Types of Time Value of Money
The types of time value of money have been stated below.
Simple Interest
With simple interest, interest is calculated only on the principal part. The interest earned does not compound over time. Simple interest is a type of interest calculation where the interest rate is applied only to the original principal amount. Here is a simple answer of simple interest in firm as stated below.
- When a firm borrows or lends money, interest is charged or paid to account for the time value of money. The longer you borrow money, the more interest you pay.
- In simple interest, the interest rate is only applied to the original amount of the principal. The interest does not compound (gain) over time.
- For example, if you borrow $1000 at 5% interest for 2 years, the simple interest would be $100, calculated as $1000 (principal) x 0.05 (interest rate) x 2 (years) = $100
- The total amount you would repay after 2 years with simple interest is $1100 (the original $1000 plus the $100 interest).
- In contrast, with compound interest, the interest is also applied to any earlier accrued interest. This raises the amount of interest over time compared to simple interest. Compound interest is more commonly used in firms.
Also, read about Inflation Accounting.
Compound Interest
With compound interest, interest is figured on the principal amount and any interest earned. Interest compounds over time. For example, $100 funded at 5% compounded annually for 2 years earns $10 in the first year. In the second year, interest is earned on $100 + $10 = $110. So you earn $110 * 5% = $5.50 in the second year. The total amount after 2 years is $100 + $10 + $5.50 = $115.50.
- Compound interest is a form of interest that is figured on the initial principal amount and any hoarded interest from prior periods.
- In compound interest, the interest amount earned in one period is added to the principal for the next period, and the interest for the next period is calculated on the new principal - the original amount plus earned interest. This process repeats, compounding the interest over time.
- This leads to compound interest growing at an accelerated rate compared to simple interest, where interest is calculated only on the original principal amount.
- The part of compound interest paid depends on several factors, as stated below.
- The principal amount - The higher the principal, the more interest is earned.
- The interest rate - The higher the interest rate, the more interest is compounded and earned.
- The compounding period - Interest compounded more often compounds faster. Daily compounding earns more interest than annual compounding, for example.
- The length of time - The longer the money is borrowed or funded, the more compounding periods and the more interest is earned.
- Because compound interest revs over time, lenders (like banks) prefer compounding interest over simple interest.
- Compound interest is also vital for investments, as interest or returns compound to generate higher overall gains.
Also, read about Macro and micro economic policy.
Present Value
The present value refers to the current worth of a future money. It factors in interest rates to decide how much money today would be needed to grow to the future amount. The present value is always less than the future value due to the interest and the time value of money.
The present value of a cash flow is the current worth of that cash flow depicted in today's dollars. It accounts for the time value of money, which is the concept that money today is worth more than the same amount in the future due to inflation, opportunity cost, and risk.
When calculating present value, future cash flows are discounted back to the present using a discount rate. The discount rate means the return that could be earned on an investment of similar risk and duration.
For example, if you have $100 due one year from today and the right discount rate is 5%, the present value would be about $95.23, calculated as follows.
$100 / (1 + 0.05) = $95.23
By discounting the $100 future cash flow at a 5% rate, we determine that $95.23 today is equal to receiving $100 one year from now.
Firms use present value calculations for decisions like the ones noted below.
- Assessing whether a capital investment or project is economically viable
- Comparing potential cash flows to decide which has the highest present value and should be pursued
- Fixing if an acquisition or merger creates present value above the purchase price
- Picking the appropriate interest rate to charge for a loan or pay for a bond
Read about Economic Monetary Policies.
Future Value
The future value refers to the amount that a current amount of money grows to over time with interest. The future value is always more than the present value. For example, $100 invested today at 5% interest compounded annually will grow to $110 in 2 years. The $110 is the future value of $100 in 2 years.
The future value of money is the amount the principal will grow over time through compounding interest or returns. Future value gauges account for the time value of money - the concept that a dollar today is worth more than a dollar in the future.
When calculating future value, the starting amount (the present value or principal) is risen using a growth rate over many periods. The growth rate typically means an expected rate of return through interest, income, or appreciation.
For example, if you invest $1,000 at a 5% annual rate of return and want to know how much it will be worth in 5 years, the future value calculation would be:
$1,000 × (1 + 0.05)^5 = $1,278
The $1,000 principal grows to $1,278 in 5 years at a 5% annual rate of return.
Businesses use future value calculations for decisions, as stated below.
- Deciding how much an investment will grow over time
- Setting savings or deposit goals
- Calculating how much to charge for a loan to cover principal and interest payments
- Hurling returns on investments or assets
- Gauging the future value of income creeks like rent or royalties
Understand about Budgetary control.
Discount Rate
The discount rate is the interest rate used to determine a present value from a future value. A higher discount rate lowers present value as your money could earn more interest over time. Discount rates should reflect the risks and inflation over the period involved.
A discount rate is the interest rate used to determine the present value of future cash flows. It reflects the return that could be earned by investing today and adjusting for risk.
Discount rates are used to estimate the present value of future cash flows to account for the time value of money. Money today is worth more than the same amount in the future due to opportunity cost, inflation, and risk.
To calculate the present value of a future cash flow, you discount it (reduce its value) using the right discount rate. The higher the discount rate, the lower the present value of that future cash flow.
Firms use discount rates for decisions, as stated below.
- Setting likely assets and projects. A higher expected return would require a higher discount rate, giving a lower present value and requiring a higher payoff to be helpful.
- Comparing capital investments. Projects with higher present values based on an even discount rate are more financially attractive.
- Setting loan interest rates. Lenders use a discount rate that covers the cost of funds, risk of default, overhead costs, and profit margin.
- Determining bond values. Investors require a discount rate that compensates them for the risk, time value of money, and bond liquidity.
Read about Human Resource Accounting.
Opportunity Cost
Opportunity cost refers to the help you could have received by taking an alternative action. In terms of the time value of money, it means the lost interest you could have earned with money received earlier. For example, receiving $10,000 today means you can invest it and earn 5% annual interest. Receiving $10,000 one year later means missing the opportunity to earn $500 interest (5% of $10,000). The $500 is the opportunity cost of receiving the money a year late.
In simple terms, opportunity cost means the value of the next best opportunity when a particular choice is made. If you choose one special investment or course of action, you give up the likely gain from the next best choice.
For example, if a firm has $100,000 to invest, it could do the following.
- Invest in a project with an expected 10% return
- Leave the money in a bank account earning 5% interest
The opportunity cost of investing in the project is the 5% interest that could have been earned by keeping the money in the bank account - $5,000 in this case.
The opportunity cost principle states that rational individuals should only take action if the benefits exceed the next best-forgone opportunity. When evaluating potential investments or loans, firms consider the following.
- The expected returns - How much money will be made?
- The required investments - How much money needs to be spent?
- The opportunity cost - What is the return on the next best alternative?
If the expected returns do not exceed the required investment plus the opportunity cost, the decision may not be worthwhile from a financial perspective.
So opportunity cost is an important consideration in the time value of money for firms. When assessing likely actions that involve money over time, it's critical to consider the following.
- The returns offered by those actions
- The required investments or costs
- The potential returns of choices, meaning the opportunity cost
Inflation
Inflation lowers the purchasing power of money over time. Money received in the future will not buy as much stuff as the same amount today. Inflation must be considered when evaluating the time value of money. Higher inflation means money now is worth significantly more than money in the future.
Inflation is the steady rise in prices for goods and services over time, which erodes the purchasing power of a given currency unit. Inflation makes future dollars worth less than today's dollars.
The time value of money concept admits that money today is worth more than the same amount in the future due to factors like inflation, opportunity cost, and risk. For firms, inflation directly impacts the time value of money in two main ways such as.
- Future cash flows are worth less - Future cash flows are discounted to determine their present value. Higher inflation rates mean future cash flows must be discounted more to account for their reduced purchasing power.
- Higher discount rates are used - The discount rate should reflect the inflation rate plus any premium for risk and return. Higher inflation translates to higher discount rates and lower present values for future cash flows.
For example, at a 5% inflation rate and 10% required rate of return.
- A $100 cash flow 1 year from now has a present value of $91 ($100 / 1.10 = $91)
- But at 8% inflation and 12% required return, the present value drops to $89 ($100 / 1.12 = $89)
The higher discount rate needed to compensate for the raised inflation reduces the present value more.
Firms must consider inflation when the next happens
- Assessing investments and projects
- Setting loan interest rates
- Repaying or issuing bonds
- Defining appropriate salary gains
In all cases, higher and erratic inflation makes future cash flows riskier, so firms aim for a return that exceeds the inflation rate to earn a real profit after accounting for the loss of purchasing power over timeframe.
