Time Value of Money

Essay by uknownuseanonCollege, UndergraduateA, June 2008

download word file, 4 pages 0.0

Financial planning and the use of time value of money principles are important to any successful business. Financial managers and potential investors who understand and utilize these concepts make sound financial decisions that benefit a company as well as its stakeholders. The basic notion of time value of money is that a dollar today is worth more in the future by investing it. Benjamin Franklin understood this concept in 1798 when he said, "Remember that time is money." The fundamental tools of finance consist of the following: the time value of money (TMV), present value, future value, opportunity costs, annuities and the rule of '72.

"Investors hear lots of talk about compounding, the process used to find the future value of a cash flow, but much less about discounting, the process used to find the present value of a cash flow." (McCaffery, 2000) Simply put, cash received at different times has different values.

Understanding the connection between the value of dollars today and that of dollars in the future is looking at how funds invested will grow over time.

According to InvestorWords.com, an Interest rate is a rate that is charged or paid for the use of money. Compounding interest is interest that is earned on the initial principal and accumulated interest over time or simply put, interest earned on interest. (Brealey, Myers, Marcus, 2007) The formula for compound interest is A = P(1 + r)n.

According to financialdictionary.com, present value is the amount that a future sum of money is worth today given a specified rate of return. To obtain the present value one simply divides future value by 1 plus the interest rate. An example of present value would an investment that earns %15 per year and can be redeemed for $10,000 in five years would have a...