The concept of the time value of money stands for the idea that the value of money that will be obtained in the future is lower than that of money available at the moment (Magloff, 2018). In the time value of money, the value of funds that are on hand at the present moment is viewed as higher because this money can be invested and used to earn interest. Practically, an investment made promises today to earn interest that exceeds the amount of money that was invested initially.
For example, investing 2 dollars today, one is promised to receive 2.50 dollars at the end of the year. This means that the present value of the future 2.50 dollars is 2 dollars. Using this simple demonstration, it is possible to understand the perspective from which investors evaluate their future interests.
Time value of money is a rather important concept in the field of financial management. This concept is commonly used in investment strategies as it helps to resolve problems that involve future returns on investment and operations such as loans, leases, savings, and mortgages. Moreover, the importance of time value of money is boosted by the trends and processes that can potentially influence lent or invested money. Such risks include inflation and default that can produce a negative impact on the invested money.
In this case, default stands for the situation when the borrower fails to pay back the money they lent on the exact day specified in their agreement. This is where another principle of the time value of money plays a part. Specifically, the value of a particular sum of money generated in the future is higher than the value of the same sum obtained in a more distant future (Irfanullah, 2013).
The concept of the time value of money is widely applied when analyzing cash flows and their worth that appears at different periods of time. Using this principle in financial management, investors and analysis can calculate the value of a certain sum of money available on the present day that will occur in the future at different times. The calculations of the time value of money can help analysis, and investors assess when a series of payments need to be made in order to generate the anticipated sums of money in the future (Irfanullah, 2013). Such calculations rely on three major concepts used in the time value of money, such as present value, future value, and interest.
In order to understand the present value, it is necessary to apply the concept of discounting. Practically, the future payments need to be discounted with the consideration of the existing rate of interest. The discounting of future payments has to be carried out up to the present day. This action will both reflect the time value of money for that individual scenario and demonstrate what is referred to as the present value. Discounting is an important aspect of present value calculations.
In fact, this concept is also known as a discounted value. For example, in order to find out the present value of 12000 dollars received dollars with the interest rate of 5 percent after one year, one needs to discount the future value considering interest rate and time using the following formula: PV=FV*(1 + i)-n. This will give the investors 11428 dollars of present or discounted value. The same formula is used to determine the future value of a sum of money present on hand to date.
Also, this formula takes into account such phenomenon as compounding that is commonly applied to interest in order to describe interest that is earned on the original interest (“The miracle of compounding,” 2008). There are different types of compounding that are distinguished by their frequency – daily, weekly, monthly, and annual. In cases of compounding, the interest rate earned on interest over certain time periods is added to the balance and can be calculated. Future value for 500 dollars invested for a year with an interest rate of 5 percent will be calculated using the following formula: 500*(1 + 0.05/12)12. The result is 525.58 approximately, which means that due to the little sum of the original investment, the compound interest produces 0.58 dollars only.
An annuity is another concept tightly connected to the principle of the time value of money. It stands for a contractual agreement sold by financial establishments as a product. In an annuity, a financial institution receives and grows funds from an individual who purchased it. It involves the point of annuitization at which a series of payments are made by the institution to the individual (“Annuity,” 2018).
The major benefit of an annuity is its capacity to generate a steady flow of money created based on the principle of the time value of money. Annuities are individually shaped, taking into account various factors and aspects such as structure, benefits, growth rate, and the periods of time that determine annuitization and for which the entire operation is expected to last. In order to calculate the present and future value of annuities, it is critical to consider all the different factors that produce an influence on the generated cash flow.
Annuity. (2018). Web.
Irfanullah, J. (2013). Time value of money (TVM). Web.
Magloff, L. (2018). Define the “time value of money. Web.
The miracle of compounding. (2008). Web.