Factors That Affect the Time Value of Money

Topics: Time value of money, Interest, Time Pages: 3 (1091 words) Published: December 16, 2006
Factors that Affect the Time Value of Money
Time value of money is the concept that an amount of money in one's possession is worth more than that same amount of money promised in the future (Garrison, 2006). The reason for this is that money today can be invested to earn interest and therefore will be worth more in the future (Brealey, Myers, & Marcus, 2004). This paper will explain how annuities affect time value of money (TVM) problems and investment outcomes. In addition, this paper will briefly address the impact of interest rates, present value, future value, opportunity cost and the rule of 72 on the time value of money. Annuities

An annuity is an evenly spaced number of payments or money received in the same amount (Cedar Spring Software, Inc., 2002). Each TVM problem has five variables: interest rate or return, time or number of periods, future value, present value, and amount of payments either made or received (Brealey, Myers, & Marcus, 2004). The present value of annuity payments received over a number of years is less than if one had the full amount in hand now to invest. The reason for this is opportunity cost. If the full amount of the annuity could be invested today in a lump sum, the final value during the same term of the annuity would be much higher due to compound interest. So opportunity cost in this case is the total amount of the annuity payments over the length of the annuity and the value of investing the annuity's total value today at a specified rate of return. For example, person is receiving annuity payments of $500 per month for 20 years will receive 12 x 500 x 20 = $120,000 during the annuity period . If that same person had $120,000 in his or her hand to invest today at a modest 6% interest compounded annually, they would have $120,000 x (1.06)20 = $384,856 at the end of the 20 years. The 0pportunity cost of this annuity is $384,856 - $120,000 = $264,856. This annuity caused the person to miss the opportunity to make an extra...

References: Brealey, R. A., Myers, S. C., & Marcus, A. J. (2004). Fundamentals of corporate finance (4th ed.). [University of Phoenix Custom Edition e-text]. New York, New York; McGraw Hill/ Irwin. Retrieved September 11, 2006, from University of Phoenix, Resource, FIN325 - Financial Analysis for Managers II website.
Cedar Spring Software Inc. (2002). Present value of an annuity. Retrieved September 14, 2006 from http://www.getobjects.com/Components/Finance/TVM/pva.html
Garrison, S. (2006). Time value of money. Retrieved September 14, 2006 from http://www.studyfinance.com/lessons/timevalue/index.mv
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