Time Value of Money

Time Value of Money

“Money has a time value associated with it and therefore a dollar received today is worth more than a dollar to be received in the future” (Block, Hirt, 2005). The time value of money may be based on the concept that one would prefer to receive a fixed payment today rather than the same fixed payment at a future date. This paper discusses some of the key components of time value of money and identifies the application of time value of money in various businesses.

Commercial banks use various time value of money formulas daily. One example of the application of time value of money in commercial banks is through mortgages. Using the formula for present value of an annuity, a bank will solve the formula to determine the monthly payment amount, the borrower’s monthly mortgage payment.

Credit card financial service companies are commonly known to issue private student loans. Therefore, credit card companies would use the time value of money to determine loan payment schedules and the number that students most fear, the ending balance, the future value of the loan. Credit card companies would use the formula for present value of an annuity to determine the payment schedule, and they would use the formula for future value of an annuity to determine how much money the student will end up paying the credit card company at the end of student loan.

Insurance companies also use time value of money. A structured settlement is one example. If a person owes $100,000 payable in $20,000 increments over the next five years, the present value of the settlement is less than $100,000. Therefore, the person would be better off paying the lump sum now if possible.

The same time value of money can be seen in state governments and lotteries. For example, a person wins a lottery worth one million dollars. This person is given three options, and each option has a different fee attached to it. The first option is to receive $20,000 a year for the next 50 years. The second option is to receive a lump sum now of one million dollars. This option has the largest fee. The third option is to receive half the money now and the other half over the next 25 years. One would use the time value of money to determine the better deal.

Time value of money can also be seen with retirement plan financial service providers. For example, a customer goes to a service provider and says that he would like to retire in 25 years with one million dollars. He would like to know how much he should invest now to ensure that he has one million dollars at retirement. If the person only intends to deposit money one time, the answer lies in