Lessons in Corporate Finance

CHAPTER 13 The Time Value of Money: Discounting and Net Present Values

With this chapter, we begin the third section of this book on valuation. At the start of the book, we mentioned that a CFO had three main jobs: to make good financing decisions, to make good investment decisions, and not to run out of money while doing the first two. Section one dealt with not running out of money. The second section dealt with good financing and other financial policies. This section deals with making good investment decisions. In order to do that, we must first learn the tools used in valuation. Of these, perhaps the most important is discounting and net present value (NPV). Unlike much of this book (which your authors don’t feel is included in other financial texts; otherwise we would not have written it), discounting and NPV are covered in all basic accounting and finance texts. What follows below is our take on the subject.

The Time Value of Money

The time value of money is one of the most powerful concepts in finance. It is a concept that small children understand when they say, “I want it now, not later, now!” Quite simply, the idea is that a dollar today (or anything for that matter) is worth more than a dollar tomorrow.

An easy way to start the explanation of the time value of money is to consider a bank account. If you invest $100 in a bank account at the start of the year and earn 5% annual interest on your funds during the course of the year, how much will you have at the end ...