Time Value of Money and Cost of Capital Simplified
Understanding discount rates and the time value of money.
As a business grows, it has to think about how it will fund its business and its growth. Financing comes from various ways, primarily debt, common equity, and preferred stock. With all decisions, a crucial component is how much that decision will cost. In financing, the best alternative for funding your business is through the minimum cost of capital.
The whole purpose of understanding the time value of money is essential and straightforward for finance. $100 today is worth much more than $100 ten years from now. But why is this so? Would you prefer $100 today compared to $200 in 10 years? This would be a much harder question. It would depend a lot on what you’re using the money for today.
To answer the second question, you would have to see how much you could do with the money if you received it today instead of ten years from now. Whether you want to invest it in your business or invest it in stocks, we’ll assume that you’re using it for something to generate a return. If you can make 10% every year on your present $100, in ten years due to compounding, this would be much higher than $200, and you would have made $259.37 in ten years compared to your $200. 10% is known as a discount rate.
