Time Value of Money

Time Value of Money

Time Value of Money

An individual's best friend owes him $600 dollars, and asks if he can pay the individual back in six monthly installments of $100 dollars, is this a good way to be paid? This decision is a good example of the concept of the Time Value of Money or TVM. Time value of money is the concept that "a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future" (Getobjects, 2002). Factors that might affect TVM like compound interest, present value, future value, opportunity costs, annuities, and the rule of 72 are important to understand when planning your financial future.

Interest can be defined as either a fee that is charged by a lender for borrowed money or as a return upon an investment (Investorwords, 2007). Compounded interest occurs when an investment returns interest upon the initial investment and the interest accrued every period since the initial investment was made (Econedlink, 2007). The initial investment is often referred to as the present value.

Present value is how much money a future payout on an investment is worth today, or at the time of the initial investment (Henderson, 2002). If after one year an individual receives 1000 dollars off an investment that had a 8 % interest rate then that amount he initially invested $1000/1.08 = $925.92. Due to the time value of money the present value is expected to be lower than the future value and will be worth less the longer an individual has to wait to receive the future payment (Getobjects, 2002). The $925.92 initially invested would be referred to as the present value, and the $1000 dollars that was received at the end of the period would be referred to as the future value.

Future value is the amount of money a particular investment will be worth given a certain period of time (Econedlink, 2007). Suppose an individual wanted to know the future amount of money he would have after depositing $600 dollars in an account paying 6 % interest and not touching it for a year. The future value of the money invested would be 600*1.06 = $636 dollars. Due to the time value of money the future value of the initial investment is expected to be greater, and the difference depends upon the number of compounding periods and the interest rate being used (Getobjects, 2002).

Another concept tied to time value of money is opportunity costs. The opportunity cost of a decision is not just the financial investment, but also your time and the costs of whatever your alternatives might have been. If an individual has the choice of going to the zoo or to a museum and decides on the zoo; his opportunity cost is not only the price of admission to the zoo, but also what you lost by not going to the museum. This is important because if an individual chooses to allow his friend to pay a debt back over time the opportunity costs of lost interest might on an investment that could have been made with the bulk sum might be more than the individual wanted (Econedlink, 2007).

Annuities are payments that are made at equally spaced intervals until a certain amount has been reached (Brealey, Myers & Marcus,