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Time Value Of Money Essay

1022 words - 4 pages

AbstractThe initial steps on the way to understanding the connection between the value of dollars today and that of dollars in the future is by looking at how funds invested will grow over time. This understanding will allow a person to answer such questions as; How much should be invested today to produce a specified future sum of money?TIME VALUE OF MONEYGenerally, borrowing money is not free, unless it is a small amount for lunch from a friend. Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the amount borrowed per a period of time, usually one year. The current market rates are composed of three items.The Real Rate of Interest is what compensates lenders for postponing their own spending throughout the tenure of the loan. An Inflation Premium is added to offset the chance that inflation may gobble into the value of the money throughout the tenure of the loan. Additionally, a variety of Risk Premiums are added to compensate the lender for risky loans such as unsecured loans made to borrowers with questionable credit ratings or loans that the lender may not be able to easily resell.The first two components of the interest rate listed above, the real rate of interest and an inflation premium, collectively are referred to as the nominal risk-free rate. In the United States, the nominal risk-free rate is estimated by the rate of US Treasury bills.Simple interest is calculated on the original principal only. Interest from past periods are not used in calculations for the subsequent periods. Simple interest is usually used for a single period loan of less than a year, such as 30 or 60 days loans. The formula is:Simple Interest = p * i * nwhere:p = principal (original amount borrowed or loaned)i = interest rate for one periodn = number of periodsCompound interest is calculated each period on the original principal and all interest accumulated during past periods. The interest rate normally is stated as a yearly rate. The compounding periods can also be yearly, semiannually, quarterly, or even continuously.Imagine compound interest as a succession of back-to-back simple interest contracts. The interest earned in each period is added to the principal of the previous period to become the principal for the next period. For instance, you borrow $10,000 for three years at 5% annual interest compounded annually. The following shows the compounding principle.* Interest year 1 = p * i * n = 10,000 * .05 * 1 = 500* Interest year 2 = (p2 = p1 + i1) * i * n = (10,000 + 500) * .05 * 1 = 525* Interest year 3 = (p3 = p2 + i2) * i * n = (10,500 + 525) *.05 * 1 = 551.25Total interest earned over the three years = 500 + 525 + 551.25 = 1,576.25. The power of compounding can have an amazing effect on the accumulation of wealth.Money held denies its power to earn. Future Value is the amount of money that an investment made today (the present value) will grow to by some future date. Because money has time value, we...

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