Time Value of Money

Time Value of Money

“One of the basic principles of finance is the time value of money. This essential insight allows us to make several important calculations that are fundamental to financial management. The time value of money concept states that a dollar received today is worth more than a dollar received in the future” (Freeman, 2000). This is because interest can be earned on a dollar received today. The money today can be invested to earn interest and therefore will be worth more in the future. Time value of money (TVM) is the process of calculating the value of an asset in the past, present, or future (Brealey, Myers, & Marcus, 2007, 89). This paper will briefly address how annuities affect TVM and investment outcomes, the impact of interest rates and compounding, present value, future value, opportunity cost, and the rule of 72 on the time value of money.

Annuities

The term annuity is used in finance theory to refer to any terminating stream of fixed payments over a specified period of time. The term is derived from the word �annual’, which would mean an equal series of payments or deposits made annually; however, in finance the annuity could be monthly, quarterly, semi-annually, or any equal time period. An annuity is an evenly spaced number of payments or money received in the same amount (Brealey, Myers, & Marcus, 2007, 95).

Interest Rates and Compounding

Interest is a fee paid on borrowed capital. By far the most common form in which these assets are lent is money, but other assets may be lent to the borrower. Interest is the multiplier that makes the fact that money has a time value a true statement. Interest rates are the percentage of initial investment or loan received or charged during a period of time. Simple interest is computed only on the original amount borrowed. It is the return on that principal for one time period. In contrast, compound interest is calculated each period on the original amount borrowed plus all unpaid interest accumulated to date (Brealey, Myers, & Marcus, 2007, 98). In the short run, compound Interest is very similar to Simple Interest, however, as time goes on difference becomes considerably larger. The conceptual difference is that the principal changes with every time period, as any interest incurred over the period is added to the principal. Put another way, the lender is charging interest on the interest. Compound interest is always assumed in TVM problems

Present Value and Future Value

Present value and future value are concepts that involve the affects of time on money. When calculating present value there is an assumption that a future amount of money is discounted by a certain percentage of the principle compounded for each period or year in the future (Brealey, Myers, & Marcus, 2007, 98). The result shows how much a future amount of money is worth today.

Future Value is the amount of money that an investment with a fixed, compounded interest rate will grow to by some future date. The investment can be a single sum deposited at the beginning of the first period, a series of equally spaced payments, or both. Since money has time value, one can naturally expect the future value to be greater than the present value. The difference between the two depends on the number of compounding periods involved and the going interest rate (Brealey, Myers, & Marcus, 2007, 99).

Opportunity cost

Opportunity cost is the loss of potential gain from the best alternative to any choice. Thus, opportunity cost is the cost of pursuing one choice