Understanding the Time Value of Money (TVM)

An Annuity is any sequence of equally spaced payments made over a certain period of time with a definite end date. For example, a car loan is typically paid in monthly installments of the same amount for a period of five years. This is an annuity payment on the car. This should not be confused with perpetuity, which is the same type of payment but made infinitely, or forever. (Brealey, Myers, Marcus, 2003)

An annuity can affect the outcome of an investment based on the terms of the payments. The longer it takes to pay off an investment, the more interest is paid in, which can mean a loss to the investor. For example, if a car loan is taken out for 60 months, or five years, the buyer may have a larger monthly payment, but the principal will be paid off faster than if paid over a period of 72 months or six years.

Compound interest is the concept of interest upon interest. It is making interest on the principal plus the interest rate instead of just the principal. Interest rates increase the amount of the investment and the return to the investor. Compound interest means more money to the investor, because they are earning on the interest as well as the principal. As the rate of interest increases the rate of return, the investor makes more money.

Present value is the dollar amount needed to reach a certain financial goal. The more there is to start with, the higher the Future Value, which is that goal, is likely to be. For example, if a college fund is set up for a child upon his or her birth, with the intention of the fund having $100,000 in it by the child's eighteenth birthday, how much will the fund need to start with in order to achieve this goal? That's present value. Present value's impact on TVM is that the amount of the original investment can be increased due to interest that it will earn over the years.

Future value is the opposite of present value, in that the PV amount is already known but the ending amount is yet to be determined. If the dollar amount starts at $35,000, how much will the total be in eighteen years? Future value's impact on TVM is the same as present value. The $35,000 has the opportunity, with interest, to increase its worth over the years. If not for the opportunity to accumulate that interest, the value of the money would be less in eighteen years than it is at present.

Opportunity cost is the process of choosing one good or service over another. (thinkquest.org) This can have an affect on TVM as it gives the investor the opportunity to choose between different lenders to see which will give the best rate of interest or return, therefore increasing the future value of the money. For example, a person has the choice of investing in two different funds, one with a 3% interest rate over a period of seven years, and one with a 6% interest rate over a period of eight years. The investor has the choice as to what investment is the best financial move for him to make.

The rule says that to find the number of years required to double your money at a given interest rate; you just divide the interest rate into 72.(moneychimp.com) For example; if one were to invest $15,000 at an interest rate of 8% per year, it would take nine years to grow that investment to $30,000. 72/8=9. Without the rate of interest and following TVM, there would be no opportunity for the money to increase at all.

Conclusion

Investing can be a complicated business and understanding interest rates, present and future value of money can be quite confusing. The time value of money concept makes the process a bit easier by giving specific formulas to calculate outcomes. By learning and using these concepts and applying them in our own investments, we will not only become better money managers, but hopefully wealthier money managers as well.

References

Brealey, R.A., Myers S.C., Marcus A.J. (2003) The Time Value of

Money. Fundamentals of Corporate Finance, 4e. The McGraw-

Hill Companies. Retrieved June 16^th, 2007 from University

Of Phoenix online student web.

Opportunity Cost Shop (n.d.)Thinkquest.org Retrieved

June 16^th, 2007 from

http://library.thinkquest.org/3901/annie/op.htm

Rule of 72 (n.d.)Moneychimp.com Retrieved

June 16^th, 2007 from

http://www.moneychimp.com/features/rule72.htm

Time Value of Money, Introduction (2002)Get Objects.com

Retrieved June 16^th, 2007 from http://www.getobjects.com/Components/

Finance/TVM/concepts.html