Time Value Of Money Application Paper

Time Value of Money Application

Introduction

Money is an essential part of our lives; therefore, it is imperative to understand how factors such as time, discount, and interest rates affect its value. For example, understanding the effective rate on a business loan, the mortgage payment in a real estate transaction, or the true return on an investment depends on understanding the time value of money (Block & Hirt, 2005). This paper discusses the time value of money with specific attention to three areas: present value, future value, and future-value annuity. The paper further discusses discount and interest rates.

Time Value of Money

The time value of money concept implies that if you have a preference of collecting certain amount of money today or at a future date from now, the money you should anticipate at a future date from now should be in greater amount than the collectable amount today. This concept also means that dollar collected today is valued more than future dollar because one can begin to earn interest immediately. Most people would prefer to receive $10,000 now than defer payment into the future. The time value of money demonstrates that it is better to have money now rather than later.

Present Value

The present value of money is an amount today that is comparable to a future payment, or succession of payments, that has been concise at certain interest rate. If one were to collect $ 50,000 right now, the present value would of course be $50,000 in that the present value is what the investment gives if to spend the amount today. If $50,000 were collected in a year, the present value of that amount would not be $50,000 because that amount is not hand at this time. In order to find the present value of the $50,000 to be received in the future, one should pretend that the $50,000 is the total future value of an amount that was invested today. Therefore, to find the present value of the future $50,000, one should find out how much to invest today in order to receive that $50,000 in the future. The formula, present value (PV) equals future value (FV) divided by (one+interest) raised to the power of n (number of periods) is used to calculate the present value, (Block & Hirt, 2005). Understanding how to use the formula used to determine present value could help consumers decide whether to accept anything from 0% financing on a new car purchase to how paying points on a mortgage can effect your payment (Henderson, 2002). The lower the discount rate the higher the present value is on sum of money. The converse is also true, the higher the discount rate the lower the present value of the sum. The calculation used to find present value is often used with lotteries. Lottery winnings can be paid in one lump sum or in equal structured payments made regularly, also known as annuities.

Future Value

The future value of money is simply the amount of money that will be earned on a given sum of money at a certain time in the future. In calculating the future value, one should measure the value of money that is allowed to grow at a given interest rate over a period. Let us say an investor has $50,000 and would like to know the value of his money after four years, at an annual rate of 5 percent. At the end of the first year, the investor will have $50,000 Ð"-- 1.05, or $52,500. By the end of year two, the $52,500 will have grown to $55,125 (52,500 Ð"-- 1.05). The formula FV=PV (one+i) ^n is used to calculate the future value, (Block & Hirt, 2005).

Future Annuity Value

The definition of future annuity is the prospective value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today (Investopedia, 2007). Potential income allows an individual or company to plan for the future. Presently a person can invest money now over time and watch their investment grow. Future annuity allows individual to make a series of equal payments or receipts that occur at evenly spaced intervals (Get Objects, 2007). For investors or businesses, it puts them on a payment plan with the intention of adding value to their capital for a company or individual. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due (Get Objects, 2007). The value streams are expected for future payments that will grow to after a given number of periods at specific compound interest (Get Objects, 2007).

The future value of an annuity due is identical to an ordinary annuity. Each payment that is made must be made at the beginning (Get Objects, 2007). Each payment occurs earlier because if a person or business cash out early they still gain more money with interest that allows them to gain the most out of there investment (Get Objects, 2007).

To calculate the future value annuity it must be done in single amounts. The annuity values are generally assumed to occur at the end of a period of time (Block & Hirt, 2007). The future value of investment is computed by a specific amount taken today and determines its value in the future assuming that it earns a rate of return each period (Block and Hirt, 2007). If a person invests $1,000 at the end of each year for four years at 10 percent, the investment will grow every year upon payments is made on time (Block & Hirt, 2007). The value is calculated taking the present value multiplying it against the year and interest rate raised. Companies and individuals may find the future value for each payment and then the total from them to find the future value of an annuity (Block & Hirt, 2007).

Interest Rate

Monetary policy action transmits to the economy through its effects on market interest rates, Roley (2007). Federal Reserve (Fed) controls the monetary policy, which influences the flow of money into the economy; if interest rate increases, there would be a tendency to minimize spending. The high interest