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The Time Value of Money

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Autor:   •  May 17, 2017  •  Research Paper  •  2,561 Words (11 Pages)  •  73 Views

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The Time Value of Money

A Written Report

Presented to the

Center for Graduate Studies

Adventist University of the Philippines

In Partial Fulfilment

of the Requirements for the Course

BUAD515 Financial Management and Control

Lady Christifanie T. Mataya-Dapat

March 16, 2017

Introduction

Money has time value. A peso today is more valuable than a year hence. It is on this concept “the time value of money” is based. The recognition of the time value of money and risk is extremely vital in financial decision-making.

Most financial decisions such as the purchase of assets or procurement of funds, affect the firm’s cash flows in different time periods. For example, if a fixed asset is purchased, it will require an immediate cash outlay and will generate cash flows during many future periods. Similarly if the firm borrows funds from a bank or from any other source, it receives cash and commits an obligation to pay interest and repay principal in future periods. The firm may also raise funds by issuing equity shares. The firm’s cash balance will increase at the time shares are issued, but as the firm pays dividends in future, the outflow of cash will occur. Sound decision-making requires that the cash flows, which a firm is expected to give up over period, should be logically comparable. In fact, the absolute cash flows, which differ in timing and risk, are not directly comparable. Cash flows become logically comparable when they are appropriately adjusted for their differences in timing and risk. The recognition of the time value of money and risk is extremely vital in financial decision-making. If the timing and risk of cash flows is not considered, the firm may make decisions, which may allow it to miss its objective of maximizing the owner’s welfare. The welfare of owners would be maximized when Net Present Value is created from making a financial decision. It is thus, time value concept which is important for financial decisions.

Thus, we conclude that time value of money is central to the concept of finance. It recognizes that the value of money is different at different points of time. Since money can be put to productive use, its value is different depending upon when it is received or paid. In simpler terms, the value of a certain amount of money today is more valuable than its value tomorrow. It is not because of the uncertainty involved with time but purely on account.

The difference in the value of money today and tomorrow is referred as time value of money. Money has time value because of the following reasons:

  1. Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash is in our control as we make payments to parties. There is no certainty for future cash inflows. Cash inflows are dependent out on our Creditor, Bank etc. As an individual or firm is not certain about future cash receipts, it prefers receiving cash now.  
  2. Inflation: In an inflationary economy, the money received today, has more purchasing power than the money to be received in future. In other words, a peso today represents a greater real purchasing power than a peso a year hence.  
  3. Consumption: Individuals generally prefer current consumption to future consumption.  
  4. Investment opportunities: An investor can profitably employ a peso received today, to give him a higher value to be received tomorrow or after a certain period of time.  

Uses of the Time Value of Money

  • Companies use this principle in many ways and here are some examples:
  • Accountants use it for calculations of account for transactions such as loan amortization, lease payments, and bond interest rates.
  • Managers use it for managing of cash receipts and disbursements; and capital budgeting.
  • Marketers use it for funding new programs and products justifiably.
  • Individuals also benefit from this concept through:
  • For financial planning.
  • For calculation of the value of our savings.
  • For calculation of our investments.
  • For calculation of our lump-sum of periodic cash flows.

Definition of Variables Affecting Time Value of Money

Situations may vary like in the case of annuity or perpetuity payments, the generalized formula has additional or less factors but in general, the most fundamental TVM formula takes into account the following variables:

  • FV = Future value of money
  • PV = Present value of money
  • i = interest rate
  • n = number of compounding periods
  • t = number of years

Future Value is the “sum to which today’s investment will grow by a specific future date, when compounded at a given interest rate. Conversely, the sum on a specific future date that will result in today’s investment if discounted at a given discount rate.”

Present Value is the “estimated current value of a future amount to be received or paid out, discounted at an appropriate rate, usually at the cost of capital rate. PV provides a common basis for comparing investment alternatives. Also called present worth.

Simple Interest is the amount of principal times the stated rate of interest for a single period with no compounding. If the period of time for which we are examining simple interest is less than a year, the interest rate for a single period is known as a periodic rate. If the instrument pays interest more than once a year, the interest rate will generally be known as a stated annual interest rate or a quoted interest rate.

Compounding period is so-called “specified interval” or compounding interval.

“Annual compounding” means that the interest earned during the year also starts earning interest in the next period, that is, at the end of one year. Similarly, monthly compounding means that the interest earned during the one-month period will also start earning interest at the end of the month. Unless stated otherwise, a “calendar time period” will be defined as follows:

1 year = 12 months

1 year = 365 days

1 year = 52 weeks

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