1 Answer | Add Yours
Businesses invest money for creating assets of various kinds like land, equipment, stocks, and other types of working capitals. They do this to be able to earn a profit. How attractive an investment in a particular business or particular type of assets is directly linked to the amount of profit earned.
But the absolute quantity of profit is not a satisfactory measure for comparing attractiveness for different type of investment. Same amount of profit earned on two different type of assets with considerable difference in investment is not equally attractive. An investment that gives same return with lower investment is definitely preferable. Therefore, to compare attractiveness of investments with different level of investment we can use the concept of rate of return. Thar is we can measure the profits in terms of percentage of the investment made. Thus, for example, a profit of $500 on an investment of $2000 comes to rate of return of 25% which is better than profit of $600 on investment of $3000, which is equal to rate of return of 20%.
The rate of return also is not a very satisfactory measure of attractiveness of investments. Typically, an investment made in business continues to give returns for many years. The distribution of profit along the time line is also very important. A profit of $100 today is definitely more attractive than same profit next year or distributed over few years. This preference for having money earlier can be attributed to several reasons. One very clear advantage of having money earlier is that we can then earn interest on it or invest it in business and earn profit. This if we earn interest of 10%, the amount of $100 is as attractive as $110 after one year. This concept of money now being more attractive than some time in future is called time value of money.
We can assess attractiveness of rate of return on different investments by discounting them by a suitable factor representing the time value or a notional interest rate. Let us say this discounting rate is 10% per year then the discounted present value of $100 dollars received today is $100. But the present value of $100 received after one year is only $90.91 ($100 dividedby by 1,1), and that after two years is $82.64 ($100 divided by 1.1^2 or 1.21). In this way we can calculate present value of any stream of returns over a period using appropriate rate of discounting.
Thus we can say that effect of time on rate of return is that the effective rate of return on any assets over a period of time gets reduced by a suitable factor representing time value of money. This techniques of adjusting rate of returns for effect of time is often called the technique of discounted cash flow. Another variation of this technique is internal rate of return, which expresses the total amount of return received over a period as a compound rate of interest on the initial value of investment.
We’ve answered 318,944 questions. We can answer yours, too.Ask a question