Time Value of Money
Time Value of Money
Time Value of Money (TVM) is an economic theory that suggests the idea that money available today is more valuable now versus the future. Three reasons for TVM are inflation, risk and liquidity (Investopedia, 2008). As a result, borrowers charge interest to ensure that the value of their money is not eroded by inflation. Inflation is an increase in the cost of goods and services provided. Risk is the possibility that an investment may yield different results than the results expected. “The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this greater potential return is that investors need to be compensated for taking on additional risk of lending money out” (Marshall & McManus 1966), and because the loan might not be easily sold to another borrower if need be, that is, it has low liquidity. Liquidity is the company’s ability to meet its current obligations and is shown on the statement of financial position or balance sheet (Marshall & McManus, 1996). This paper will focus on various financial applications of the Time Value of Money (TVM) and explain the components of the discount/interest rate. The paper will attempt to offer examples of each financial application and show how the components of discount and interest rates interact with TVM.
Applications of TVM
Some of the applications of TVM include the following: capital budgeting, the valuation of companies for mergers, retirement planning, and amortization of loans and saving, and investment management. Each of these applications has one or more components of TVM. Either present or future value, present value of perpetuity, loan amortization, cash flow diagram, or present and future value of an annuity and discounted cash flow.
Capital budgeting
According to Garrison (1988), capital budgeting is an investment concept, that requires the commitment of funds now in order to receive some desired returns in the future.
Time Value of Money (TVM) is an economic theory that suggests the idea that money available today is more valuable now versus the future. Three reasons for TVM are inflation, risk and liquidity (Investopedia, 2008). As a result, borrowers charge interest to ensure that the value of their money is not eroded by inflation. Inflation is an increase in the cost of goods and services provided. Risk is the possibility that an investment may yield different results than the results expected. “The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this greater potential return is that investors need to be compensated for taking on additional risk of lending money out” (Marshall & McManus 1966), and because the loan might not be easily sold to another borrower if need be, that is, it has low liquidity. Liquidity is the company’s ability to meet its current obligations and is shown on the statement of financial position or balance sheet (Marshall & McManus, 1996). This paper will focus on various financial applications of the Time Value of Money (TVM) and explain the components of the discount/interest rate. The paper will attempt to offer examples of each financial application and show how the components of discount and interest rates interact with TVM.
Applications of TVM
Some of the applications of TVM include the following: capital budgeting, the valuation of companies for mergers, retirement planning, and amortization of loans and saving, and investment management. Each of these applications has one or more components of TVM. Either present or future value, present value of perpetuity, loan amortization, cash flow diagram, or present and future value of an annuity and discounted cash flow.
Capital budgeting
According to Garrison (1988), capital budgeting is an investment concept, that requires the commitment of funds now in order to receive some desired returns in the future.