Time Value of Money

Topics: Net present value, Time value of money, Rate of return Pages: 12 (3690 words) Published: March 15, 2011
To carry on business, corporation needs an almost endless variety of real assets. Many of these assets are tangible such as machinery, factories, offices, others are intangible, such as technical expertise, trademarks, patents. All of them need to be paid for. So, there are always two questions: “what real assets should the firm invest in?” And “how should the cash for the investment be raised?”. The answer to the first question is the firm’s investment, or capital budgeting decision. The answer to the second is the firm’s financing decision. The financial managers have responsibility to do that. And one of significant tools that financial managers use is time value of money. It indicates the value of money figuring in a given amount of interest earned over a given amount of time. From the future or present value of a cash flow, financial managers will decide which investment projects are optimal. To understand more about time value of money, as well as its implications in financing and investment, our group will answer three questions below: Question 1: What is time value of money? How is it important? Question 2: Motivation and formula of calculation of future values and present values of a simple (single) cash flow, an annuity, and a perpetuity? Question 3: Implications in financing and investment?

Alternating theories is illustrations and examples that allow people to image them in practice. CONTENT
QUESTION 1: WHAT IS TIME VALUE OF MONEY? HOW IS IT IMPORTANT? Any rational person would like defer payment into the future if he/ she have to pay and take the money in the present if he/ she are to receive. We can see that there are three elements here, i.e. present, future and money. Or we can say that the theory lying behind such behavior of paying and receiving money is something relating to TIME. And that theory is called TIME VALUE OF MONEY. As said above, people always want to get money as soon as possible and hold it as long as they can. What they want to possess is not only money but also time. All things being equal, it is better to have money now rather than later. This is because time has its own value and having time on your side means that you can realize that value in the form of money. To make it simple, let us take a look at an example. Assume that you have a dollar today. What can you do with it? You could use it to buy some food immediately. Alternatively, you may decide to forgo that current consumption and wait until later to purchase your food. If you just stop here and hold one dollar in your pocket till a month later when you go to store and purchase your food with it, then you are losing your time value of money because you have not earned any interest from it yet. You only get time value of money when you earn some interest from the amount of money that you have just postponed to consume. So how and why can you earn the interest? Now that you have delayed to buy food, you decide to lend the amount of money to another with the promise of being paid back at some future time. Because you are giving up food today, you would demand a return sufficient to buy at least as much food in the future. And as future is always embeded with risks, for example, the borrower may refuse to pay you back, or the borrower may pay you back but due to rising prices you can no longer purchase the same amount of food as you had expected to buy. Because of those risks, you would require the borrower an interest rate, but if you ask for a too high interest rate, you would bear the risk of finding no loan taker. Now assume that someone has to pay you $10,000. Would you prefer him/her to pay you now or sometime in the future? Obviously the answer is present because having money today rather than later allows you to use the funds for consumption purposes or investment. To illustrate, we have provided a timeline: [pic]

It is clear that option A is more profitable as the future...
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