Time Value of Money

Time Value of Money

Time Value of Money (TVM) is an economic theory that suggests the idea that money available today is more valuable now versus the future. Three reasons for TVM are inflation, risk and liquidity (Investopedia, 2008). As a result, borrowers charge interest to ensure that the value of their money is not eroded by inflation. Inflation is an increase in the cost of goods and services provided. Risk is the possibility that an investment may yield different results than the results expected. “The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this greater potential return is that investors need to be compensated for taking on additional risk of lending money out” (Marshall & McManus 1966), and because the loan might not be easily sold to another borrower if need be, that is, it has low liquidity. Liquidity is the company’s ability to meet its current obligations and is shown on the statement of financial position or balance sheet (Marshall & McManus, 1996). This paper will focus on various financial applications of the Time Value of Money (TVM) and explain the components of the discount/interest rate. The paper will attempt to offer examples of each financial application and show how the components of discount and interest rates interact with TVM.

Applications of TVM

Some of the applications of TVM include the following: capital budgeting, the valuation of companies for mergers, retirement planning, and amortization of loans and saving, and investment management. Each of these applications has one or more components of TVM. Either present or future value, present value of perpetuity, loan amortization, cash flow diagram, or present and future value of an annuity and discounted cash flow.

Capital budgeting

According to Garrison (1988), capital budgeting is an investment concept, that requires the commitment of funds now in order to receive some desired returns in the future. Components of capital budgeting includes: present value analysis and the cash flow diagram. Present Value (PV) is the estimated present worth of an amount of cash to be received or paid in the future (Fess and Warren, 1986, p.387).

An example of PV would be $100 on hand today would be more valuable $100 to be received a year from today. In this case, if the $100cash on hand today can be invested to earn 10% per year, the 100 will accumulate $110 by one year from today. The $100 on hand today can be referred to as the present amount that is equivalent to $110 to be received a year from today (Fess and Warren, 1986, p.387)...

The Cash Flow Diagram is an actual drawing which shows the change in cash during the year, and shows cash provided from or used by operating, investing, and financing activities.

Valuation of companies for mergers

Present Value of a Annuity (PVA) “is simply the sum of the present value of each of the annuity payment amounts.” (Marshall & McManus, 1996, p.208) An example would be assume a firm purchase some government bonds in order to temporarily invest funds that are being held for future plant expansion.

The bonds will yield interest of $15,000 each year and will be held for five years. The present value of the $15,000 in interest received a year from now is $13,395 as compared to only $8,505 for the $15,000 interest payment to be received five years from now. This example shows how money has time value (Garrison, 1988).

“Discounted cash flow uses the present value concepts to compute the present value of cash flows expected from a proposal.” (Warren & Fess, 1986, p. 715) and the use of estimating the attractiveness of an investment are some of the uses for discounted cash flows.

Future Value (FV) is an investment whereas the outlay of money is given a fixed compounded interest rate with the expectation of growth in the future. Installment payments and leasing are a form of future value. An example of FV would be the applied use of the “double to 72 rule”. The rule states that one’s money doubles based on a wide range of interest rates. Whereas the doubling time is (72/100r), the symbol r being the interest rate. An example would be a 10% interest rate applied would generate an investment doubling in 7.3 years!

Retirement planning

Some examples of retirement planning would include life insurance and 401k plans. Both of these savings are designed for the future and offer penalties for taking money out prior their maturity.

Amortization of loans.

The amortization of loans occurs when the loan amount is spread