Capital Allocating Decisions: Time Value of Money

Any investment decision depends upon the decision rule that is applied under circumstances. However, the decision rule itself considers following inputs: cash flows, project life and discounting factor.

The effectiveness of the decision rule depends on how these three factors have been properly assessed. Estimation of cash flows requires immense understanding of the project before it is implemented; particularly macro and micro view of the economy, polity and the company. Project life is very important, otherwise it will change the entire perspective of the project. So great care is required to be observed for estimating the project life. Cost of capital is being considered as discounting factor which has undergone a change over the years. Cost of capital has different connotations in different economic philosophies. Particularly, India has undergone a change in its economic ideology from a closed- economy to open-economy. Hence determination of cost of capital would carry greatest impact on the investment evaluation.

In this paper, we are going to analyse the time value of money. We study how investors and borrowers interact to value investments and determine interest rates on loans and fixed income securities. Interest is paid by borrowers to lenders for the use of lenders' money. The level of interest charged is typically stated as a percentage of the principal (the amount of the loan). When a loan matures, the principal must be repaid along with any unpaid accumulated interest. In a free market economy, interest rates are determined jointly by the supply of and demand for money. Thus, lenders will usually attempt to impose as high an interest rate as possible on the money they lend; borrowers will attempt to obtain the use of money at the lowest interest rates available to them. Competition among borrowers and competition among lenders will tend to lead interest rates toward some competitive level. Factors affecting the levels of interest rates will do so by affecting supply and demand conditions for money. Among these factors are inflation rates, loan risks, investor inter-temporal monetary preferences (how much individuals and institutions prefer to have money now rather than have to wait for it), government policies, and the administrative costs of extending credit.