Economic Finance: Principles Involved in the Time Value of Money (Research Paper Sample)

Economics Finance
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Explain 5 weaknesses in the concept of time value of money and show how these weaknesses impact discounted cash flow(net present value) in practice, e.g., as a decision making tool.
Introduction
Money has a time value attached to it. The time value of money concept states that available cash is worth more in the present time than the same amount in the future. This involves calculating the net value of the amount received at different points in time which reveals that money has potential earning capacity (Lokken, 1986). The time value of money takes into consideration a number of variables that include: the rate of interest, rate of inflation, discount rate, duration, the number of cash flows, and the nominal balance. This concept enables investors to make decisions on saving or investing money.
One weakness of the time value of money is that it is difficult to accurately determine the rate of returns. The investor is required to peg an estimated rate, which is quite the risk since the rate is subjective and thus overrides other investment risks. Additionally, the investment may not have the same level of risk throughout its entire time duration which affects the overall future value (Gardner, 2004). For instance, the investment may have a high risk of loss in the first years and a relatively low risk of loss in the last year. This would require the investor to peg different rates for each year which makes the calculation model very complex. This is further exacerbated if there are additional cash inflows throughout the whole time duration. For instance, if an investor is to receive 100 dollars today, he may choose to receive the 100 dollars now or 105 dollars in 1 year. The 5% rate of return is worthwhile but he may choose to make another investment that would yield higher amounts say 8%. However, there is no guarantee that the rate of return will remain constant at 5% throughout the time frame.
Another weakness of the time value of money concept is that it ignores the rate of inflation making it difficult to determine the accurate expected cash flows. The rate of inflation decreases the value of the current cash flow over time in that the price of purchases increases, decreasing the number of purchases you can make with the same amount in the future compared to now. Additionally, without a guaranteed return on investment, it may be difficult to determine the expected cash flows which leave the investor to work with estimates and there is a chance that they could be off (Dempsey, 2003, pp.240-253). For instance, a company seeking to purchase software worth 100,000 dollars today may make the same purchase three years later at 200,000 dollars. This means that the time value of the available money decreases since it costs twice as much to buy the same software. The Company should invest the available cash today at a rate equal to or higher than the estimated rate of inflation to mitigate this risk. 
Moreover, the time value of money concept takes into consideration the cash inflows and cash outflows only, forgoing other hidden costs incurred during the time duration (Moon and Lee, 2003). Different investments carry different costs of managing the investments expressed in an expense ratio. Investors often think that higher management fees are worth it since they translate to a stronger performance of the investment but this is not always the case (Drake and Faboozzi, 2009). These costs slowly drain the investment which means the investment must perform better to earn back these indirect costs. These hidden costs include loads and commissions, annual custodian fees, marketing, repairs and maintenance, and purchases among others. This means that the projected profitability of the investment may not be accurate. For instance, if a company hopes to spend 10,000 dollars to acquire a new equipment and 500 dollars are paid out as a commission to the middleman who facilitated the acquisition, the 500 dollars are an indirect cost but have implications on the future value of the investment as this amount has to be earned back.
The time value of money concept makes it difficult to analyze alternative investment opportunities that have varying amounts. The different time value-based methods to calculate the time of money consider different variables which presents a complex analysis. Just because an investment is large in scale does not mean that it is the best investment in terms of returns since the risk is higher and vice versa (Klausner, 2003). The investor must assess the returns from the investments to get an accurate idea of which investment is better. For instance, an investor has 2 projects; project A that requires a 1000 dollars investment and has an estimated return of 1500 dollars, and project B that’s