F-Cube Series – Finance Fundamentals for Founders – Time Value of Money

In order to be a successful entrepreneur or business-person, one needs to have a strong understanding of finance and the concept of ‘Time Value of Money’ is at the heart of finance. In fact, it’s so fundamental to the field that you’ll learn about it in every business class and financial management course.

Let’s start with an example; would you rather get $1 now or $2 later? The answer depends on how much time passes between now and then: if there are two days between now and then, the expected return from investing one dollar would be 50 cents (= 1 x 2/365), so choosing to take $2 later means sacrificing an opportunity cost of 50 cents per day.

This concept is any business-owner’s bread-and-butter; and here’s why:

It helps you understand how interest rates work on loans and investments which will help you pinpoint investor expectations and how you can get funding for your growth. 

When you are looking to raise capital either by equity financing or loans, the investors or financing partners are looking for returns over and above risk-free returns (such as those from a Government bond or Savings Account). Hence it is important to understand the risk and return of investment that investors are expecting.  Understanding these expectations will help founders create their own financial projections with more clarity on what they can afford in terms of returns or when they should try again if an investor isn’t interested.

For example, an investor might have a 5 year lifespan before going public or being bought out by another company for $30 million. That would give them an annualized return of 25%. When such returns exceed any other investment avenue that they could put their money into, then your business will be seen as the most attractive to investors.

Time value of money helps you answer the below questions

1) What is the real cost of capital?  (P.S. Did you know – cost of equity financing is the highest – we will cover this in future topics)

2) When is it smart to borrow and when is it better to raise capital via equity financing? What is the risk-return profile of each of these types of capital?

3) How to attract fresh rounds of investments by offering exit to current investors at attractive returns – what returns did existing investors get and what could be expected for the incoming investors? (the IRR!)

4) How is the value of your business impacted due to a cash flow based approach? (The DCF method, which follows the time value of money principle)

Founders can get a better understanding of what value or return is expected by considering the risk and return from an investor’s perspective.

If you want to learn more about cash flow prediction or valuation, contact us today for your free consultation.