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 The Time Value of Money (TVM) serves as a foundation for all other notions in finance. It influences business finance, consumer finance and government finance. Time Value of Money (TVM) results from the concept of interest. Time Value of Money (TVM) is an important concept within the financial management. It compares investment alternatives and then to solve problems, which involving loans, mortgages, leases, savings, and annuities. In determining the future value, we measure the value of an amount that is allowed to grow at a given interest rate over a period of time (Block & Hirt 2005). Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctual. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later (Croome 2003). The concept of Time Value of Money (TVM) is that the dollar that company has today is worth more than the promise or expectation that the company will receive a dollar in the future. Money, which a company holds today, is worth more because the company can then invest it and earn interest. Therefore, a company should receive some compensation for foregoing spending. For instance, a company can invest their dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. Therefore, one can say that the future value of this dollar is $1.06 given a 6% interest rate and a one-year

Time Value of Money 3 period. It follows that the present value of the $1.06 a company can expect to receive in one year is only $1. One of the key concepts of Time Value of Money (TVM) is that a single sum of money or the series of equal, evenly spaced payments or receipts promised in the future is converted to an equivalent value today. Conversely, a company can determine the value to which the single sum or the series of future payments will grow to at some future date. Identify at least one financial application of Time Value of Money (TVM) in commercial banks. This could be the interest, which commercial banks receive from the borrowers. The Interest is a charge for borrowing money; it usually stated as a percentage of the amount borrowed over the specific period. The computation of Simple interest is only on the original amount, which borrower borrowed. It is the return on that principal for one time. Moreover, there is compound interest, which the calculation of each period on the original amount borrowed plus all the unpaid interest accumulated to date. Identify at least one financial application of Time Value of Money (TVM) Identify at least one financial application of Time Value of Money (TVM) in Credit card financial service companies. Loan Amortization is a method of repaying a loan in equal installments. In each of the payments part will go toward the interest and then any of the remainder will go to reduce the principal. Therefore, when reducing the balance of the loan, a progressively larger portion of each payment goes toward reducing principal of the loan.

Time Value of Money 4 Identify at least one financial application of Time Value of Money (TVM) in Insurance companies and State governments lotteries. Present Value is the amount today that an equivalent to a future payment, or the series of payments, that has been discounted by an appropriate interest rate. The future amount can be a single amount that will be received at the end of the last period; therefore as the series of equally spaced payments (an annuity), or both. Moreover, since the money has time value, the present value of any promised future amount will be worth less the longer they have to wait to receive that payment. Identify at least one financial application of Time Value of Money (TVM) in Retirement plan financial service providers. This fall under the Future Value, this is the amount of money, which is investment with a fixed and compounded interest rate that will grow to by some future date. The investment can be a single sum deposited at the beginning of the first period, with series of equally spaced payments (an annuity), or both. Since money has time value, they naturally expect the future value to be greater than the present value of money. The difference between the two depends on the number of compounding periods, which involved the going interest rate.

Time Value of Money 5 Reference Block, S.B., & Hirt, G.A. (2005). Foundations of Financial Management, 11th Edition. New York. McGraw-Hill/Irwin Croome, S ( 2003) Understanding the Time Value of Money. Investopedia.com Retrieve on October 19, 2007 from http://investrio.investopedia.com/articles