[ASPITZ1]

3. Why is the time value of money so important in capital budgeting decisions?

Here is my answer am I on the right track?

First off time value of money is what happens to the value money over a period. How this affects capital budgeting is like this: Say a company has 10,000 in profit that they can either take now or wait a few years to take. Let’s say the company takes the money now in a 5 year period if the money was invested properly will produce an even greater amount; so after 5 years of investing the 10,000 dollars is now 60,000. Now on the other side if the company waits 5 years to receive the money they are only going to get 10,000 so the company didn’t make anything on it while waiting to get it in their possession and they had to wait to make any investments. It’s an obvious decision that any company would want to take the money immediately rather than later so they can invest and create more money or spend it to benefit the company in the immediate sense. So the money a company has now will not be the same that it has in the future.

How this relates to capital budgeting decisions allows the finance division to see what the company has on hand now, look at how it’s being invested for any depicted amount of time and determine about what profit might be made. Not always a profit is made either, if not invested properly the company can lose money which should also be taken into account.

[morgaine300]

Let’s say the company takes the money now in a 5 year period if the money was invested properly will produce an even greater amount;

Just as a note, that sentence is pretty confusing.

As for being on the right track... perhaps at the very beginning of a right track as opposed to off completely on the wrong track, but not really very far down it...

It’s an obvious decision that any company would want to take the money immediately rather than later so they can invest and create more money or spend it to benefit the company in the immediate sense.

Yup, that's a pretty obvious decision, except that it's not the one they're normally trying to decide. Why do they even need to make the decision of whether to take the same amount of money now as opposed to later? Of course they want it now.

Note the important point in that sentence: the same amount of money.

But it's not usually about the same amount of money. Do I want $10,000 now or later? Well, duh, now. The basic idea of what happens to the money over time is actually a crutial part of it, yes, but that's just the very beginning. You have to apply it to something.

How about instead: do I want $10,000 now, or do I want a $1500 payment every year for the next 6 years. Now I have something to compare, and now it's not obvious anymore. Or how about I can have the $1500 payment every year for the next 5 years, or I can have $12,000 at the end of 5 years. TVM can be used for all sorts of things, like just figuring out your car payment. But since you're trying to make a comparison of choices, I'm using examples of choices where it's actually useful. And an important component of that is the potential earnings on any of the situations.

How this relates to capital budgeting decisions allows the finance division to see what the company has on hand now, look at how it’s being invested for any depicted amount of time and determine about what profit might be made. Not always a profit is made either, if not invested properly the company can lose money which should also be taken into account.

On the general right track but a bit over-simplified. Not really an easy question to tackle though.