Question 3 (a)
Relevance of the time value of money to financial decisions
4 marks
- Time to write
- About 8 minutes
From an older CBCS paper
Question
Question 3 (a) · 4 marksExplain how the time value of money is relevant to financial decision making.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning of the time value of money 1 mark 1 min
- 2 Reasons for it 1 mark 2 min
- 3 Relevance to investment, financing and dividend decisions 2 marks 4 min
Easy marks
- Meaning of the time value of money (step 1, 1 mark): a definition in one or two lines. It opens the answer, so it takes a minute or two.
Short on time? Step 3 carries 2 of the 4 marks: guard its minutes.
Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The idea. Financial decisions commit money now for benefits spread over future years. Simply adding up the future benefits and comparing them with the outlay assumes that a rupee has the same value whenever it is received, which is incorrect. ₹1,000 in hand now is worth more than ₹1,000 receivable after a year; the extra compensation needed for parting with money now is interest, the time value of money.
- preference for present consumption over future consumption;
- investment opportunities: present cash can be invested to earn more;
- uncertainty about the future, the most important reason;
- inflation, which erodes the purchasing power of money.
Relevance to financial decisions
- Investment decisions: projects are compared by discounting their cash flows (NPV, IRR), so a project whose returns come later is valued less.
- Financing decisions: the cost of debt or of a lease is found by comparing the present value of the payments with the funds received.
- Dividend and valuation decisions: a share's value is the present value of the expected dividends.
- Money received at different times is made comparable by compounding (to a future date) or discounting (to the present).
Where the 4 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of the time value of money | 1 |
| 2 | Reasons for it | 1 |
| 3 | Relevance to investment, financing and dividend decisions | 2 |
| Total | 4 |
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