Time Value of Money

In financial management, one of the most important concepts is the Time Value of Money (TVM). Time Value of Money concepts helps a manager or investors understand the benefits and the future cash flow to help justify the initial cost of the project or investment. Many of the assets businesses and individuals own are financed with money borrowed from others, so the understanding of TVM is crucial to making good buying decisions. To recognize how annuities affect the time value of money, managers need to consider the factors of interest rate, opportunity costs, future and present values of money, and compounding.

Interest Rates and CompoundingIn most business cases, borrowing money is not necessarily a free enterprise. It costs companies money to obtain funds on credit to finance various aspects of their business. The fee that a borrower pays to a lender for use of its money is interest. The annual percentage rate (APR) makes assumptions based on simple interest, which is interest only earned on the principal investment.

Another method of accruing interest is through compounding. Compound interest is not only charged on the original investment, but also assessed on the interest charged or earned for each period. "When comparing interest rates, it is best to use effective annual rates. This compares interest paid or received over a common period (1 year) and allows for possible compounding during the period" (Brealey, Myers, & Marcus, 2007). The effective annual interest rate allows for figuring out what the monthly fee of borrowing money will cost a business.

Present ValuesThe present value of money is also known as discounting. The discount rate is sometimes called the opportunity cost of money. Money can be invested to earn interest. Because money is of more value when it is cash in hand, the person holding the...