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Time Value Of Money Essay

753 words - 3 pages

In financial management, one of the most important concepts is the Time Value of Money (TVM). Time Value of Money concepts helps a manager or investors understand the benefits and the future cash flow to help justify the initial cost of the project or investment. Many of the assets businesses and individuals own are financed with money borrowed from others, so the understanding of TVM is crucial to making good buying decisions. To recognize how annuities, a set of fixed payments over a specified length of time, affect the time value of money, managers need to consider the factors of interest rate, opportunity costs, future and present values of money, and compounding. (Investopedia, 2006)Opportunity CostsMany times firms need to decide on how to best utilize its cash on hand. Should they invest it in the stock market or purchase more equipment with the hopes that it will increase productivity and profitability? A tough decision in some cases, but businesses should determine which is the wiser choice based on their financial situation. The opportunity cost associated with these choices is whether or not the company could have earned more money by choosing to do something else with the funds. TVM help managers in figuring out which of the opportunities presented is the best option. The preferred alternative is one that increases the company's monetary value today as opposed to a later point in time.Interest Rates and CompoundingIn most business cases, borrowing money is not necessarily a free enterprise. It costs companies money to obtain funds on credit to finance various aspects of their business. The fee that a borrower pays to a lender for use of its money is interest. The annual percentage rate (APR) makes assumptions based on simple interest, which is interest only earned on the principal investment.Another method of accruing interest is through compounding. Compound interest is not only charged on the original investment, but also assessed on the interest charged or earned for each period. "When comparing interest rates, it is best to use effective annual rates. This compares interest paid or received over a common period and allows for possible compounding during the period."(Brealey, Myers, & Marcus, 2003, 100) the effective annual...

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