FINANCE 501 Module 2 Case

FINANCE 501 Module 2 Case

Time Value of Money

It is often said "time is money" to mean that we should not waste it. But in finance, they say literally, that is to say that the time really is money. So what is the time value of money? How can we explain that a dollar today is worth more than dollars in a year or more? 

The time value of money becomes a reality obvious to everyone, simply by recalling what we could buy dollars for several years? Probably much more than what one can buy today. The easiest way to explain the influence of time on the value of money is that it can produce its own money, which undoubtedly influences its value. Indeed, by placing 100 dollars for one year to 10%, will give us 110 dollars at the end of the year without selling or buying anything! The interest rate reflects the time value of money and it really covers several elements, namely:

• Inflation: the purchasing power of dollars is not the same from year to year. A lender of dollars today should provide him a refund covering the inflation rate in one year so as to maintain the same purchasing power.

• Suppose that there is no inflation, and what you can buy one dollars today is the same as a year. The lender's preference to consume now that in a year which would explain some of the interest rate that is sort of the price of renouncing consumption today to future consumption.

• The risk associated with the uncertainty of what the borrower will make money attributed to it also includes a price in the interest rate.

In financial mathematics express this time value of money by "capitalization" and "discount". The notion that money has a time value is one of the fundamental concepts finance them. Imagine that we are in an environment of certainty (ie, are ca-peace to predict the future with complete accuracy) and the State we borrow $ 1,000 and in return, promises to return safely 1,040 dollars within a year. This means that, in an atmosphere of certainty equivalent of 1,000 dollars to 1,040 dollars today in within one year, or what is the same, the amount of money in a year is 4% higher than today.

Therefore, in this environment, the rate of interest (4% in our example) is the rate of exchange between the values of money at two certain times. Thus ...