Time Value Money

Essay by markthomasUniversity, Bachelor'sA+, September 2006

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In order to understand the actual relationship in how the value of dollars of today and the value of dollars in the future is by establishing how income invested will grow over time. This will give a better understanding and will help to answer questions that are involved such as how much should be invested today to produce a specified future sum of money.

In the majority of most situations, when you borrow money is not for free. When this happens there is something that is related to this and that is interest. Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the amount borrowed per a certain amount of time. Which can usually ranges from a year or more. How this is determined is by the current market rates, which are composed of three items.

The real rate of interest is what compensates lenders for postponing their own spending during the term of the loan.

An Inflation Premium is added to offset the possibility that inflation may eat into the value of the money during the term of the loan. In addition, various Risk Premiums are added to compensate the lender for risky loans such as unsecured loans made to borrowers with questionable credit rating 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, together are referred to as the nominal risk-free rate. In the US, the nominal risk-free rate is estimated by the rate of the US Treasury bills.

Simple interest is calculated on the original principal only. Interest from prior periods is not used in calculation for the following periods. Simple interest is normally used for...