Time Value of Money

Running Head: Time Value of Money

Time Value of Money

University of Phoenix

Believe it or not many people through out the years thought that by putting money to the side, under the mattress or, even in the cookie jar that eventually one day they would be rich. Well not to spoil the surprise but the years it would take to make one rich by those means are far off and nothing in between. This is where Time Value of Money comes in. Time Value of Money is the idea that a dollar today is worth more than a dollar in the future, even after the adjustments of inflation, interest rates, and appreciation until the time come for the dollar in the future to be received. Simply stated invest. There are a variety of financial applications of the time value of money. This paper will identify different financial application, and components of a discount and interest rate. The goal is to list various financial applications, and explain the components of discount and interest rates.

Financial Applications

The time value of money can be applied to many everyday financial decisions. Suppose a parent wants to set aside present funds for their child’s educational future. Several factors will impact the ability to yield a return, such as the number of periods involved and the applied interest rate. For this reason, the concept of the time value of money can be calculated by several financial applications. The financial applications consist of future values and present values, annuity, and yield of an investment, which will be discussed.

When considering the above example of setting aside funds for college, the parent may need to be aware of various future and present values of money. 50 years from now “tuition at an average private university (over four years) will go from $64,000 to $455,000” (Block, 2005, p. 244). Interest rates applied over time are a direct reflection and indicator of how much a dollar amount will be worth, which is also known as the future value of a single amount. The present value of a single amount has an indirect relationship with future value. Present value implies that a discount rate is in effect, since the amount is worth less in the present than in the future. Hence, what the parent puts in the college fund today will be worth less now, but in the future the amount will be worth more.

Annuity is “a series of consecutive payments or receipts of equal amounts,” (Block, 2005, p. 242). For the parent putting monies in a college fund account, annuity would represent the value of equal amounts of payments for the duration of the investment, taking the interest rate into consideration. When calculating annuity, the future value of each payment is identified, and totaled to get future value of annuity. One important note is that an assumption is made that payments occur at the end of each period and the last payment is not compounded. When calculating present value of annuity, “the payment is reversed, as each individual payment is discounted back to the present and then summed up,” (Block, 2005, p. 244). This method is used to find out the present value of an annuity. Another financial application that can be used is the annuity equaling a future value and the annuity equaling a present value. The parents may want to use these applications to determine how much to set aside at the end of each period in order to reach a desired amount, or if they may want to determine the size of an annuity equivalent to a present value. At times, deferred annuity occurs when an annuity begins in the future. For example, the amount of the college fund payments may change in the child’s high school years. The combination of annuity and single payment amounts would change the present value.

The last financial application of the time value of money is the yield of an investment, or interest rate. One can discover the yield on a present value of a single amount or the yield on the present value of annuity. At times, interest may be compounded at different periods, such as monthly, or quarterly. In this case, variations in how the interest is applied will alter the present and future value amounts.

The time value of money can be determined using a variety of the financial applications mentioned.

Discount/Interest Rate

The Discount rate is the fee eligible financial institutions charge to borrow