Time Value of Money in Economic Decisions - Research Paper Example

An Opportunity cost arises when one is made to wait for the amount in future. In this context, Blue jay Manufacturing Company is looking at two options. These options include outsourcing portions of its in house manufacturing or making a capital investment towards expansion of in house manufacturing. Capital budgeting is thus essential in making a financial analysis of the two options presented to make a decision that will have the best outcome. Time value of money uses the present value and the future value of cash flows.

In this case Butler wants to keep the manufacturing in house and to do so there is need for a capital investment to be made. Investing this cash denies the business a chance to outsource since the money cannot be realized till the investment pays off. Time value of money is used here to calculate the future value of the money which is then compared to the investment value at maturity. If the investment value at maturity is greater than the calculated future value of money, then it is considered a good investment.

However, if the future value of money is greater than the value of the investment then it is not a good capital investment and Butler would be advised to go ahead and outsource (Crosson and Needles, 2008). This is how time value of money is used in making an economic decision. It helps to calculate the value of money at a future date and compare it with its present value so as to determine a worthy investment. To clearly understand the basics of time value of money, it is important to understand the Net Present value.

Net Present Value is the difference between present values of cash outflows and the present values of cash inflows. It is calculated to check the profitability of one alternative over the other. A positive NPV is an indication that it is a good investment whereas a negative NPV shows that it is not a worthy investment (Steven, 1986). In this case, future cash flows estimates of outsourcing are generated. These cash flows are then discounted to one lump sum present value for example $600,000. If the suppliers are willing to provide their services at a price below $600,000 then management can give the go ahead to outsource for this presents a positive NPV.

However, if the suppliers charge more than $600,000 it would be a very costly move and thus management would chose not to outsource. Consequently, the same analysis should be done for the case of in house manufacturing. If the NPV of in house manufacturing is found to be greater than the NPV of outsourcing, then by all means a capital investment should be made to expand in house manufacturing and vice versa. Net Present Value calculations take inflation and returns into account while analyzing the time value of money.

In simple terms, it is the present value of future cash flows without accounting for the purchase price (Crosson and Needles, 2008). It is considered the most standard method for using time value of money to appraise long term investments during capital budgeting. The Pay Back Period is also another method that is used to determine the time value of money. However, it only measures the risk and not the returns. The Pay Back period measures the time taken for cash inflows to equate to the capital investment made.

The shorter the period the more worthy the investment is. Time value of money