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Time Value of Money

Table of Contents

Abstract………………………………………………………………………………3

Time Value of Money………………………………………………………………..4

Future Value and Present Value…………………………………………………......5

Challenges…………………………………………………………………………...6

Summation…………………………………………………………………………..8

References…………………………………………………………………………...9

Abstract

Time value of money operations are the backbone of financial decisions in business. The basics of their operation lie in interest calculations that can be used to determine the value of money five years ago, today and even well into the future. These calculations can be tricky and are weighed with outside challenges that can affect them positively and negatively ...view middle of the document...

Simple interest is essentially the rent paid on borrowed money and is paid out at the end of each term on only the initial principal. If a business gave a bank $100.00 to hold at a 5% simple interest per year, the money would grow as follows:

Year 1: 5% of $100 = $5 + $100 = $105

Year 2: 5% of $100 = $5 + $105 = $110

Year 3: 5% of $100 = $5 + $110 = $115

Year 4: 5% of $100 = $5 + $115 = $120

Year 5: 5% of $100 = $5 + $120 = $125

With compound interest, interest payments are calculated on not only the initial principal, but also the accrued interest over time. The same $100.00 investment at 5% compounded annual interest would grow as follows:

Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00

Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25

Year 3: 5% of $110.25 = $5.51 + $110.25 = $115.76

Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55

Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63

As you can see in the examples, compound interest results in a geometric growth of funds rather than a simple linear growth seen in simple interest and if funds can held in a compound interest matrix for longer periods of time, the growth becomes even more dramatic as illustrated below.

Simple Interest Compound Interest

(“Study Finance: The Time Value of Money”, 2013).

Simple and complex interest are the building blocks for Future Value (Fv) and something many people use every day in their personal lives as the use checking, savings, and investment accounts. Future Value (Fv) is represented mathematically as Fv = Pv(1+nt) for simple interest and Fv = Pv(1+i)^n for compound interest where I is the rate of return and n is the number of periods. Using the above illustrated returns, the formula for Fv using compound interest would be as such:

Fv = 100(1+.05)^5 = $127.63

Present Value (Pv) is the reciprocal function of compound interest future value (Fv). This simply means that if a business needs $100.00 in 5 years from investments today at 5% compounded annually, present value will show the initial amount of that money that needs to be invested at a given return rate. The formula for that calculation is Pv = Fv/(1+i)^n where i is the rate of return, and n is the number of periods. Inserting the numbers from the example above, we get the following:

Pv = 100/(1+.05)^5 = $78.35

(“Study Finance: The Time Value of Money”, 2013).

With an understanding of how the calculations work and how Pv and Fv play a role in money decisions, it is easier to see how managers use these calculations in business situations to make educated choices regarding capital, but it is important to also understand the challenges associated with time value of money situations.

Challenges

The challenges associated with time value of money situations are normally out of the direct control of decisions makers, but must be considered in any decision that might be made. The three main challenges are inflation, risk, and opportunity...

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