![]() To pick the “right” option rationally, you must consider the time value of money, which is essentially the required rate of return (i.e. In the second option, you can receive $11,000 - but it’ll take one year in the future before the funds are received.In the first option, you can receive $10,000 right now.The time value of money is the basis of the net present value ( NPV) calculation.Īs a brief example, let’s say that there are two investment options, as outlined below: If you risk one dollar in an investment, you should reasonably expect gains of more than solely your initial one-dollar contribution as a return.įor each incremental unit of risk you take on, you should expect a proportionally higher return in exchange. ![]() With that said, cash flows received in the future (and with increased uncertainty) are worth less than the present value (PV) of the cash flows. Since money tends to decline in value over time due to factors such as inflation, the purchasing power of money also decreases. future uncertainty should be costlier than the lower risks identified on the present date.
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