Time Value of Money



Answer# 1

The financial management is dependent on the concept of time value of money. That is "A Dollar today has more worth than a dollar tomorrow." Expressed more precisely: if we consider today a document (e.g. an IOU signed by a debtor) promising the payment of one dollar in a year, this document has a value today, which depends on the quality the signatory of the acknowledgment of debt, but in any case is less than a dollar. One dollar now can be placed at a certain interest rate, and it will become more than a dollar tomorrow.

• If this is set to dollar interest simple, it will accumulate the same interest in each period. For example, one dollar placed in a simple interest of 5% annual interest will generate five cents in one year, 5 cents in 2 years, etc.

• If the dollar is set to compound interest, interest will themselves generate future interest. This is the principle of capitalization. In our example, one dollar placed in a 5% interest compounded annually generate 5 cents in interest a year, then this total (1.05 dollar) will generate an interest of 5.25 cents the following year, and this total (1 + 0.05 + 0.0525) will generate an interest of 5.51 cents the year after, etc.. In the same way that one dollar is worth more today than tomorrow dollar, one dollar collected in one year will have a current value lower. The update (expressing future dollar today) is the inverse of the capitalization (expressed in current Dollars in dollar future).

This concept in the financial management is initially linked with such financial distinctions for example the cost of bearing equity and loans. Hence, the main idea is that the money that is available now will worth more than it will received in the near future because of a number of other factors which may be internal and external linked or inter linked with each other. These factors are linked with each other in a manner that they had a direct impact on the money value. The underlined rule which holds this concept is the interest that is earn on the invested amount (Smal C., 2001). For instance, assume 10% rate of return i.e. $100 invested in a security today will worth more i.e. $110 in a single year that is, $1000 multiplied by 1.10. On the other hand, one year from now $1000 will be received which is value $95.24 today ($100 divided by 1.1). Through time value of money, one can calculate the following four values: 

A dollar's future value (FV$)

A dollar's Present Value (PV$)

Future Value of an Annuity (FV of Annuity)

Present Value of an Annuity (PV of Annuity)

Importance of time value of money for financial managers it is importance for the financial manager who understands the concept of the time value of the money in order to make and compare the investment alternatives and hence to solve the problem that arises in loans, mortgages, leases savings and ...