Present Value and Future Value

FINANCE PLAN

Finance Plan

Explain the concept of time value of money. How would you use this in personal financial planning such as borrowing or saving for the future?

Time value of money happens to be one of the most crucial concepts in finance. In basic terms, as Fernando (2021) points out, this particular concept postulates that a dollar is worth more at the present moment than it would be at a certain point in the future. This, according to the author, is more so the case given the earning potential of money. To be more specific, in the words of the author, “a sum of money in the hand has greater value than the same sum to be paid in the future” (Fernando, 2021). This particular concept could come in handy in a wide range of personal finance scenarios. For instance, if I were to save a specific amount of money for a long time period, it would be wised to put the said sum in an interest-earning account, as opposed to having the same amount locked away in my safe at home. In the latter scenario, the sum would be worth much less in ten years than it is today.

Compare the process of compounding to determine future values and the process of discounting to determine present values.

In compounding, an amount of money (both the original and cumulative amount at each period) earns interest over a specified number of periods. Thus, a good example of compounding to determine future values would be investing $1000 today at a certain rate of interest every year for twenty years. The formula in this case would be FV=PV(1+i)t, in which case FV denotes future value, PV denotes present value, i represents the rate, and t denotes the number of periods. It therefore follows that if the $1000 were to be invested for 10 years at 15% rate p.a., then the future value would be computed as FV=$1000(1+0.15)10.

On the other hand, when it comes to discounting to determine present values, Graham, Adam, and Gunasingham (2020) make an observation to the effect that this has got to do with “determining the present value of a payment or a stream of payments that is to be received in the future” (149). Towards this end, the authors indicate that in in efforts to value future cash flows, the relevance of discounting cannot be overstated. The formula offered by the authors in this case is PV = FV/(1+r)t.