Exam 12: Analyses of Costs and Outcomes

Correct Answer:

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A $100 benefit available in five years is more valuable than the same amount available in ten years due to the time value of money, which is a core principle in finance. The time value of money concept states that a certain amount of money today has a greater value than the same amount in the future due to its potential earning capacity. This is primarily because of the following reasons:

1. Inflation: Over time, the purchasing power of money tends to decrease due to inflation. Inflation erodes the value of money, meaning that what $100 can buy today, it might not be able to buy in five years, and even less in ten years. Therefore, receiving $100 in five years is more valuable because it will likely have more purchasing power than if you received it in ten years.

2. Investment Opportunity: Money available now can be invested, and due to compound interest, it can grow over time. If you receive $100 in five years, you have the opportunity to invest it and earn interest or returns for the next five years. If you receive it in ten years, you miss out on those five additional years of potential investment returns.

3. Risk and Uncertainty: Even though the question assumes that both benefits are absolutely assured, in the real world, there is always some level of risk and uncertainty associated with future payments. The longer the time frame, the greater the uncertainty. Therefore, a benefit received sooner is typically preferred because it reduces the exposure to potential unforeseen events that could affect the payment.

4. Preference for Consumption: Generally, people have a preference for consumption sooner rather than later. This is known as positive time preference. Receiving a benefit in five years aligns better with this preference, as it allows for earlier consumption or use of the funds compared to waiting ten years.

5. Liquidity Preference: Liquidity refers to how quickly and easily an asset can be converted into cash. People tend to prefer having liquidity sooner rather than later, as it provides flexibility and the ability to respond to opportunities or emergencies.

In summary, due to inflation, the potential for investment returns, risk and uncertainty, preference for earlier consumption, and liquidity preference, a $100 benefit available in five years is more valuable than the same benefit available in ten years. This is why financial calculations often involve discounting future amounts to present value to compare the value of money at different points in time.