TIME VALUE OF MONEY 1

Time Value of Money

Gina H. LaFrance

ACCT 301-B03
TIME VALUE OF MONEY 2

Abstract

A dollar today is worth more than a future dollar received because today’s dollar can be

invested to earn interest while the future dollar is held in the control of another. This paper

introduces the key concepts of the Time Value of Money (TVM), tools used for computation and

some practical applications for the use of time value of money formulas. TVM is a key factor in

business and economic decisions. The use of TVM in business is essential for assisting people in

making investment decisions and evaluating alternatives that have fluctuating cash flow patterns

over time. For example, compound interest (or rate of return) calculations are used to determine

a financial institutions annual percentage rate (APR) for disclosure to account holders and

banking regulators or discounting, which is inversely related to compounding, used in the

valuation of stocks, bonds, business ventures, real estate and capital expenditure projects. There

are plenty of applications of time value of money in finance. The Time Value of Money is

related to the concept of opportunity cost in economics. The cost of any decision includes the

cost of the alternative opportunity choices declined.

Keywords:

Annuity: money paid at regular intervals each year

Cash Flow: amount of cash collected and paid over a specified period of time

Compound: to pay interest based on principal plus previously accrued interest

Discount: extracting of interest from a future amount to reduce to today’s dollars

Interest: “rent” paid for the use of money for a period of time

The following variables are used in calculating the Time Value of Money:

i = interest rate (rate of return)

I = Amount invested at the start of the period

t = specified period of time

n = number of time periods

PMT = payment

CF = Cash flow (the subscripts t and 0 mean at time t and at time zero, respectively)

PV = present value (PVA = present value of an annuity)

FV = future value of the invested amount (FVA = future value of an annuity)

Time Value of Money

The basic concept of the time value of money is that cash received at a later date is not

equal to the same amount of cash which is currently on hand. The cash on hand has earning

power and can be invested for growth. Time value of money is the math of finance with four

basic approaches: future value (FV) of a single amount, future value of annuity (FVA), present

value (PV) of a single amount, and present value of annuity (PVA). [ CITATION MBAFun \l

1033 ] The Time Value of Money mathematics quantifies the value of a dollar through time

depending on the interest rate or rate of return earned on the investment and is used in many

areas of finance such as computing compounding interest on a savings account, calculating

annual rate of return on a mutual fund, evaluating long term bonds, loan amortization or leases,

evaluating future cash flows from a capital project, etc. The Time Value of Money concepts are

grouped into two areas: Future Value and Present Value. Future Value describes the process of

finding what an investment today will grow to in the future. Present Value describes the process

of determining what a cash flow to be received in the future is worth in today's dollars.

[ CITATION Mat01 \l 1033 ]

Since money has a time value, we must take this time value of money into consideration

when we are making financial decisions. We do this by restating money values through time

with Time Value of Money Calculations. Time value of money calculations are used to shift

dollar values through time. They can be used to state future dollar flows in present value terms

or to restate present value amounts into future dollar values. The calculations are the most

powerful tool available for making financial and business decisions. Once the methods of

restating money values through time is mastered, they can be used for restating cash flows in

such a way as to make them comparable in the financial decision making process. The
TIME VALUE OF MONEY 5

calculation of present values is the foundation for many financial decisions facing both

individuals and managers in all types of firm. The process allows numerous calculations related

to the earning of interest, the earning of non-interest returns on investments, loan related

problems, capital budgeting decision processes, insurance programming problems, and almost

any business asset purchase or investment decision. They also provide the foundation for some

of the most widely used valuation concepts and valuation models employed in finance.

There are five key components in TVM calculations. These are: present value, future value,

the number of periods, the interest rate, and a payment principal sum. Providing you know four

of these values, you can rearrange the TVM formulae to calculate the fifth. [ CITATION QFin \l

1033 ] A simple example takes the amount of $20,000 invested at 10%. At the end of a year,

that $20,000 is worth $22,000 (the original $20,000 plus the $2,000 earned in interest). The

$20,000 held today can be referred to as the present value of $22,000 which will be received a

year from today.

Future Value

For dollar amounts at some point in the future, we use the term "Future Value" or the initials

"FV". Money can increase in value over time because of interest or other types of returns (i.e.

dividends or price depreciation). Practical applications of future value of a single amount

include estimating the value of a 401K on the day you retire or 529 plans when a child starts

college, the amount that a U.S. savings bond will be worth in 10 years, and the estimated value

of your home five years from now.

Under compound interest, interest is earned not only on the initial principal but also on the

accumulated interest. Interest begins to be earned on the accumulated interest as soon as it is

paid, which occurs at the end of each compounding period. This is in contrast to simple interest,

under which interest is only earned on the initial principal. [ CITATION Mat01 \l 1033 ]

An annuity is a series of equal cash flows for a definite period of time. A fixed-rate home

mortgage is an annuity.
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Present Value Single Amount

For dollar amounts in the present, we use the term "Present Value" or the initials "PV".

Present Value describes the process of determining what a cash flow to be received in the future

is worth in today's dollars. Therefore, the Present Value of a future cash flow represents the

amount of money today which, if invested at a specific interest rate, will grow to the amount of

the future cash flow at that time in the future. The process of finding present values is called

Discounting and the interest rate used to calculate present values is called the discount rate. For

example, the Present Value of $100 to be received one year from now is $90.91 if the discount

rate is 10% compounded annually. [ CITATION Pre13 \l 1033 ] The calculation of present

values is the foundation for many financial decision making processes including the area of

capital budgeting decisions and other business investments.

All business investment decisions should be based on Discounted Cash Flow (DCF) decision

tools such as Net Present Value (NPV). Once the incremental after-tax cash flows associated

with an investment project are identified, the process of calculating the NPV is nothing more

than a series of PV$ and PV of Annuity calculations that help answer the following questions:

Does the project have a positive Net Present Value?

Does the project have a percentage return that is greater than our cost of capital?

If we undertake this project, will we increase the economic value of our firm?

Are the incremental benefits of the project greater than the incremental costs?

All automobile loans, equipment loans, home mortgage loans, and credit card loans that

require a periodic payment (such as a monthly payment) that contains both interest due and a

payment on the loan principal are often called loan amortization problems. They are, in reality,

nothing more than PV of an Annuity problem.

Computation Tools for Time Value of Money

A number of computational tools can be used to calculate future value, present values,

annuities, and rates of return. The long, more difficult method is manual calculations using the

formulas as shown in Figure 1. The most basic are financial tables located in the back of the

textbook (Excerpt of FV shown in Table 1). Spreadsheet functions, like Microsoft Excel are

easiest to use (Microsoft Excel Object shown in Table 2). There are also financial calculators

that can help compute time value of money, such as the Hewlett Packard HP-12C which is a

standard handheld calculator in use for more than 25 years.

TVM Calculation Tools

Table 1. Excerpt of FV Financial Table

Table 2. Excel Spreadsheet to calculate TVM. Double click to open worksheet and type

information in yellow highlighted cells to calculate value for table above and amount.

Interest # of time
TVM Formula Amount
Rate (i) periods (n)
PV=1/(1+i) n $ 20,000 10% 1
0.90909
$ 18,181.82

FV=1*(1+i) n $ 20,000 10% 1

$ 8,000 8% 5
PVA=1-(1/(1+i) n) /i 3.99271
$ 31,941.68

$1,760,000 9% 5
FVA=(1+i)n-1/i 5.98471
$10,533,091

$ 1,760,000 9% 5

PVAD=PVA*(1+i) 4.23972
$ 7,461,906.98

$ 1,760,000 9% 5
FVAD=FVA*(1+i) 6.52333
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Figures

Figure 1.

Summary of Time Value Money Concepts [ CITATION ACCT301 \l 1033 ]

References:

Griffin, M. P. (2009). MBA Fundamentals Accounting and Finance. New York: Kaplan.

Mathis, R. (2001). The Time Value of Money. (Prentice-Hall, Inc.) Retrieved Jun 18, 2013, from
Corporate Finance Live by Rock Mathis:
http://www.prenhall.com/divisions/bp/app/cfl/TVM/TimeValueOfMoney.html

Present Value. (n.d.). Retrieved Jun 18, 2013, from Business Finance Online:
http://www.zenwealth.com/BusinessFinanceOnline/TVM/PresentValue.html

Spiceland, D., Sepe, J., & Nelson, M. (2013). Intermediate Accounting (7th ed.). New York, NY,
US: McGraw-Hill Irwin.

Time Value of Money. (n.d.). Retrieved Jun 27, 2013, from QFinance.com:
http://www.qfinance.com/contentFiles/QF02/g1xtn5q6/13/1/time-value-of-money.pdf