You are the chief financial officer of a firm. The firm has an expected liability (cash outflow) of $2 million in ten years at a discount rate of 5%.
- Calculate the amount the firm would need on the present date as savings to cover the expected liability.
PV = FV / (1+r)^n
PV = 2,000,000 / (1 + .05)^10
PV = 2,000,000 / 1.6289
PV = $1,227,822.46
- Calculate the amount the firm would need to set aside at the end of each year for the next ten years to cover the expected liability.
PMT = (r(PV) / 1-(1+r)^(-n)
PMT = 61,391.123 / 1 – (1.05)^(-n)
PMT = 61,391.123 / 1 – 0.6289
PMT = 61,391.123 / 0.3711
PMT = $165,427.74 annually
Using the Argosy University online library resources, identify an article that demonstrates the application of time value of money principles to a business decision.
- Explain the specific business decision that management made after computing this value. Analyze how management used the concept of the time value of money principles to make this decision.
The Time Value of Money (TVM) is the principle that one dollar today is worth more than one dollar in the future. Businesses use the TVM in determining if big projects will be profitable. In capital budgeting, they use it to determine if the cash flows estimated will cover the total costs of the project analyzed. If the estimated cash flows are less than the total project costs than the project should not be pursued. In budgeting, businesses determine if opening a new location would be profitable. For example, if the new location costs $110,000 and the estimated net cash flow is $16,000, for a total of $160,000. At first this seems profitable but with the cost to borrow the money has an annual percentage rate of 10 percent, the present value would equal $98,314. This is less than the initial investment of $100,000 so this would not be a project to pursue (Merritt, n.d.). Another example is that suppliers would give discounts to buyers to increase early payments of their debts because they can do more with the early discounted payment than wait for full payment in the future.
- Analyze factors other than the time value of money that management considered or should have considered in reaching the business decision.
The TVM is determined without risk to the value of money. The factors that could affect the TVM are inflation, taxes, contractual terms, economic activity, and credit risk. The most important principle to understand regarding risk in the idea of independence. Independent events occur by chance and can only be determined by analyzing the probability that the event occurred in the past to determine the probability of the event to occur in the future (Saylor Academy, 2012).