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Time Value of Money Application Paper The concept of the Time Value of Money is one of the most important concepts in finance. Money has a time value, which means that a dollar today costs more than a dollar next year. A dollar today is worth more, because we can earn interest on a dollar and have more than one dollar next year. Then after, the interest that is earned by you on that one dollar also earns an interest on it, and as this occurs, the amount you have will be much more than one dollar with a lapse of time.
It should be also noted that how much more it will be in case we choose investing, depends upon the opportunities for investing that one dollar today. For example, in case the person chooses to invest in a government bond earning i% per one year, then the persons one dollar will be worth $ (1 +i) at the end of one year and (1 +i) t at the end of t years Similar to this, earning $ 1 at the end of year t will be worth 1 / (1 +i) t today So, the general idea behind the concept of the Time Value of Money is that one dollar received in the future is worthless than one dollar today, and, vice versa, one dollar received today is worth more than one dollar in the future. This occurs because of the interest that can be earned on the amount, and the connecting link between the today (present) and the future is this interest rate. In its turn, Future Value (FV) is the concept that determines what amount of money today will be worth at some point in the future: Future Value of Money = Present Value of Money x Future Value Interest Factor Present Value of Money (PV) is the concept that determines what amount of money at some point in the future is worth today: Present Value of Money = Future Value of Money x Present Value Interest Factor The concept of Time Value of Money is very important in finance, because it is a crucial factor that influences the decision whether or not to make purchases or to invest for various business and financial projects. Time Value of Money allows determining whether the future benefits will be large enough in order to justify the capital expenditures.
Finally, Time Value of Money allows calculating the present value of future benefits that will be generated by these capital projects (Foundations of Financial Management, 2008). The applications of TVM are employed by each of the following businesses: commercial banks, credit card financial service companies, insurance companies, state governments lotteries, retirement plan financial service providers, and many others. Lets take the commercial banks in order to illustrate this example. The most illustrative example is deposit. For example, when the person decides to deposit one hundred dollars a month every month during five years in his saving account in the bank, he will have to use the Future Value of An Annuity method in order to calculate the value of his savings at the end of the period (five years). The Present Value of An Annuity is the reverse of the future value of the annuity, and is calculated by the following formula: PVA = A X PVIVA, where PVA is Present Value of An Annuity, A is Annuity Payment, and PVIFA is an interest factor given an interest rate and time period (Foundations of Financial Management, 2008).
For example, in the lottery, in case the person wins the lottery and chooses to be paid in equal payments over a long-term period of time, his payment by the end of this period will be not worth as much to him in the present as the payment during the first year of payments. Now, lets examine the present value of a single amount. As we have already known, Present Value is the mathematical reciprocal of the future value of money. This concept of time value of money is also used in state governments lotteries.
For example, when the person becomes a lottery winner, he has the option to choose, either to get a lump sum payout, either to choose the usual 20 - 25 year annuity payout. Traditionally, a lottery winner is offered to choose a long-term annuity payout. When the person would like to choose the lump sum, the amount he has won would be approximately half of the advertise prize amount. However, the money that the lottery winner receives in the lump sum in the present (now) is worth more to him than the money the lottery winner will receive over twenty or more years because of the tie value of money. The present value of a lump sum can be calculated using the following formula: PV = FV X 1 / (1 + i) n where FV is Future Value of Money, i is interest rate, and n is time. What concerns the insurance companies they also employ the application of the Time Value of Money.
For example, a portion of the payments the insurance recipient is due to receive in the future is the interest the insurance company hasn't earned yet. At a time when the insurance recipient settled his case with the insurance company, the company invested the settlement amount in an annuity that is now paying a combination of principal and interest to the insurance recipient (Time Value of Money, 2008). Yet, as we have already understood, any payment amount that will occur in the future is not worth the same payment amount today. In case it would be incorrect, the insurance company would readily have given the insurance recipient a lump sum for the full amount of money at the time the recipient's case was settled. Instead, the insurance company prefers to structure it over a relatively long period of time. Again, the retirement plan service providers also imply the concept of the Present Value of Money, where the dollars they receive worth less than the dollars they will give to the retired persons.
The concept they use is the Future Value of an Annuity (FVA) (for example, the retirement Funds such as IRA, 401 (k), Keough, etc). In case we calculate the Future Value of an Annuity, we have to take into account the value of compounding for each time period in which the annuity is deposited. (Foundations of Financial Management, 2008) The formula used here is as follows: FVA = A X FVIFA, where FVA is Future Value of Annuity, A is an Annuity Payment, and FVIFA is an interest factor given an interest rate and time period This implies the number of equal contributions (deposits) made by the person over some length of time, where the contributions received by the retirement plan service providers are invested in various stocks, financial securities, mutual funds, or bonds. The future value of accumulation here is the function of the number and magnitude of contributions, reinvested interest, dividends, and undistributed capital gains. (Time Value of Money, Chapters 4 - 5, 2008) References Foundations of Financial Management. (2008). Retrieved March 9, 2008, from web ime Value of Money, Chapters 4 - 5. (2008). Retrieved March 9, 2008, from web Time Value of Money. (2008). Retrieved March 9, 2008, from web
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Research essay sample on Time Value Of Money Application
