Page 472 - Introduction to Business

446 PART 5 Finance

It is generally true that capital budgeting decisions are separate from financing
decisions. That is, financial managers initially select the investment projects with
highest potential economic value. Other managers raise required funds needed to
purchase assets, pay for labor, and cover other investment costs. If earnings from an
investment project exceed its costs, it is considered a feasible investment project
that will increase economic profits and related share values.
A crucial aspect of this kind of capital budgeting analysis that complicates mat-
ters is that earnings and costs normally occur over time. How do we compare the total
earnings and total costs in this case? Do we simply add up the earnings over time and
do the same for costs? As we will see in the next section, simply adding up the earn-
ings and costs over time does not consider that fact that the value of money changes
over time. Let’s take a closer look at the relationship between money and time.

reality If you were offered stock options for excellent job performance at a
CH ECK company, would you work harder than otherwise?

Time Value of Money and Interest Rates

LEARNING OBJECTIVE 2
Use the time value of money to differentiate between present values and future
values of money.
Money is worth less tomorrow than it is today. The main reason is that inflation
causes goods and services to cost more tomorrow than they do today. In 1960, you
could buy a McDonald’s hamburger for 25 cents. Today, the price of the same ham-
burger is about 80 cents. Rising costs of food, labor, equipment, land, buildings, and
so on, have caused the price of a hamburger to increase. Another reason that
money declines in value over time is that people would rather spend it now than
later. Suppose you were given a choice between a dollar received today and a dollar
received one year from now. If there were no inflation over the next year, which dol-
lar would you want? Most people would say that the dollar today is worth more to
them than the dollar tomorrow. If they had the dollar today, they would have more
options for spending the money than if they received the dollar in one year. The dif-
ference in the values of the dollar in this case is due to the time preference for con-
sumption. Simply put, people prefer to consume now rather than later, all else
being the same.
Now consider the situation that arises when one person wants to borrow money
from another person. The lender transfers money to the borrower and gives up
some current consumption. The lender can only use the money for consumption in
time preference for consumption The the future, after the borrower repays the loan. Due to the lender’s time preference
desire by people to consume goods and for consumption, the borrower must pay the lender an additional amount called
services now rather than in the future
interest as compensation for the declining time value of the money. Suppose $100
interest The amount that a borrower
must pay a lender in addition to the is borrowed for one year, there is no inflation, and the interest charged by the lender
principal value, as compensation for the is $2, due to the time preference for consumption. In this case the rate of interest is
declining time value of money 2 percent ($2/$100 0.02), which is known as the real rate of interest. The real rate
real rate of interest The interest rate of interest is known to be fairly constant over time, as the time preference for
charged by lenders on loans to consumption does not change much over time.
borrowers for forgoing present
consumption for future consumption The lender still has the problem of inflation decreasing the purchasing power of
his or her money over time. When he or she later gets the money back from the bor-
rower, the lender faces the problem that the money will buy less than before. Prices
of goods and services generally rise over time. As protection against inflation—the
rising prices of goods and services—the lender will demand additional interest from
the borrower. This rate of interest will be equal to the expected rate of inflation over

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