Time Value of Money

Running Head: TIME VALUE OF MONEY

Time Value of Money

Team C:

University of Phoenix

MBA 503: Introduction to Finance and Accounting

Time value of money is the concept that an amount of money in one's possession is worth more than that same amount of money promised in the future (Garrison, 2006). Today money can be invested to earn interest and therefore will be worth more in the future (Brealey, Myers, & Marcus, 2004). This paper will explain how annuities affect time value of money (TVM) and investment outcomes. In addition, this paper will briefly address the impact of discount and interest rates, present value, future value, opportunity cost and the impact interest has on money being borrowed.

Time Value of Money

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. (Gallager&Andrew, 1996).

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 (Gallager&Andrew, 1996).

An annuity is a number of repeated payments or receipts in the same amount (Cedar Spring Software, Inc., 2002). "The annuity values are generally assumed to occur at the end of each period" (Block & Hirt, 2005). Each TVM problem has five variables: interest rate or return, time or number of periods, future value, present value, and amount of payments either made or received (Brealey, Myers, & Marcus, 2004).

Applications of the Time Value of Money

Borrowed Funds

Today's lenders demand that interest be paid on borrowed funds as current dollars are lent out today in anticipation of higher returns in the future. Part of the payments will go toward the payment of interest, with the remainder applied to debt reduction. We assume the borrower knows the present value and wishes to determine what size annuity can be equated to that amount. We can use the time value of money to indicate the necessary payments on a loan. In other words, what annuity paid over "n" years is the equivalent of "n" dollars' present value with an "n" percent interest rate will the borrower needs to pay off the loan? In this case we use the formula for determining the size of an annuity equal to a given present value.

Invested Funds

For the investor, TMV may be used to determine the interest rate that will equate an investment with future benefits. For example, if one assumes a $10,000 investment will return $1,490 a year for the next 10 years, what is the yield? One could use the formula to find the yield on the present value of an annuity.

After solving the problem for the "present value of an annuity of $1" (PVIFA) one can use the chart and determine that when n = 10 periods the yield is 8 percent.

Saved Funds

The saver may also use TMV to determine how much money needs to be set aside each period to earn a certain return on their savings. In this case, the annuity equals a future value. For example, one might decide when a child is born to make monthly contributions to a college fund. If the goal is to have $30,000 at the end of 18 years, the formula associated with this category can be used to solve for the size of the required monthly deposits needed to meet that goal.

Other samples of problems that use this formula include when the unknown value is the size of the payment, and the known values are the interest rate per period, future value, and the number of periods.

When using financial applications of the time value of money the number of payments must be determined in the computation. These fixed payments are made in periods that are in evenly spaced intervals of time. Typical periods are measured in days, months, quarters. For example, mortgages are paid on a monthly basis, charges on credit cards are calculated on an average daily balance, and dividends are paid quarterly. Periods are intentionally not stated in years since each interval must correspond to a compounding period for a single amount or a payment period for an annuity (Gallager&Andrew, 1996).

Components of a Discount/Interest Rate

When