Why is it important to adjust all cash flows to a common date?

QUESTION

Why is it important to adjust all cash flows to a common date?

Worth of money is affected by the time value of money (TVM) concept which states that a dollar received today is worth more than that received anytime in future. TVM concept arises because of the following reasons: (1) Re-investment opportunities- Money received today can be re-invested to earn returns. Thus at a future date, money will increase in value because of the interest earned. For example if the rate of interest in the market is 10% per annum, then $1 today will compound to $1.1 ($1*(1 10%)) in one year. So, worth of $1 will be $1.1 after a year. (2) Risk and uncertainty- there is always a risk associated with future receipts or payments as the borrower may refuse to pay due to some unavoidable circumstances. (3) Preference for present consumption- individuals generally prefers current consumption¦

to future consumption. Hence money received today is more valuable than that received later. Thus the same sum of money will be worth different amounts at different dates. To compare cash flows received or paid at different dates, they need to be brought to a common level i.e. a common date. Thus they are all adjusted using the techniques of compounding and discounting; compounding to calculate the value of a sum of money at a future date and discounting to calculate the present value of money to be received or paid at a future date.

ANSWER:

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