Financial Management Time Value of Money
Time plays an important role in finance. It is a common practice, if a child is asked whether he/she would take a dollar bill now or six months later, then, the child would reply, saying right now. Though children say it ignorantly, it is true that money obtained now is greater in value than the same amount of money obtained one year or two years later. This is because, the money coming in will be invested in some or another form which will yield a profit. This profit will add to the principal amount, increasing the value of money in the future.
This shows the importance of Time Value of Money. The understanding of Time Value of Money (TVM) helps in the proper calculations of retirement plans, loan payment schedules and decisions to invest in new equipment. In fact, of all the concepts used in finance, none is more important than the Time Value of Money, also called Discounted Cash Flow (DFC) analysis.
The first step in a time value analysis is to setup a time line to help you visualize what’s happening in the particular situation. An example, where PV represents $100 that is in a bank account today and FV is the value that will be in the account at some future time, say 3 years from the present time.
Periods 0 1 2 3 4
Cash PV =$100 FV = ?
The intervals from 0 to 1, 1 to 2, 2 to 3 and 3 to 4 are time periods such as years or months. Time 0 is the present time and it is the beginning of period 1. Time 1 is one period from today and it is both the end of period 1 and the beginning of period 2 and so on.
Here we can assume the interest rate as 5%. The cash flow for one year would result in an addition to the principal amount which comes to 100+5 = 105. The second year will also result in an interest of 5% ie $5. Again the $5 will be added to the principal amount. After the completion of second year the amount is $110. After the completion of third year the amount will be $115. So, $100, after 3 years in investment stands at $115. This is just an illustration.
These kind of time lines are especially important for learning time value concepts, but even experts use them to analyze complex problems.
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