Everyone is familiar with the saying that time is money. We understand the concept because of our learning experience during our first job. For most people, the first job during high school is one in which we get paid by an hourly wage. We also learn about the concept time is money, when we take a ride in a theme park, rent a cycle at the beach, or rent a movie.
In business we have to invest money to produce products and deliver services. Companies raise money by borrowing and or issuing stocks. It does not matter how the company raises the money; there is a cost for money.
Money does not grow on trees, and no one will give you money for free; there is a cost for raising money (Ahmed, 2010).
That is one of the reasons managers must learn how to perform the time value of money analysis before making business and management decisions.
The time value of money concept extends beyond the concept of time is money, it includes time, money, and cost of money. The time value of money concept states that money in your hand today is worth more than the money you will receive at a later date.
Let’s assume you have the choice of receiving $1,000 dollars today or $1,000 dollars after one year.
Which would you choose?
Of course, you would select $1,000 today because you can invest the $1,000 that you receive today and earn interest on $1,000. Let’s assume that the current rate of return is10%; in that case, you will end up with $1,100 at the end of one year.
If you have selected the option of receiving $1,000 after one year you will have lost the $100 growth in the investment, and end up with $1,000 rather than $1,100. This example shows that money in your hand today is worth more than money you will receive at a later day.
Managing a business without concern for profits is not good management (Ahmed, 2014).
The management of businesses involves raising and investing funds and generating profits. The analysis of time value helps managers in functional areas such as marketing, finance, operations management, human resources, and information technology in making profitable management decisions.
Let’s review the following three alternatives that are available to functional managers, and to select the best alternative based on the profitability. These investment alternatives may be for an advertising and promotional plan in marketing, a new plant and equipment decision in finance, a quality improvement program in operations management, an employee retention plan in human resources, or a new network installation in information technology.
A rational manger will select the project with the highest profitability. Alternative number 2 is the most profitable project. However, the problem with the above decision-making process is that we are ignoring the time value of money.
To determine the profitability of the alternatives, we need to bring the cash flows from the alternatives for years 1, 2, and 3 to the present value, and compare these with the initial investment to determine the profitability of the alternatives in today’s dollars.
The process of bringing the cash flows from the investment to the present value and comparing these with the initial investment is referred to as net present value (NPV). It is calculated by subtracting present value (PV) of all the cash inflows flows from the Initial investment.
Now let’s evaluate the alternative using the NPV analysis, and assume that the required or discount rate of the company is 10%. Based on the NPV analysis, the profitable alternative is alternative number 3. If we had ignored the TVM concept when making the management decision, we would have selected an alternative that would have adversely impacted the profitability of the firm.
Profitable management decisions are based on both qualitative and quantitative analysis.
The following are the selected examples of the application of NPV analysis in the five functional areas of business.
The managers will be able to evaluate the profitability of all the available advertising and promotional plans based on the amount invested in the plan and its impact on sales and profitability.
The managers will be able to evaluate the profitability of replacing the old plant or building a new plant based on the investment in the plant equipment and the cash flows generated from the use of the plant and equipment.
The managers will be able to evaluate the profitability of quality improvement programs based on the investment in the program, and the cost savings generated and/or sales increased by the implementation.
Human Resources Management
The managers will be able to evaluate the profitability of retention plans, benefits packages, and training programs based on the investment, cost savings, and productivity improvements.
The managers will be able to evaluate the profitability of hardware and software installation based on the investment, and the cost savings generated from the implementation.
The managers will be able to evaluate the profitability of sustainability initiatives based on the investment and the cost savings or increase in profits.
The time value of money concept is useful in analyzing the internal rate of return of marketing plans, quality improvement programs, human resources retention strategies, sustainability initiatives and new technology projects.
© 2017 Mohammed R. Ahmed
Ahmed, M.R. (2017). Hope and Health Will Bring Happiness Into Your Life.
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