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Time Value Of Money

By rawand1989 Mar 01, 2015 1548 Words


Time Value Of Money
Rawand Ibrahim
Florida State College At Jacksonville
Dr. Daniel J. Mashevsky
FIN4501-Investment Management

Table of Contents
Introduction2
Components of interest rate3
Stocks and Bonds4
Interest rate4
Future Value5
Determining Present Value6
Conclusion6
Reference:7

Introduction

What is the time value of money? (Campbell Harvey, 2012) “Time value of money is initially defined as the concept that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. In other words, the idea that a dollar today is worth more than a dollar in the future, because the dollar received today can earn interest up until the time the future dollar is received”. In this paper we will discover what it means when people refer to time being money by learning to calculate the value of the present dollar as well as the value of the future dollar. Later, with examples, we will continue to find out exactly why interest is the foundation of time value of money. Components of interest rate

(Business Dictionary, 2015) “A capital market is a financial market that works as a passage for demand and supply of debt and equity capital”. In each capital market, there are major components within. A capital market consists of three major parts; the stock market, the bond market, and the money market. The first component of a capital market is the stock market. (Marshall Brain, Dave Roos, 2015) “The stock market is a place where shares are bought and sold, or also known as stock exchange”. The second component of a capital market is the bond market. The bond market is a financial market that is made up of many people. Amongst the many people that make up the bond market some are as follows; bond issuers, underwriters, buyers, and brokers. You know, kind of like a little ecosystem, they all depend on each other and need each other in order to be successful. Last but not least, the third component of a capital market is the money market. The money market, like the bond market, also consists of a chain of people. (Business Dictionary, 2015) “The money market is a network of banks, discount houses, institutional investors, and money dealers who borrow and lend among themselves”. An example of the money market would be a parent choosing to invest their children’s college funds temporarily. By investing their children’s college funds, the parent is securing interest on their investment and making more than they had originally invested. Therefore, the parent will have more funds for their children’s college tuition just because they chose to invest their money in the present. Stocks and Bonds

Stocks and bonds can be very similar yet so different. What many people are not aware of is that just as stocks can potentially go up and down in price, bonds can as well. This is very common considering we hear much more about the stock market then we ever do about the bond market. Just as banks associate direct and indirect financing with time value of money, stocks and bonds connect with time value of money similarly. Stocks and bonds have values that fluctuate constantly, in other words stocks and bonds can be worth much more in the present compared to the value in the future. This is due to time value of money and everything that goes in to bonds and stocks, which makes them increase/decrease in value such as; yield rates, interest, and also competition. Interest rate

What is interest rate? (Reem Heakal, 2015) “An interest rate is the cost of borrowing money, or on the other side of the coin, it is the compensation for the service and risk of lending money”. An example of interest rate would be if someone was anticipating buying a house and they were to borrow money from the bank in order to put a down payment down for a house that they are looking to purchase. In this case, if the bank approves them for a loan and lends out money to this person, the agreement between the bank and the homebuyer would be to pay back the loan in a timely manner with an interest rate on each payment they make back. Since the homebuyer would be in need of the money for the house, they would agree to the interest rate and pay an additional amount on each payment made back to the bank which is called interest rate. Here we see another connection with time value of money with the potential earning capacity of a dollar today compared to a dollar in the future with respect to an interest rate. With this being said, do you know the real rate of interest? We study that the real rate of interest is the rate of interest an investor expects to receive after allowing room for inflation. Inflation is another word for expansion or increase. Therefore, interest rate and the real rate of interest vary due to allowing room for expansion. With that being said, investors are more thrilled about the real rate of interest they are expecting to receive as opposed to interest rate due to any possibilities of inflation. Future Value

(Finance Formulas) “Future value is a formula that is commonly used in finance to calculate the value of a cash flow at a later date than originally received”. The term future value is associated with the idea that an amount today is in fact worth a different amount at a later time, which once again is all connected to the time value of money. A great example of future value would be if someone gave you the option of receiving $500 today or $500 in a year. It would be a wiser decision to accept the $500 today as opposed to accepting the $500 in a year because receiving the $500 today gives room for investment and expansion until the next year, whereas receiving $500 in a year would still just be a solid $500. Trying to expand that $500 now would possibly double the value until the next year. The way that the future value formula is broken down is quite simple. (Investopia 2015) “FV=PVx(1+r)^n”. Determining Present Value

Just as there is a future value, there is also a present value. We learn that the opposite of future value is present value, and present value would be calculated by the value of a dollar in the future. An example of present value and calculating present value would be as follows; with an interest rate of 10% the present value of $500 whether it be spent or earned one year from now would be $500 divided by 1.10, which calculated equals to $454. What this example is explaining to us is that the present value of $500 in the future is in fact less than the initial amount in the future. Just as the future value has a formula that is broken down, present value does too. The formula for present value is broken down as follows: (Investopia, 2015) “PV= FV/(1+r)^n”. PV is referring to present value, FV is referring to future value, r is referring to the interest rate, and n is referring to the number of years. For example, $500 in 2 years with an interest rate of 10% would be calculated as follows: PV= $500/(1+0.10)^2= $500/1.10^2= $413.22. With this simple and practical formula, it is with ease that one can figure out how much their present sum of money will be worth in the future with a specific interest rate. Conclusion

In conclusion, time value of money is present in all aspects of finance. Whether you are dealing with capital markets and their major components, direct and indirect financing, stocks and bonds, interest rate, or future and present value, it is important to know how to calculate the time value of money so that you are aware of potential losses/earnings that your money can make. Knowing how to calculate the time value of money is a key aspect of any and every finance student’s career.

Reference:
Goodman, J. (2015, January 1). Stocks and Bonds | Scholastic.com. Retrieved February 7, 2015, from http://www.scholastic.com/teachers/article/stocks-and-bonds Hofstrand, D. (2012, January 1). Understanding the Components of an Interest Rate. Retrieved February 7, 2015, from http://www.agmrc.org/business_development/getting_prepared/business_and_economic_concepts_and_principles/understanding-the-components-of-an-interest-rate/ Garrsion, S. (n.d.). StudyFinance: Time Value of Money. Retrieved February 7, 2015, from http://www.studyfinance.com/lessons/timevalue (n.d.). Retrieved March 2, 2015, from http://financial-dictionary.thefreedictionary.com/Time Value of Money What is capital market? definition and meaning. (n.d.). Retrieved March 2, 2015, from http://www.businessdictionary.com/definition/capital-market.html

A Stock Exchange - HowStuffWorks. (n.d.). Retrieved March 2, 2015, from http://money.howstuffworks.com/personal-finance/financial-planning/stocks2.htm

Time Value Of Money Calculations - CFA Level 1 | Investopedia. (2008, April 18). Retrieved March 2, 2015, from http://www.investopedia.com/exam-guide/cfa-level-1/quantitative-methods/time-value-money-calculations.asp

Future Value. (n.d.). Retrieved March 2, 2015, from http://www.financeformulas.net/Future_Value.html

Forces Behind Interest Rates. (2003, December 4). Retrieved March 2, 2015, from http://www.investopedia.com/articles/03/111203.asp

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