Time Value of Money
The time value of money serves as the foundation of finance. The fact that a dollar today is worth more than a dollar in the future is the basis for investments and business growth. The future value of a dollar is based on the present dollar amount, interest rate and time period involved. Financial calculators and tables can assist in computing the future and present values, which eases the pain of the mathematically challenged. Yield or rate of return can also be calculated.
One financial application of the time value of money is buying or selling a house mortgage note. Although normally handled by financial institutions, individuals can use this as an investment opportunity. The first step is having the note is calculated for present value. A Certified Mortgage Appraiser determines the current value of a mortgage note. The note is calculated by figuring out the present value using several factors including the interest rate, liquidity, collateral and degree of safety (Groom, 2006). Determining the future value, which Block and Hirt (2005) describe as "..the value of an amount that is allowed to grow at given interest rate over a period of time."(p.35) is more complicated than calculating bond values, but follows the same principles. It depends on financial factors such as market swings, economic growth patterns, inflation, as well as the interest rate. Bond rates are guaranteed, so they are low risk but also result in low yield. The future value of property is riskier, but also has the potential for greater returns.
Another application of the time value of money is a car loan. A favorite ploy of car dealers is to push a sale based on the fact that the buyer will have the "same payment" but a newer and of course, better car. The smart consumer will compare the present value to the future value, taking into consideration the interest rate being paid, total amount due at the end of the loan and anticipated worth of the vehicle. The MBA graduate will add to this calculation the opportunity cost which D. Henderson points out is redundant in word use, but an invaluable concept to the financial world. The true cost of something is what you give up to get it. " as contract lawyers and airplane pilots know, redundancy can be a virtue. In this case, its virtue is to remind us that the cost of using a resource arises from the value of what it could be used for instead. "(2002).
In the above example, if the consumer was to buy a less expensive car, or finance less of the car price, the funds not being used for car payments could be invested for a higher yield. The table (See Amortization Table 1) in the text demonstrates how part of the loan payment is applied towards the principle and rest goes towards reducing the principle amount (Block, Hirt, 2005).
The main learning of the amortization table is that the owner will pay slightly more in interest costs (41,000) as he did for the loan of 40,000. So the car that was...