Introduction:
Time value of money is the concept of compare
investment alternatives and to solve problems involving loans, mortgages,
leases, savings and annuities.
The concept is that have the value of money today is more than the promise
and expectations that we will receive money in the future. The money that we
hold today is worth more because we can invest it and earn interest.Time value of money
Time Value of Money (TVM) is an important concept
in financial management. It can be used to compare investment alternatives and
to solve problems involving loans, mortgages, leases, savings, and annuities.
TVM is based on the concept that a dollar that you
have today is worth more than the promise or expectation that you will receive
a dollar in the future. Money that you hold today is worth more because you can
invest it and earn interest. After all, you should receive some compensation
for foregoing spending. For instance, you can invest your dollar for one year
at a 6% annual interest rate and accumulate $1.06 at the end of the year.
You can say that the future value of the dollar is $1.06 given a 6% interest rate
and a one-year period. It
follows that the present value of the $1.06 you expect to receive in one
year is only $1.
A key concept of TVM is that a single sum of money
or a series of equal, evenly-spaced payments or receipts promised in the future
can be converted to an equivalent value today. Conversely, you can
determine the value to which a single sum or a series of future payments will
grow to at some future date.
Interest
Interest is a charge for borrowing money, usually
stated as a percentage of the amount borrowed over a specific period of
time.
Simple
interest and compound interest
Simple interest is computed only on
the original amount borrowed. It is the return on that principal for one time
period. In contrast, compound
interest is calculated each period on the original amount borrowed plus all unpaid interest accumulated
to date. Compound interest is always assumed in TVM problems.
Present Value
Present Value is an amount today that is equivalent to a
future payment, or series of payments, that has been discounted by an
appropriate interest rate. The future amount can be a single sum that
will be received at the end of the last period, as a series of equally-spaced
payments (an annuity), or both. Since money has time value, the present
value of a promised future amount is worth less the longer you have to wait to
receive it.
Future Value
Future Value is the amount of money that an investment
with a fixed, compounded interest rate will grow to by some future date. The
investment can be a single sum deposited at the beginning of the first period,
a series of equally-spaced payments (an annuity), or both. Since money
has time value, we naturally expect the future value to be greater than the
present value. The difference between the two depends on the number of
compounding periods involved and the going interest rate
Managerial
prospect of time value of money
Managers study how investors and borrowers
interact to value investments and determine interest rates on loans and fixed income
securities.through use of time value managers can find out the interest rate
and present and future value of money. Interest is paid by borrowers to lenders
for the use of lenders’ money. The level of interest charged is typically
stated as a percentage of the
Principal (the amount of the loan).
When a loan matures, the principal must be repaid along with any unpaid accumulated
interest. In a free market economy, interest rates are determined jointly by the
supply of and demand for money. Thus, lenders will usually attempt to impose as
high an interest rate as possible on the money they lend borrowers will attempt to obtain the use of
money at the lowest interest rates available to them.
Time value of money problem refers to situations
involving the exchange of money at one point in time for the rights to the
future cash flow associated with that investment. The passage of time between
the outflows and inflows in a typical investment situation results in different
current value associated with cash flows that occur at different points in
time.
Why the value is
greater in the future?
There are primary reasons why a money to be received
in the future is worth less than a dollar to be received immediately. The first
and most obvious reason is the presence of positive rates of inflation which
reduce the purchasing power of dollars through time. Secondly a dollar today is
worth more today than in the future because of the opportunity cost of lost
earning, that is it could have been invested and earned a return between today
and a point in time in the future. Thirdly all future values are in some sense
only promises, and contain some uncertainty about their occurrence. As a result
of the risk of default or nonperformance of an investment, a dollar in hand
today is worth more than in excepted dollar in the future. Finally, human
preferences typically involve anxiety, or the preference to consume goods and
services now rather than the future.
Applications of the time value of money:
There are some applications of the time value of
money.
1.
This concept is used to purchase
equipment or new product decision.
2. Future
payments , future worth of an investment, regular payments necessary to provide
a future sum to amortize a loan, determination of return on an investment,
determination of the value of the bond.
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