Time Value of Money

¶ … value of money reflects the fact that money diminishes in value over time. A dollar today has more buying power than a dollar tomorrow does. The time value of money holds under conditions where there is inflation. As the price of goods and services rises over time, the purchasing power of a dollar diminishes over time. The time value of money concept in finance reflects this reality by translating the nominal value of future cash flows into present day dollars to reflect the difference in purchasing power that occurs over time.

It is important for financial managers to understand the concept of time value of money for a couple of different reasons. The first is that they are often working with their clients in the long run. As an example, if you are working on a retirement plan for a customer, you cannot simply assume that those future dollars -- which are often twenty or thirty years in the future -- are going to be able to buy the same goods and services as they will today. So it is important to recognize this when making financial plans. You would want, ideally, to earn on the investments a rate that is higher than the rate at which the purchasing power of that money erodes. Indeed, this is especially important in retirement planning because the person is trying to live for several years on money that they earned in just 30 or 40 years -- someone who lives thirty years after retirement will have to live on their savings for about as long as they worked for, so it is critical that the financial manager is able to understand the value of the money in the accounts of such an individual.

Another important consideration with the time value of money is that the value of future cash flows has to be adjusted to present day values. This makes a big difference when evaluating between multiple options where the primary difference is in the timing of the cash flows. An example of these would be considering an investment in a new business idea. One business idea might have a smaller payoff but one that occurs within a couple of years. The other idea might have a larger nominal payoff that is several years away. However, because the timing of the cash flows is different, these options are hard to compare with one another. As a result, these cash flows must be translated to present day dollars in order that they can be compared accurately.

Finally, it is important for financial managers to understand the time value of money because there are costs to investing. For example, a business acquires capital through a variety of means, but there is always a cost. If the business borrows, then the interest rate is the cost of capital. If a business is using equity, that equity also has a cost in dividends and internal growth opportunities. So it is important for financial managers to recognize that capital is not free. Therefore, the business or personal with capital needs to invest that capital to earn a return. However, the value of that return must take the cost of capital into consideration. That is where the discount rate in time value of money comes into play -- this is a measure of the cost of capital that is used to evaluate the investments that a company or person makes.

3. a) 1.093 * $120,537.19 = $131,747.15

b) $337,891.22 * 1.504 = $508,188.39

c) $420,891.12 * 3.479 = $1,464, 280.21

d) $525,520.22 * 7.076 = $3,718,581.07

4 a) $262,126.17 * .79 = $207,079.67

b) $325,003.21 * .582 = $189,151.87

c) $421,567.35 * .386 = $162,724.99

d) $631,500.05 * .231 = $145,876.62

5. The present value of these payments is as follows:

$525,891.12 * 4.160 = $2,187,707.06

6. The present value of these payments is as follows:

$637,891.24 * 8.11519 = $5,176,608.61

7.

I feel that this module has given me a lot of practice at working with the net present value calculations. These were done using the tables provided. The different tables provide an opportunity to work on the time value of money concept. There are different ways in which the time value of money comes into play in financial planning and it was interesting to see the different ways in which the concept is applied in the real world, as there were all real world examples of putting the concept of time value into action.

I also learned what the time value is and how it is important. There are many dimensions of the time value of money. It was valuable just to think about how the time value of money is important in so many different ways for the financial manager. With this understanding, the concept is better put into practice. This is valuable for me because it made me put myself in the position of someone who works with the time value of money and then explain why I need to really understand this concept.

Present value and future value are two different but related concepts. Present value is interesting because it forces you to look at the real value of the future cash flows rather than just the nominal value. Knowing that the real value is what is important makes it even more important to understand this concept because it is used in business to make investment decisions and it is used by people who are looking to invest as well in their portfolios.