TIME VALUE OF MONEY

Time Value Of Money

[Institute Name]

Time Value Of Money

Introduction

Businesses need to understand how their money, investments, or loans are a benefit or detriment to them over time. To gain a better understanding, one should contemplate the time value of money (TVM). According to Benshoof (2005), "The time value of money quantifies the value of money over time. The time value of money depends upon the rate of return or interest rate that can be earned by investing the current money on hand" (p. 74). To recognize how annuities-a set of fixed payments over a specified length of time-affect the time value of money managers need to consider the factors of interest rates, opportunity cost, future and present values of the money, and compounding.

Opportunity Cost

Many times firms need to decide on how to best utilize its cash on hand. Should they invest it in the stock market or purchase more equipment with the hopes that it will increase productivity and profitability? A tough decision in some cases, but businesses should determine which is the wiser choice based on their financial situation. The opportunity cost associated with these choices is whether or not the company could have earned more money by choosing to do something else with the funds. TVM helps managers in figuring out which of the opportunities presented to them is the best option. The preferred alternative is one that increases the company's monetary value today as opposed to a later point in time.

Understanding Interest Rates and Compounding

In most business cases, borrowing money is not necessarily a free enterprise. It costs companies money to obtain funds on credit to finance various aspects of their business. The fee that a borrower pays to a lender for use of its money is interest. The annual percentage rate (APR) makes assumptions based on simple interest, which is interest only earned on the principal investment.

Another method of accruing interest is through compounding. Compound interest is not only charged on the original investment. It is also assessed on the interest charged or earned for each period. "When comparing interest rates, it is best to use effective annual rates. This compares interest paid or received over a common period (1 year) and allows for possible compounding during the period" (Brealey, Myers, & Marcus, 2004, p. 100). The effective annual interest rate allows for figuring out what the monthly fee of borrowing money will cost a business.

Determining Present and Future Values of Annuities

Annuities can be greatly affected by the present and potential future values of the money invested. Freeman (2000) describes the terms in the following manner: "Present value (PV) is the worth, in today's dollars, of a particular financial sum. Future value (FV) is the value of that sum projected to some point in the future, given a certain interest rate" (p. 34). Present and future values are aids to helping managers make a more informed decision on whether a particular investment or loan opportunity is right for the business. Future and present values do ...