Time value of money (“TVM”) is defined as the idea that money available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also often referred to as “present discounted value” (Answers Corporation, 2006). TVM concepts help people like managers or investors understand the benefits and the future cash flow to help them determine if the future benefits will justify the initial cost of the project or investment.
To recognize how annuities (a set of fixed payments over a specified length of time) affect the TVM, managers need to consider the factors of interest rates, opportunity cost, future and present values of the money, and compounding. In this paper, I will explain how annuities affect TVM problems and investment outcomes. I will also address the impact of the following on TVM; interest rates and compounding, present value, opportunity cost, and annuities as well as the Rule of 72.
How do annuities affect TVM problems outcomes? Annuities are an investment that promise a constant amount of cash over a certain period. Since annuities generally gain interest, the organization receiving the payments is gaining interest. Annuities can be calculated differently based on the terms of the agreement between the two parties (Brealey, Myers, & Marcus, 2006).
How do annuities affect TVM investment outcomes? Annuities affect TVM investments in a negative manner when the money is accumulating interest. If the money is paid with simple interest, the interest is calculated annually at the rate determined. If the interest is compounded, the interest is calculated annually on the existing balance and as the balance grows. When these investments are in favor of the loaner/bank, the compounded interest is the positive calculation since it earns more money for the loaner/bank (Brealey, et al., 2006).
What is the impact of interest rates and compounding on TVM? When compounding periods are more frequent, interest is received more often; thus, the future value is greater. In addition, when analyzing, the greater the interest rate equates to the greater the return on investment. Both of these, interest rates and compounding periods, can quickly increase the rate at which an investment grows or a debt increases (Brealey, et al., 2006).
What is the impact of present value on TVM (of a future payment received)? The present value of money is also known as discounting. The discount rate is sometimes called the opportunity cost of money. Money can be invested to earn interest. Because money is of more value when it is cash in hand, it has more value since the person holding the cash can invest the cash and, in return, earn interest. When payments are not received, cash flow is reduced; therefore, interest earned is reduced. The relationship between present value and time and interest rate is exponential, i.e.: the greater the interest rate, the smaller the present value (Brealey, et al., 2006).
What is the impact of future value on TVM (of an investment)? The future value of money is also known as compounding. Future value is calculated by understanding how much interest the money will ear, how long it will be earning the interest and if the money will be compounded annually or at another interval. The impact of future value on an investment most likely will be greater than the present value (Brealey, et al., 2006).
What is the impact of opportunity cost on TVM? Opportunity costs are benefits of lost or forfeited as a result of selecting one alternative course of action over another. When an organization makes a bad decision with its existing cash balance, and the choices are not clearly calculated and analyzed, money can be lost if the value can increase in one choice over the other and the lesser of the two are selected (Brealey, et al., 2006).
What is the impact of annuities and the Rule of 72? The Rule of 72 states that in order to calculate the number of years necessary to double your money at a particular interest rate, one must divide the interest rate into the number 72. For example, if you would like to know how long it will take to double your money at eight percent interest, divide eight into 72 and the result is nine years. When the investor/manager can quickly calculate the return on investment, they will be able to make a quicker decision in regard to the investment or budget decision (Brealey, et al., 2006).
TVM is clearly a useful financial concept for managers to apply in their business practices. Figuring present and future values of the firm’s annuities allows for executives to calculate an expected rate of return on financial dealings. Through the understanding of TVM, managers can have an enhanced image of how the company’s investment opportunities are working for the betterment of the firm.
Answers Corporation (2006). Time value of money. Retrieved November 1, 2006, from http://www.answers.com/topic/time-value-of-moneyBrealey, R., Myers, S., Marcus, A. (2004). Fundamentals of corporate finance (9th ed.). New York, NY; McGraw-Hill/Erwin.