Time Value Of Money

The Basic Law in Finance Ð'- Time Value of Money

We earn money to spend it and we save money to spend it in the future. However, for most people spending money in the present time is more desirable since the future is unknown. We can gratify the desire to spend money today rather than in the future by knowing the basic law in finance Ð'- time value of money. This means that a dollar today is worth more than a dollar at some time in the future. Unfortunately, people very often want to buy things at the present time which cost more that what they earn, so they pay with credit cards or take out loans which have to be paid off at some point in the future. In this paper we will discuss the present value of money, the future value of money, compounding effect of money, and annuities. Knowledge of this basic time value of money principles and calculations is crucial for making sound financial decisions in business as well as in our personal lives.

Looking at the borrowing transaction from the borrower's perspective, there are consumers and businesses (not to mention the deficit-ridden government) who really need that dollar today and who are willing to promise to pay back more than that dollar in the future. Businesses can invest borrowed funds in capital to hopefully create profits which are more than sufficient to repay the borrowed funds (principal) plus interest. Consumers and governments borrow for various reasons but are expected to have income in the future sufficient to repay principal and interest (Understanding the Time Value of Money).

The time value of money has applications in many areas of Corporate Finance including capital budgeting, bond valuation, and stock valuation. Furthermore, the time value of money concepts can be grouped into two areas: Present Value and Future Value. Present value describes the process of determining what a cash flow will gro to in the future. Future value describes the process of finding what an investment today will grow to in the future.

The present value of money states that a dollar today is worth more than a dollar at some point in the future. It is easier to understand while looking at an example: $1,000 invested at a 5% interest in savings will be worth $1,050 in one year. Therefore, if we can have $1,000 today it is better than having $1,000 in a year since we can invest it and earn interest on it making the time value of money work for us. The process of finding present values is called discounting and the interest rate used to calculate present values is called the discount rate.

The Net Present Value (NPV) of a project indicates the expected impact of the project on the value of the firm. Projects with a positive NPV are expected to increase the value of the firm. Therefore, the Net Present Value decision rule specifies that all independent projects with a positive NPV should be accepted. When choosing among mutually exclusive projects, the project with the largest (positive) NPV should be selected. The NPV is calculated as the present value of the project's cash inflows minus the present value of the project's cash outflows.

For example, the asset manager of a property management firm must evaluate the overall dollar value of a lease transaction. The value of a lease is determined by looking at several financial components including:

Ð'* The amount of rent collected over the term of the lease;

Ð'* The costs associated with signing a lease;

Ð'* The existing (or budgeted) costs already associated with running the building;

Ð'* The Net Present Value of a lease;

Ð'* Theoretically, the alternative uses for the money.

Listed below is an example of the calculations the asset manager can review.

Initial Outlay Year 1 Year 2 Year 3 Year 4 Year 5

Cash In $116,667 $206,000 $212,180 $218,545 $225,102

Cash Out

TI's: ($180,000)

Comm: ($ 82,710)

OPEX $85,000 $85,000 $85,000 $85,000 $85,000

Net Cash Flow ($262,710.00) $31,667 $121,000 127,180 133,545 140,102

Keep the previous concept in mind:

Ð'* $100.00 in the future is only worth $89.29 today with a 12% discount rate.

Or, ask yourself this question:

Ð'* What is today's value of future net receipts?

Initial Outlay Year 1 Year 2 Year 3 Year 4 Year 5

Cash In $116,667 $206,000 $212,180 $218,545 $225,102

Cash Out

TI's: ($180,000)

Comm: ($ 82,710)

OPEX: $85,000 $85,000 $85,000 $85,000 $85,000

Net Cash Flow ($262,710.00) $31,667 $121,000 127,180 133,545 140,102

- - - - -

- - - - -

Today's Value (262,710.00) - - - - -

28,788.18 ------- - - - - -

100,000.00 ---------------------- - - - -

95,552.22 ------------------------------------- - - -

86,992.32 ---------------------------------------------------- - -

91,213.03 -------------------------------------------------------------------- -

$139,835.75 The present value of future net income; "NPV."

The future value of money invested is calculated by adding the present value and the interest earned (interest equals to present value times the rate of the interest, and is represented as a percentage). However, the future value of money may also work against us when for example we pay with credit cards and we have to pay it off with the money from the future plus interest expense.

Suppose that instead of receiving $1,000 we spent $1,000 by purchasing merchandise on a credit card. Note that a dollar