1. Time Value of Money
The "time value of money concept" is based on the assumption that investors prefer to receive $1 today rather than $1 in one year.
There are several possible reasons that underlie this assumption:
Liquidity preference: if money is received today it can either be spent or reinvested to earn more in future. Hence, investors have a preference for having cash/liquidity today.
Risk: cash received today is safe, future cash receipts may be uncertain.
Inflation: cash today can be spent at today's prices but the value of future cash flows may be eroded by inflation.
2. Investment Appraisal
Discounted cash flow (DCF) techniques can be used to evaluate business projects (i.e. for investment appraisal). Two methods are available:
(1). Net present value (NPV); and
(2). Internal rate of return (IRR).
3. Limitations of DCF Techniques
Despite the theoretical superiority of DCF techniques, it appears that in practice many company managers prefer to use non- DCF methods of appraisal such as payback or return on capital employed .
Possible reasons for this reluctance to use DCF methods include:
The potentially complex and time-consuming process of calculating NPV and/or IRR.
T Difficulty in explaining DCF techniques to non-financial managers.
T Complexity of estimating an appropriate discount rate, particularly for unquoted firms.
T Managers may feel little connection between DCF techniques and their own reported performance and bonus systems.
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