Introduction The objective of this paper is to get an understanding of the concept of the time value of money. We first study the two important concepts in the area: Present value and the Future Value and its importance to the subject of corporate finance…
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It is based on the simple premise that “A penny in hand today is worth more than a penny in hand tomorrow”. This is on the basis of assumption that the money in hand today can be invested in various investment options which will increase the amount. Moreover, there is also an opportunity cost that is associated with the cash that is received later. This is the cost of the best foregone opportunity that could have been taken with the cash available (Econedlink.org, 2011). Cash received later can’t be used for any investment options present at the current time frame. The concept finds significant applications in the area of capital budgeting, lease versus buy decisions, accounts receivable analysis, financing arrangements, mergers and pension funding (Ross et.al., 2007, pg. 60). The concept of time value of money is used in every financial decision. This is done through two types of calculation. One includes calculating the present value of the cash that will be received at a later stage while the other calculates the future value of the cash that is received now. One very important concept related to the time value of money is the Net Present Value (NPV). It is the sum of the present value of all the cash inflows minus the present value of its costs (Brigham & Ehrhardt, 2010, pg. 183). Net present finds usage in evaluating if the proposed projects shall be taken or not. If the net present value of the total project cash flows is negative, it should not be taken. The concept of the time value of money also finds application in evaluating the present value of various investment options such as bonds and stocks and identifying the best option to invest. 2. The formula for calculation of future value assuming that compound interest is given is: r is the rate of interest and n is the time period (Bierman & Smidt, 2003, pf. 17). a.) Present Value = $15,000 n = 5 years r = 7% b.) Present Value = $19,500 n = 3 years r = 4% c.) Present Value =$ 29,900 n = 7 years r = 2% d.) Present Value = $14,200 n = 10 years r = 0.9% 3. The formula for the calculation of present value for a given future value assuming application of compound rate of interest is: r is the rate of interest and n is the time period. a.) Future Value = $17,500 r = 4% n = 3 years b.) Future Value = $41,000 r = 5% n = 5 years c.) Future Value = $120,000 r = 12% n = 2 years d.) Future Value = $790,000 r = 1% n = 8 years 4. Let us assuming that we are getting the payment at the beginning of the years. The cash flow timeline looks like: Calculating the present value of the three future payments at the interest rate, r of 4% where, Present Value (Yi) is the present value of the cash received in year i The total present value is Thus the present value of the stream of annual payments is $519,497. 5. Let us assuming that we are getting the payment at the beginning of the years. The same is deposited into a bank account at the same time. The cash flow for the bank account will be: 6. Calculating the future value of the three payments at the end of third year at an interest rate of r = 2%, we get where Future Value (Yi) is the future value at the end of three years for the cash deposited in the bank account in year i. The total Future value at the end of three years is Thus, we can see that the amount in the bank account at the end of three years is $374,592 Conclusion We studied the importance of the concept of time value of money and calculated the same for different scenarios. The analysis enables us to
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