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Time Value Of Money Essay

880 words - 4 pages

In financial management, one of the most important concepts is the Time Value of Money (TVM). Many of the assets businesses and individuals own are financed with money borrowed from others, so the understanding TVM is crucial to making good buying and borrowing decisions. This paper will examine the effect of annuities and other investments on TVM problems and investment outcomes.TVM and Opportunity CostThe essence of the TVM concept is that today's dollars are worth more than the expectation of dollars that will be received in the future (GetObjects.com, 2006). TVM is premised on the economic principle of opportunity cost. If a business or individual spends money on one activity instead of another, must consider the cost of the lost opportunity to carry out the activity not chosen when calculating the relative benefit of the chosen activity. When applied to investment, it only makes sense that the borrower should compensate the lender for forgoing other opportunities to use their money. That compensation, while taking several forms, is generally described as interest (Investopedia.com, 2008).Present and Future Value of MoneyPrinceton University's Richard Spies expressed the time value of money in its simplest terms in saying that, "A dollar today is worth more than a dollar tomorrow" (Moseley, C., 1998). While putting cash in a box and burying it in the ground may keep it safe, its value starts to diminish immediately because of inflation. In order to protect an investment from the effects of inflation, an investor needs to purchase an asset whose future value will be greater than its present value plus the effect of inflation. The rate of return before inflation, also known as the nominal rate, less the rate of inflation is the real rate of return on the investment. So, if the real return is positive, the future value of an investor's money will be greater than its present value. There are several ways to accomplish the necessary income to overcome inflation, such as interest paying investments.InterestInterest on money borrowed can be calculated in several ways. Simple interest is computed once in a period on the principal borrowed. Compound interest is computed over several periods on the principal plus the interest from the previous periods (GetObjects.com, 2006).Albert Einstein called compound interest the "8th Wonder of the World." (Woodward. D., 2006). Compound interest has the power to turn a relatively small investment into a large return. For relatively small interest rates, the "Rule of 72" demonstrates how quickly compound interest can multiply an investment. The rule simply states that an investment will double in 72/r years, given an interest rate of r compounded annually (Brealey, Myers, & Marcus, 2003, p.79). It assumes that the investment can earn...

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