Table of Contents
The time value for money is a concept that suggests cash at hand is more valuable than a future saving of the same amount (Drake and Fabozzi). This is because money available at present has the potential to earn compared to money received at a later date. The principle behind this concept is that as long as money can earn interest, any sum of money is more valuable sooner than later (Drake and Fabozzi). Ideally, money put in banks earns interest, but it is better to put the same amount of money into an investment because it will appreciate in value immediately and not over time.
Simple and Compound Interest
Simple interest is the additional amount of money paid on a loan or the money a person earns by keeping their money in a bank. It is straightforward and its best for small loans such as car loans. It is calculated by multiplying the amount given by the rate agreed on and the time (Trivedi). The time can be anything from days to months to years. The formula is P*I*N where P is the principal amount, I am the interest rate, and N is the time. On the other hand, compound interest is the additional amount calculated from the initial sum of money agreed on, plus the accumulated interest on the total time the loan has been borrowed. Thus, it can be referred to as interest on interest because the total amount accrues faster than when it is simple interest. Moreover, the amount of interest paid in compound interest depends on the time and rates applied. The interest is calculated by multiplying the principal amount by one, the yearly interest rate raised to the number of compound periods then subtract one, ([P(1+i) n]-P) (Trivedi).
Ordinary and Annuity
Annuity due is a payment that has to be made immediately at the start of a period. A period, in this case, could mean a week, a year, or a week. An example of an annuity due is rent or school fee. It is paid before the services are given. The payment is made to a person who owns an asset, for instance, an apartment building. It is easier to deal with an annuity due because they can be factored into monthly payments. However, a person cannot use the money at a later date because it will already be paid off. The person receiving the payment is better off because he can raise money for a given period and make an investment. The person making the payments has a legal obligation to make the payments, while the person receiving the payment has the legal obligation to provide the service agreed on. On the other hand, an ordinary annuity is a payment made at the end of each period (Edwards). Hence, an ordinary annuity is payment done after a service has been offered (Edwards). The total value of an annuity due is calculated about an ordinary annuity. Ideally, the cost of a comparable ordinary annuity is calculated, then the value gotten is multiplied by a factor that is agreed on, (Annuity due=Annuity ordinary *(1+i)) (Edwards).
Investors use the concept of time value for money to invest as soon as possible with their money. Cash at hand has the potential of earning interest hence; most should be gotten from it. For instance, if someone has $50, he can receive the same amount of that money. However, if the person chooses not to do anything with the $50, then it loses its value. It is better to invest it or deposit it in a bank because at least there will gain some interest. Investors would use discounted cash flow technique when informs of the present value of a given sum if it was received at a later date. The difference in the calculation is referred to as the discounting factor. Such information is critical when making decisions. It can prompt people in business to make an investment immediately, or wait because the value of money will be higher. TVM is the idea that any money received today is worth more than the same amount of money received later (Drake and Fabozzi). Therefore, investors use this information to make the most use of their money as soon as possible, so that it can have more value.
A lease is an example of an annuity because payments are made at even intervals. Hence, investors can use the time value for money and calculate the future value of the annuity, with the assumption that the payments will be made with a specified interest rate. On bonds, it is important for any businessperson to know how to determine the price of a bond because it indicates the returns. Valuation of a bond is to establish the fair price of a bond. Ideally, the fair value of a bond is its current price and the expected amount of cash it is expected to bring forth. Hence, the worth of a bond is established by discounting the bond’s supposed cash flows to the current price keeping in mind the suitable discount rate. After that, other factors that relate to the bond can also be determined. Additionally, Time Value for Money is important because it enables investors to calculate precisely the value of a coupon date to avoid ‘dirty price’ and ‘clean price.’ Dirty price is the interest that accrues when the bond is not valued precisely.
Time Value for money is a financial concept that an amount of money at hand is more valuable than the same amount of money at a later date because money has the potential of earning interest (Drake and Fabozzi). Simple Interest is the additional amount of money paid on top of a loan. It is calculated by multiplying the amount given by the time and rate agreed on. Compound interest is the additional amount paid from a loan, plus the total interest that has accrued for the time the credit has been issued. The total interest paid on compound interest is higher than the total amount paid on simple interest. Annuity due is the amount paid at the beginning of a period while an ordinary due is an amount paid at the end of a period. Both of them are payments made at even intervals and valuation of leases can be used to determine the amount that will be paid after a defined period of time by investors. Time Value for Money is an important aspect because it informs investors on how to make short term and long-term projects. Since leases are paid for at even installments, an investor can calculate the projected interest rate of the price that will be paid in future, as long as the interest rate remains the same throughout the period. When it comes to bonds, it enables investors to calculate precisely what their returns will be. Moreover, other factors that are affected by the bonds can also be calculated alongside the valuation of bonds.
- Drake, Pamela Peterson, and Frank J. Fabozzi. Foundations and Applications of the Time Value of Money. NY: John Wiley, 2009.
- Edwards, James Matthew. The Financial Insider’s Annuity Guide: Understanding Annuities and Your Financial Portfolio. NY: First American Press, 2010.
- Trivedi, Kashyap. Business Mathematics. Mumbai: Pearson Education India, 2011.