TIME VALUE OF MONEY

One of the basic concepts in finance is that money has a “time value.” This is to
say that money in hand today is worth more than money that is expected to be received in
the future. The reason is straightforward: A dollar that you receive today can be invested
such that you will have more than a dollar at some future time. This leads to the saying
that we often use to summarize the concept of time value: “A dollar today is worth more
than a dollar tomorrow."

The idea that money available at the present time is worth more than the same
amount in the future due to its potential earning capacity. This core principle of finance
holds that, provided money can earn interest, any amount of money is worth more the
sooner it is received. In addition, because of money's potential to increase in value over
time, you can use the time value of money to calculate how much you need to invest now
to meet a certain future goal. Furthermore, this time value of money can be use in
decision making for assist your financial.

Inflation has the reverse effect on the time value of money. Because of the
constant decline in the purchasing power of money, an uninvested dollar is worth more in
the present than the same uninvested dollar will be in the future.
COST OF CAPITAL
There is a cost of doing business that must serve as your benchmark for how you
invest in long-term assets. This costs is called cost of capital. Cost of capital define as the
opportunity cost of an investment; that is, the rate of return that a company would
otherwise be able to earn at the same risk level as the investment that has been selected.
For example, when an investor purchases stock in a company, he/she expects to see a
return on that investment. Since the individual expects to get back more than his/her
initial investment, the cost of capital is equal to this return that the investor receives, or
the money that the company misses out on by selling its stock.

Cost of capital also can be define as the required return necessary to make a
capital budgeting project, such as building a new factory, worthwhile. Cost of capital
includes the cost of debt and the cost of equity. The cost of capital determines how a
company can raise money (through a stock issue, borrowing, or a mix of the two).

For an investment to be worthwhile, the expected return on capital must be greater

than the cost of capital. The cost of capital is the rate of return that capital could be
expected to earn in an alternative investment of equivalent risk. If a project is of similar
risk to a company's average business activities it is reasonable to use the company's
average cost of capital as a basis for the evaluation. A company's securities typically
include both debt and equity, one must therefore calculate both the cost of debt and the
cost of equity to determine a company's cost of capital.
DISTINGUISH BETWEEN PRESENT VALUE AND
FUTURE VALUE
Present value is the current worth of a future sum of money or stream of cash
flows given a specified rate of return. In contrast future value is the amount of money that
an investment made today (the present value) will grow to by some future date. Since
money has time value, we naturally expect the future value to be greater than the present
value. The difference between the two depends on the number of compounding periods
involved and the going interest rate. In addition, we can say that future value is the
amount at the end of term and present value is amount of money invested in the
beginning

Furthermore, the difference between the two is contributed by time. The value of
something (an asset) may typically increase over a period of time. $100 that you give me
today is not the same as $100 you give a year later. There is an interest (or return) that
accrues when you pay me $100 a year later. It is necessary to measure the value of an
amount that is allowed to grow at a given interest over a period. This is how the future
value is determined.

The distinguish between present value and future value can be seen from the
example below: by receiving $10,000 today, you are poised to increase the future value of
your money by investing and gaining interest over a period of time. For Option B, you
don't have time on your side, and the payment received in three years would be your
future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest
acquired over the three years. The future value for Option B, on the other hand, would
only be $10,000. So how can you calculate exactly how much more Option A is worth,
compared to Option B?
Future Value Basics
If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the
future value of your investment at the end of the first year is $10,450, which of course is
calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5%
and then adding the interest gained to the principal amount:

Future value of investment at end of first year:

= ($10,000 x 0.045) + $10,000
= $10,450

If the $10,450 left in your investment account at the end of the first year is left untouched
and you invested it at 4.5% for another year, how much would you have? To calculate
this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of
two years, you would have $10,920:

We can see that the exponent is equal to the number of years for which the money is
earning interest in an investment. So, the equation for calculating the three-year future
value of the investment would look like this:

This calculation shows us that the future value after the first year, then the second year,
then the third year, and so on are different with present value that we invest in the
beginning.
DISTINGUISHING BETWEEN ACCOUNTING RATE OF
RETURN (ARR) AND INTERNAL RATE OF RETURN
Internal rate of return (IRR) is a discounted method used for capital budgeting
decisions (investment etc) while accounting rate of return is a measure for calculating
return for a one off payment. IRR is actually the discount rate that equates the present
value of the cash flows to the NPV (net present value) of the project (investment) while
accounting rate of return just gives the actual rate of return.

Furthermore, ARR provides a quick estimate of a project's worth over its useful
life. ARR is derived by finding profits before taxes and interest. ARR is an accounting
method used for purposes of comparison. The major drawbacks of ARR are that it uses
profit rather than cash flows, and it does not account for the time value of money.

In addition, the discount rate often used in capital budgeting that makes the net
present value of all cash flows from a particular project equal to zero. Generally
speaking, the higher a project's internal rate of return, the more desirable it is to undertake
the project. As such, IRR can be used to rank several prospective projects a firm is
considering. Assuming all other factors are equal among the various projects, the project
with the highest IRR would probably be considered the best and undertaken first.

There are two difference things between IRR and ARR. The first and main
difference for both of it is the an ARR is for one year only. While an IRR can be
computed for a period of 1 or more years.

Besides that, we usually use IRR when making projections of expected income of
a proposed project. On the other hand, when we speak of ARR, we usually refer to
historical data (computation of rate based on income already earned, not income
forecasted). ARR is actually a form of IRR, although for one year only.

For example, let's say you invested 100 today for a project expected to provide
income of 40 after a year. To get the ARR, we simply divide 40 by 100. The ARR then is
40%. Your project earned 40% after one year. At this time, the IRR is also 40%. Another
example, let's say you invested RM100 today for a project expected to provide income of
RM40 every year for 5 years. At the end of the first year, the ARR is 40% (40/100). At
the end of the second year, the rate is no longer 40% because now you have 140 to begin
with! The computation of ARR is 40/140, which is 28.57%. At the 3rd year, 22.22%
(40/180), and so on. For this case the IRR is somewhere between 28% and 29%.