The Time Value of Money and IRR / NPV in Financial Modeling

Ok, we are going to talk about something that effects the personal saver as well as big corporate finance teams. That is the time value of money. Some people think it is voodoo (same with the IRR) calculation, but it is a very real concept that should be understood by anybody in finance. There are a lot of good ways to explain its significance and place within financial modeling / financial planning and analysis.

time value of money

Relevant Templates:

Let's Start With and Example - I Just Went Through a Case with a Client Regarding Just this

I run across scenarios all the time where a business is trying to figure out how much cash they need to get started and what the IRR of their project is. One important thing to understand if you are trying to price large enterprise clients is the payment terms, especially if your company has large capital expenditures required at the beginning of the contract. For example, if you have a $100M contract that is earned evenly over 36 months, but to get started your company must purchase $30M in up front infrastructure. You might find it to be a good idea to charge some percentage of the total contract value up front in order to help pay for your initial capital expenditures and improve the IRR. Even though the total cash in and out is the exact same, the scenario where you collect more of the total contract value up front and less over time is advantageous because then you can reinvest that up front money into new business activity and/or pay for upfront costs. The IRR rises in that scenario even though the total ROI is unchanged.

The Time Value of Money (TVM) is a fundamental financial principle that asserts money available now is worth more than the same amount in the future due to its potential earning capacity. This core concept is based on the premise that money can earn interest or generate returns, thus a dollar today holds more value than a dollar to be received tomorrow.

Key Components of TVM:

  • Present Value (PV): The current worth of a future sum of money or stream of cash flows, given a specified rate of return.
  • Future Value (FV): The amount of money an investment made today will grow to at a future date, based on an assumed rate of return.
  • Interest Rate: The percentage at which money grows over a period.
  • Time: The period over which money is invested or borrowed.

Applications of TVM:

  • Investment Analysis: Assessing the value of investments and comparing different investment opportunities.
  • Loan Calculations: Determining payments and interest on loans.
  • Savings: Planning for future financial goals by understanding how much to save and invest today.

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. It is the discount rate that makes the net present value (NPV) of all cash flows (both positive and negative) from a particular project equal to zero. In simpler terms, IRR is the annualized effective compounded return rate that can be earned on the invested capital, i.e., the yield on the investment.

Key Points about IRR:

  • Decision Making: IRR is widely used to evaluate the desirability of investments or projects. A project is considered to be a good investment if its IRR is greater than the required rate of return.
  • Comparing Projects: It helps in comparing the profitability of projects by providing a single figure that sums up the returns over the project's lifespan.
  • Limitations: While useful, IRR should not be the sole criterion for decision-making, as it can be misleading for non-conventional cash flows or projects of different lengths.

Applications of IRR:

  • Capital Budgeting: To decide whether to proceed with a project or investment.
  • Portfolio Management: To rank investments based on their returns.
  • Financial Forecasting: To estimate future growth rates based on past performance.

TVM and IRR Relationship:

The concepts of TVM and IRR are closely related in that IRR utilizes the TVM principle to determine the profitability of investments. By calculating the rate at which the present value of future cash flows equals the initial investment, IRR essentially applies the TVM concept to find a break-even rate of return.

Understanding both TVM and IRR is crucial for making informed financial decisions, whether in personal finance, corporate finance, or investment analysis. They provide a framework for evaluating the value of money over time and the relative attractiveness of various investment opportunities.

You may also be interested in the CAPM (capital asset pricing model) that is one part of coming up with your WACC as well as the differences between the required rate of return and discount rate.

Article found in Accounting and Finance.