Time Value of Money 1

Time Value of Money

Managerial Finance II/FIN476
October 21, 2007
Time Value of Money 2
Time Value of Money
Te Time Value of Money !TVM" #er$e# a# a foun%ation for all oter notion#
in finance& It influence# bu#ine## finance, con#umer finance an% go$ernment
finance& Time Value of Money !TVM" re#ult# from te conce't of intere#t& Time
Value of Money !TVM" i# an im'ortant conce't (itin te financial management&
It com'are# in$e#tment alternati$e# an% ten to #ol$e 'roblem#, (ic in$ol$ing
loan#, mortgage#, lea#e#, #a$ing#, an% annuitie#& )In %etermining te future
$alue, (e mea#ure te $alue of an amount tat i# allo(e% to gro( at a gi$en
intere#t rate o$er a 'erio% of time* !+loc, - .irt 200/"& )0y (oul% any rational
'er#on %efer 'ayment into te future (en e or #e coul% a$e te #ame
amount of money no(1 For mo#t of u#, ta,ing te money in te 're#ent i# 2u#t
'lain in#tinctual& 3o at te mo#t ba#ic le$el, te time $alue of money
%emon#trate# tat, all ting# being e4ual, it i# better to a$e money no( rater
tan later* !5roome 2006"&
Te conce't of Time Value of Money !TVM" i# tat te %ollar tat com'any
a# to%ay i# (ort more tan te 'romi#e or e7'ectation tat te com'any (ill
recei$e a %ollar in te future& Money, (ic a com'any ol%# to%ay, i# (ort more
becau#e te com'any can ten in$e#t it an% earn intere#t& Terefore, a com'any
#oul% recei$e #ome com'en#ation for foregoing #'en%ing& For in#tance, a
com'any can in$e#t teir %ollar for one year at a 68 annual intere#t rate an%
accumulate 91&06 at te en% of te year& Terefore, one can #ay tat te future
$alue of ti# %ollar i# 91&06 gi$en a 68 intere#t rate an% a one:year 'erio%& It
Time Value of Money 3
follo(# tat te 're#ent $alue of te 91&06 a com'any can e7'ect to recei$e in
one year i# only 91&
One of te ,ey conce't# of Time Value of Money !TVM" i# tat a #ingle #um
of money or te #erie# of e4ual, e$enly #'ace% 'ayment# or recei't# 'romi#e% in
te future i# con$erte% to an e4ui$alent $alue to%ay& 5on$er#ely, a com'any can
%etermine te $alue to (ic te #ingle #um or te #erie# of future 'ayment# (ill
gro( to at #ome future %ate&
I%entify at lea#t one financial a''lication of Time Value of Money !TVM" in
commercial ban,#& Ti# coul% be te intere#t, (ic commercial ban,# recei$e
from te borro(er#& Te Intere#t i# a carge for borro(ing money; it u#ually
#tate% a# a 'ercentage of te amount borro(e% o$er te #'ecific 'erio%& Te
com'utation of 3im'le intere#t i# only on te original amount, (ic borro(er
borro(e%& It i# te return on tat 'rinci'al for one time& Moreo$er, tere i#
com'oun% intere#t, (ic te calculation of eac 'erio% on te original amount
borro(e% 'lu# all te un'ai% intere#t accumulate% to %ate& I%entify at lea#t one
financial a''lication of Time Value of Money !TVM"
I%entify at lea#t one financial a''lication of Time Value of Money !TVM" in
5re%it car% financial #er$ice com'anie#& <oan =morti>ation i# a meto% of
re'aying a loan in e4ual in#tallment#& In eac of te 'ayment# 'art (ill go to(ar%
te intere#t an% ten any of te remain%er (ill go to re%uce te 'rinci'al&
Terefore, (en re%ucing te balance of te loan, a 'rogre##i$ely larger 'ortion
of eac 'ayment goe# to(ar% re%ucing 'rinci'al of te loan&
Time Value of Money 4
I%entify at lea#t one financial a''lication of Time Value of Money !TVM" in
In#urance com'anie# an% 3tate go$ernment# ? lotterie#& @re#ent Value i# te
amount to%ay tat an e4ui$alent to a future 'ayment, or te #erie# of 'ayment#,
tat a# been %i#counte% by an a''ro'riate intere#t rate& Te future amount can
be a #ingle amount tat (ill be recei$e% at te en% of te la#t 'erio%; terefore a#
te #erie# of e4ually #'ace% 'ayment# !an annuity", or bot& Moreo$er, #ince te
money a# time $alue, te 're#ent $alue of any 'romi#e% future amount (ill be
(ort le## te longer tey a$e to (ait to recei$e tat 'ayment&
I%entify at lea#t one financial a''lication of Time Value of Money !TVM" in
Aetirement 'lan financial #er$ice 'ro$i%er#& Ti# fall un%er te Future Value, ti#
i# te amount of money, (ic i# in$e#tment (it a fi7e% an% com'oun%e%
intere#t rate tat (ill gro( to by #ome future %ate& Te in$e#tment can be a #ingle
#um %e'o#ite% at te beginning of te fir#t 'erio%, (it #erie# of e4ually #'ace%
'ayment# !an annuity", or bot& 3ince money a# time $alue, tey naturally
e7'ect te future $alue to be greater tan te 're#ent $alue of money& Te
%ifference bet(een te t(o %e'en%# on te number of com'oun%ing 'erio%#,
(ic in$ol$e% te going intere#t rate&

Time Value of Money 5
Aeference
+loc,, 3&+&, - .irt, B&=& !200/"& Foun%ation# of Financial Management, 11
t

C%ition& Ne( Dor,& McBra(:.ill/Ir(in
5roome, 3 ! 2006" Understanding the Time Value of Money. In$e#to'e%ia&com
Aetrie$e on October 1E, 2007 from tt'F//in$e#trio&in$e#to'e%ia&com/article#