Corporate Finance, 5th Edition

Chapter 16 The time value of money and 
net present value

A bird in the hand is worth two in the bush

For economic progress to be possible, there must be a universally applicable time value of money, even in a risk-free environment. This fundamental concept gives rise to the techniques of capitalisation, discounting and net present value, described below.

These are more than just tools, but actual reflexes that must be studied and acquired.

Section 16.1 Capitalisation

Consider an example of a businessman who invests €100 000 in his business at the end of 2007 and then sells it 10 years later for €1 800 000. In the meantime, he receives no income from his business, nor does he invest any additional funds into it. Here is a simple problem: given an initial outlay of €100 000 that becomes €1 800 000 in 10 years, and without any outside funds being invested in the business, what is the return on the businessman’s investment?

His profit after 10 years was €1 700 000 (€1 800 000 – €100 000) on an initial outlay 
of €100 000. Hence, his return was (1 700 000/100 000) or 1700% over a period of 10 years.

Is this a good result or not?

Actually, the return is not quite as impressive as it first looks. To find the annual return, our first thought might be to divide the total return (1700%) by the number of years (10) and say that the average return is 170% per year.

While this may look like a reasonable approach, it is in fact far from accurate. The value 170% has nothing to ...