Understanding the Time Value of Money in Entrepreneurship

 

The Time Value of Money Applies to Everyone

 

Saying “This rule does not apply to me, I am not an entrepreneur or an investor” is not really an option. The concept of the time value of money is not limited to large-scale investments. Even the cash you keep in your pocket causes you to give up potential interest income every single day.

In economic terms, this situation is called the opportunity cost of holding cash, and in finance it is defined as the time value of money. Even if you do not make a real investment, you will still expect a return on the money you hold. One of the main reasons for this expectation is the gradual loss of purchasing power over time, in other words, inflation.

For example, if the annual inflation rate is 10% and your money remains idle, at the end of the year the same amount of money will buy approximately 10% fewer goods and services. This means that the real value of your money has declined. To compensate for this loss, people who lend or entrust their money to others demand interest.

At this point, the expected return should be higher than the inflation rate. If the interest you earn is only 10%, you are not actually making a real profit; you are merely preserving the value of your money. If you choose not to lend or invest your money at all, then you are effectively accepting the loss in purchasing power.

 

Expected Returns on Capital Invested in a Business

 

As an entrepreneur, the key question is: How much return should I expect from my investment? How much above inflation and interest rates should I be willing to aim for?

The most basic benchmark is the return on government bonds and treasury bills. This is because your money can already earn a certain return through these instruments without requiring any additional effort. In financial terminology, this is known as the risk-free rate of return.

Therefore, the return you expect from entrepreneurship must be higher than this risk-free rate. The difference represents the compensation for the risk you are taking. In summary:

Minimum expected return = Risk-free rate + Risk premium

Before going deeper into the concept of the risk premium, it is also useful to mention another common investment criterion used in everyday business discussions.

 

Why Payback Period Can Be Misleading

 

One of the most frequently asked questions in business is: “How many years will it take for this investment to pay for itself?” This approach is known as the payback period. However, from a financial perspective, this method does not always lead to accurate conclusions.

For instance, assume a company outsources a metal sheet cutting process and spends 10,000 TL per year on this service. If the company needs to invest 100,000 TL in machinery to perform this process in-house, a simple calculation suggests that the investment will pay for itself in 10 years.

But the more important question is: Is this calculation truly correct? Financially speaking, it is not. The 100,000 TL investment is made today, while the 10,000 TL in annual savings are spread out over the next 10 years.

Since money today is more valuable than money in the future, the total present value of these annual savings will never be exactly equal to 100,000 TL. For this reason, relying solely on the payback period is not sufficient to properly evaluate the profitability of an investment.