Time Value of Money

Time Value of Money

The time value of money serves as the foundation of finance. The fact that a dollar today is worth more than a dollar in the future is the basis for investments and business growth. The future value of a dollar is based on the present dollar amount, interest rate and time period involved. Financial calculators and tables can assist in computing the future and present values, which eases the pain of the mathematically challenged. Yield or rate of return can also be calculated.

One financial application of the time value of money is buying or selling a house mortgage note. Although normally handled by financial institutions, individuals can use this as an investment opportunity. The first step is having the note is calculated for present value. A Certified Mortgage Appraiser determines the current value of a mortgage note. The note is calculated by figuring out the present value using several factors including the interest rate, liquidity, collateral and degree of safety (Groom, 2006). Determining the future value, which Block and Hirt (2005) describe as “..the value of an amount that is allowed to grow at given interest rate over a period of time.”(p.35) is more complicated than calculating bond values, but follows the same principles. It depends on financial factors such as market swings, economic growth patterns, inflation, as well as the interest rate. Bond rates are guaranteed, so they are low risk but also result in low yield. The future value of property is riskier, but also has the potential for greater returns.

Another application of the time value of money is a car loan. A favorite ploy of car dealers is to push a sale based on the fact that the buyer will have the “same payment” but a newer and of course, better car. The smart consumer will compare the present value to the future value, taking into consideration the interest rate being paid, total amount due at the end of the loan and anticipated worth of the vehicle. The MBA graduate will add to this calculation the opportunity cost which D. Henderson points out is redundant in word use, but an invaluable concept to the financial world. The true cost of something is what you give up to get it. “… as contract lawyers and airplane pilots know, redundancy can be a virtue. In this case, its virtue is to remind us that the cost of using a resource arises from the value of what it could be used for instead. “(2002).

In the above example, if the consumer was to buy a less expensive car, or finance less of the car price, the funds not being used for car payments could be invested for a higher yield. The table (See Amortization Table 1) in the text demonstrates how part of the loan payment is applied towards the principle and rest goes towards reducing the principle amount (Block, Hirt, 2005).

The main learning of the amortization table is that the owner will pay slightly more in interest costs (41,000) as he did for the loan of 40,000. So the car that was priced at 40,000 actually ended up costing the owner 81,000. The amount paid is compounded if the owner takes into consideration the money that could have been earned if part of those funds had been invested. At a return rate of 8%, if the buyer had purchased a less expense car at 30,000 and invested 500 per year over 20 years, he would have 22,881 out of his total investment of 10,000.

A third, textbook example, of the time value of money is relating it to the cost of capital purchases, or something that has a life of greater than one year. Business executives must take into consideration the total cost of a new project, including present and future costs, and compare those against the future benefits. The purchase of a new building is a solid example. If the cost is only looked at from the perspective of the loan pay-back period, which uses estimated cash flows it ignores the time value of money. Scott Peterson (2005) recommends using NPV or Net Present Value since it gives an objective and accurate valuation. NPV is the present value of cash flows minus the original investment. It also defined as a way of comparing the value of money now with the value of money in the future. Inflation deflates future buying power while money that is available today can be invested and grows its earnings (Kantrowicz, 2007).

The components of interest and discounts rates play an integral part in understanding the time value of money. The interest or discount rate affects the future value of investments and loans.