Time Value Of Money

Time Value of Money

The time value of money serves as the foundation for all other notions in finance. It affects business finance, consumer finance and government finance. Time value of money results from the concept of interest. The idea is that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Time value of money can be illustrated by the fact that a dollar received today is worth more than a dollar received a year from now because today's dollar can be invested and earn interest as the year elapses. Implicit in any consideration of time value of money are the rate of interest and the period of compounding. This paper will list various financial applications of the time value of money and explain the components of the discount/interest rate.

Time Value of Money

The present value of a certain amount of money is greater than the present value of the right to receive the same amount of money in the future. Stanley Block and Geoffrey (2005), state a few essential rules relating to the time value of money: 1. Money has a time value associated with it and therefore a dollar received today is worth more than a dollar received tomorrow, 2. The future value and present value of a dollar are based on the number of periods involved and the going interest rate, and 3. Not only future value and present value be computed, but other factors suck as yield (rate of return) can be determined as well. The concept of the time value of money is essential, not only to large corporations that are looking to make large gains in profits, but to lenders that are expecting to receive the best interest rates on payments for their used capital. In addition, individual citizens research the best securities to invest in order to get the most return on their risk involved.

The financial applications that make up the time value of money are vast in the scope represented. Time value of money applications assist with domestic as well as international market transactions. Applications of the time value of money are essential in the following: International Capital Markets, United States Capital Markets, the supply of Capital Funds, the organization of securities markets, and finally, the regulation of securities markets.

International Capital Markets are a place where the concept of time value of money is applied. As a result of a growing global economy, "international capital markets have increased in the last decade to become larger, more efficient, and more competitive in the new millennium" (Block & Hirt, 2005). Many companies, especially those from the United States search the international markets in order to raise debt capital and increase company liquidity. Businesses invest in international markets, not to expect a return on present value, but on the expectation of an increased value in the future.

The next opportunity for an application of the time value of money is in Government Securities, federally sponsored credit agencies, as well as state and local securities. Government Securities are ways that the, "U.S. Treasury can manage the federal governments debt to balance the flow of funds in and out of the U.S. Treasury" (Block & Hirt 2005). The Treasury sells short -term or long-term securities to cover financial deficits experienced by the U.S. Government. An individual that chooses to invest money in a security offered by the Treasury can expect returns based on the amount of the investment as well as the length of time the investment is held. In addition to Government securities, federally sponsored credit agencies extend capital to individuals that seek to finance homes with Federal Home Loan Banks or Fannie Mae. The US Government also extends credit to college students through programs like the Student loan Marketing Association.

Corporate securities are monetary investments that include financial instruments like corporate bonds, preferred stock and common stock. Bonds and corporate stock are instruments that corporations use to pay of debt. Corporate bonds must be repaid at maturity. Preferred and common stocks are tools that the company uses to increase equity capital. In comparison to corporate bonds, stocks do not have a maturity date. Preferred and common stocks carry some risk of diminished value due to market and organizational changes.

Organized Security Market also offers opportunities to increase value of money over time. Organized exchanges can operate on a national or regional basis. The exchanges are centralized areas where buyers and sellers make purchases and sales of stocks and commodities (Block & Hirt, 2005). Companies like the New York Stock Exchange (NYSE), NASDAQ, and the American Stock Exchange (AMEX) are some of the larger trading entities. As a total in 2001, NASDAQ and NYSE traded over 20 trillion dollars in volume (Block & Hirt, 2005).

The final entity that deals with the idea of the time value of money is the concept of regulation the securities markets. The Securities Exchange Commission (SEC) regulates trading and stock market transactions. This organization assists in the regulation of the securities. The SEC is responsible for overseeing the day-to-day activities of different US securities markets.

The present value and future value of money, and the related concepts of the present value and future value of an annuity, allow an individual or business to quantify and minimize its opportunity costs in the use of money. Opportunity cost, concerning the use of money, is the benefit forfeited by using the money in a particular way. The opportunity cost can be compared among specific investments where the rate of return is dependent on an interest rate that either is known or can be reasonable estimated by using the formulas for the present value and future value. The present value formula is the core formula for the time value of money; each of the other formulas are derived from this formula. The present value (PV) formula has four variables, each of which can be solved for:

1. PV is the value at time=0

2. FV is the value at time=n

3. r is the rate at which the amount will be compounded each period

4. n is the number of periods

The future value (FV) formula is similar and uses the same variable.

Future value (FV) refers to the amount of money to which an investment