.). For example, Kaplan materials I use and the Opentuition F2 lectures about WACC talk only about cost of debt and cost of equity. But other sources state that cost of capital includes opportunity costs as well. And in one of the P2 lectures on NPV opportunity costs are briefly mentioned. Could you please clarify whether Opportunity costs are actually a part of Cost of capital? Could you please help with this?
2) I thought that cost of capital represents cost of the whole capital the company has at the moment. I.e. it covers not just the new capital not yet received by the company but also the one it has for a while (e.g. loans it got a while ago, shares it issued a while ago). But after I went through WACC materials I am not sure that my understanding is correct, and cost of capital actually covers new capital that was not yet received. Could you please clarify this?
Thank you in advance.January 14, 2020 at 12:01 am
Glad I could help with the time value of money but I might have to refer you to the F2 board for detailed WACC questions.
Definitely I mention opportunity costs in my NPV notes because for Npv computations we include only relevant cash flows -of which opportunity costs are seen as relevant.
That use doesn’t quite relate to the WACC though. The WACC is the discount rate used to discount the NPV cash flows.. it represents an average of all the sources of capital & their required % return rates/ like you say.
In terms of opportunity cost – I suppose you could see the rates of return to the investors as compensating for lost opportunity to earn interest elsewhere due to their cash being tied up in investing in our company- so yes opportunity cost in that way.
Hope that helps ?
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