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Understanding the Time Value of Money and How to Apply It in Finance

Jun 3, 2023 | 0 comments

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Jun 3, 2023 | Essays | 0 comments

Time value of money concept states that the dollar or the money that a person have today has more worth than the  expectation or the promise that an individual or an entity will receive dollar or money in the future. The money that an individual has today has more worth because it can be invested and earn interest. This concept is essential to the financial mangers because they can use it in comparison of the investments alternatives, project appraisals and in solving the problems that involve mortgages, loans, savings, leases and annuities (Peterson & Fabozzi, 2009).

There are two methods used in evaluation or calculation of the lump sum amounts; the lump sum future value and the lump sum present value.

 

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  1. Lump sum future value

Shim (2012) stated that lump sum future value in evaluation is used when a business  wants  make calculations of the money it will have at future point if it makes one time deposit with no future withdrawal or deposits, given a certain time period and interest rate. This is also referred to as compounding

  1. Lump sum present value

The evaluation for the lump sum present value is used when a business want to make calculations of the amount of money it should pay today for an investment if it will lead to the generation of a certain cash flow of lump sum in the future, given a certain time period and rate of interest. This is also referred to as discounting (Shim, 2012).

In calculation of the lump sum amount future value, compounding formula is applied. In this formula, the compound interest is added to the principal which is the deposit so that the interest added also earns interest then on. This compounding formula and it has the following equation; F=P (1+i)

Where (P) is the sum of money at present, (i) is the compound interest rate, (F) is the future lump sum of money, (n) is the period of time. For example;

If $1000 is deposited in a bank that pays 12% interest per the compounding period, the total amount of money after the five periods in the account will be as follows;

F=P (1+i)

F = $1000 (1+) 5

F = $1.762

On the other hand, in calculation of the lump sum present value, discounting formula is used. In this formula, all the cash flows in future are estimated and then discounted to derive the present values. The formula has the following equation; P=

Where (F) will be received in future after (n) periods after the present value (P) is calculated by a given rate of interest (i). For example;

Five years from now, $ will be received, with a rate of interest of 12%, what is this amounts present value?

P=

P=

P= $ 1000

According to Taylor (2014), Rule of 72 is a quick and simple way of estimating how long it takes an investment to double. In using Rule of 72, the only information needed is the annual rate of return. In estimation the length of time for the money to double, 72 is divided by 72 by the rate of interest (Taylor, 2014).  The result will be the duration taken in the number of years for the doubling of the money at the given rate. For example, if the rate of return earned is 6%, how long will it take to grow $1,000 into $2000?

72/6% =12 years

In the given example, an investment of $1,000 into an account with a flat rate of 6% annual return rate after 12 years, the investment would be around $2000.

 

References

Peterson, D. P., & Fabozzi, F. J. (2009). Foundations and applications of the time value of money. Hoboken, N.J: John Wiley & Sons.

Shim, J. K. (2012). Time value of money and fair value accounting: Tools and concepts. Cranbrook: Global Professional.

Taylor, C. C. (2014). The rule of 72.

 

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