Time Value of Money: The Concept and the Importance

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Introduction

This report explains the concept of time value of money in the matters of financial management of an organization. This is the value of money which is earned with an interest over a given period of time. It purports that if a person invests money in the present day it will fetch interest and thus grow in the future. The idea lies on the assumption that the money invested today will be worth more with interest in the future. It is the most important tool for financial managers to take financial decisions in all types of business organizations. Time value of money is calculated by calculating the present and future value of money. The term present value can be understood as the worth of money when it is invested for a specified rate of return. On the other hand, future value refers to the sum to which the asset will grow or decrease on a specific date in the future.

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Definition of Time Value of Money

Time value of money is an important part in the financial theory. The concept is based on the premise that money paid today is better than money paid in the future. “The difference in the value of money today and tomorrow is referred as time value of money” (Basic Concept of Time Value of Money, pg.2).

Importance of Time Value of Money for Financial Managers:

Financial managers and investors always seek opportunities to make positive rates of return on their funds, whether through investment in appealing projects or in interest- bearing deposits or securities. Thus, the timing of cash outflows and inflows has significant economic significance, which the financial managers openly identify as the time value of money. “Time value of money is an important tool that financial managers and other market participants use to assess the effects of proposed actions. Because firms have long lives and some decisions affect their long-term cash flows, the effective application of time-value-of-money techniques is extremely important” (Gitman, pg.173).

It also permit financial managers to assess the inflows and outflows of cash that take place during different times, in order to evaluate, and assess them and relate to the firm’s overall objective of share price maximization Thus, proper appreciation of the fine value of money helps to take make intelligent value-creating decisions.

Calculate the Future Value of the followings

  1. $204,298 if invested for five years at 7% interest rate.
  2. $319,112 if invested for three years at 4% interest rate.
  3. $311,124 if invested for seven years at 2% interest rate.
  4. $299,129 if invested for ten years with 0.9% interest rate.

Solution

Calculation of Future Value of Money is as follows:

“FV = PV (1+i) n”

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Where FV = Future Value

PV = Present Value

I = Rate of interest

N =Number of periods over which compounding takes place (Calculations of Time Value of Money, pg.2).

F.V= 204,298(1+1.403)5 = 204,298(12.015) =$2,454,640.47

F.V= 319,112(1+1.125)3 =319,112(6.375) = $2,034,339

F.V= 311,124(1+1.149)7 = 311,124(15.043) =$1,680,238.332

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F.V= 299,129(1+1.105)10 =299,129(21.05) =$6,296,665.45

Calculate the present value of the followings

The present value is the value of a future amount of cash at exact point in time. “The present value factor formula is based on the concept of time value of money” (Present Value Factor, para.3).

Calculating the present value assumes that the shareholder recognizes both the rate of return or applicable interest rate and future value the investment will fetch. One discounts the rate of return or interest rate from the future amount so as to derive at the present value. Following are the equation for calculating present value:

PV = FV/ (1 + i) t” (Present Value, para.2) a. $652,126 to be received three years from now with a 4% Interest rate

Interest rate for each time period = 4%

Interest rate per year=.889

Number of Time Periods=3

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Future Value =$652,126

Present value (PV) =$652,126/ (1+.889)3 = $115074.

$128,231 to be received five years from now with a 5% interest rate

Interest rate for each time period = 5%

Interest rate per year =0.784

Number of Time Periods=5

Future Value = $128,231

Present value (PV) = $128,231 / (1+.784)5 = $14375.

$591,199 to received two years from now with a 12% interest rate

Interest rate for each time period = 12%

Interest rate per year=0.797

Number of Time Periods=2

Future Value = $591,199

Present value (PV) = $591,199 / (1+.797)2 = $164496.

$187,111 to be received eight years from now with a 1% interest rate.

Interest rate for each time period = 1%

Interest rate per year= 1.083

Number of Time Periods= 8

Future Value = $187,111

Present value (PV) = $187,111 / (1+1.083)8 = $11228.

Suppose you are to receive a stream of annual payments (also called an “annuity”) of $193,723 every year for three years starting this year. The interest rate is 4%. What is the present value of these three payments?

The present value of a collection of future cash flows specified the discount rate or rate of discount.

“Present value = annuity amount × [1 – (1 / (1 + r) n)] / r” (Present Value (PV) Annuity Calculator, para.5).

Annuity= $193,723

Interest rate per year = 2.775

Number of periods =3

Therefore, the current value of the three payments = $6334.867.

Suppose you are to receive a payment of $292,595 every year for three years. You are depositing these payments in a bank account that pays 2% interest. Given these three payments and this interest rate, how much will be in your bank account in three years?

The equation of calculating the yearly bank account is;

“S = D x [(1 + r) n]” (Jerome, para.2).

D = $292,595

r = 3.06040

n =3 year

S = $3564158

So, the total amount of bank account in three years = $3564158.

Works Cited

Basic Concept of Time Value of Money. New Age Publishers.com. n.d. Web.

Calculations of Time Value of Money. Prenhall. 2005. Web.

Gitman, Lawrence. J. principal of Managerial Finance. Eleventh Edition. Pearson Education India. 2006. Web.

Jerome, Jay. What is the Formula to Calculate Bank Interest? For Example an Invested 153000 at the Rate of 10% for 36 Months. What will be the Sum of Maturity?. Blurt. It. n.d. Web.

Present Value Factor. Finance Formulas. n.d. Web.

Present Value. Net MBA Business Knowledge Center. 2002. Web.

Present Value (PV) Annuity Calculator. Easy Calculation. n.d. Web.

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