The evaluation of capital expenditure proposals involves the comparison between cash outflows & cash inflows. The pecularity of evaluation of capital expenditure proposals is that it involves the decision to be taken today where as the flow of funds, either outflow or inflow, may be spread over a number of years. It goes without saying that for a meaningful comparison between cash outflows and cash inflows, both the variables should be on comparable basis. As such, the question which arises is “that is the value of flows arising in future the same in terms of today.”
For Example:– if a proposal involves cash inflow of Rs 10,000 after one year, is the value of this cash inflow really Rs 10,000 as on today when capital expenditure proposal is to be evaluated.? The ideal reply to this question is ‘no’. The value of Rs 10000 received after one year is less than Rs 10,000 if received today. The reasons for this can be stated as below:-
(i) There is always an element of uncertainety attached with the future cash flows.
(ii) The purchasing power of cash inflows received after the year may be less than that of equivalent sum if received today.
(iii) There may be investment opportunities available if the amount is received today which cannot be exploited if equivalent sum is received after one year.
Time Value of money:
Example:- If Mr. X is given the option that he can receive an amount of Rs 10000 either on today or after one year, he will most obviously select the first option why? Because, if he receives Rs 10000 today he can always invest the same say in fixed deposit with the bank carrying interest of say 10% p.a As such, if choice is given to him, he will like to receive Rs 10000 today or Rs 11000 (i.e. Rs 10000 plus interest @ 10% p.a. on Rs 10000) after one year. If he has jto receive Rs 10,000) only after one year, the real value of same in terms of today is not Rs 10000 but something less than that. This concept is called time value of money.