Time Value of Money Principles and Concepts
Finance professionals are responsible for identifying the most fruitful investment opportunities. To do this, they must understand how the value of money fluctuates over time. The time value of money is an essential concept for accountants, financial planners and business managers to know as its application will give them a clearer picture of how to invest money and grow their companies.
What is Time Value of Money?
The time value of money is a core concept of finance, which states that money available at the present time is worth more than the same amount in the future. This is based on the potential earning capacity. The principle argues money can earn interest and increase in value over time, therefore it has a greater worth in the present. It is also more beneficial financially to have a certain amount of money and spend it immediately, because inflation over time may reduce the buying power of the same amount. Time value concepts apply to all areas of financial management and can be used when determining capital budgeting techniques, stock and bond valuation, financial vehicle analysis, leasing and cost of capital.
Using Time Value of Money for Financial Decision-Making
Accountants and finance professionals utilize time value of money principles when making important investment and budgeting decisions. It is a critical component of capital budgeting and the net present value approach because it provides financial managers with a more accurate picture of the benefits and returns they will see on capital projects and investment opportunities. By factoring in the value of money over time, they are able to forecast cash flow and identify potential risks, which influence their investment decision-making process.
Businesses can utilize time value of money principles in several ways when making daily decisions on how to spend their money. The time value of money can be applied to evaluate a company’s options for receiving or paying money at different times. For example, the time value of money concept may come into play when deciding whether it is more cost effective to make a large purchase, such as equipment or electronics, by paying for it all upfront or using a payment plan. The same applies to receiving money. Businesses may determine it is better to give customers a discount in order to receive money immediately instead of allowing them to pay for their product over a period of time and receive less. It can also be used when developing new products to evaluate the rate of return the company can expect when undertaking new projects.
Future value is used to find out how much a cash flow will be worth in the future by factoring interest rates or capital gains over a number of time periods. The future value of an investment is calculated by multiplying the principal amount and the interest rate, then adding the gained interest back to the principal amount. Year after year, the future value will increase as the interest gained is reinvested. This is known as compounded interest. These calculations allow investors to estimate the value of their investments. They can use this information to determine whether or not the projected returns meet their needs, but they must also consider the risk of inflation. If inflation raises the price of goods too high and too quickly, then their investment may lose value.
Present value is used to determine how much a future cash flow is worth in the present. Using the average rate of return multiplied by the number of periods, the future cash flow is discounted back to the present date. Essentially, the present value shows the amount of money that would have to be invested now in order to receive the future amount. This concept can also be applied to determine the value of regular streams of income. In order to find out how much future income will be worth, the deteriorating value of money over a period of time needs to be taken into account. This technique is used in many areas of business as a way to estimate future profits on a deal and determine if the initial investment is too high.
Determining the worth of money over a period of time is not as simple as multiplying the amount of cash by the number of years. Several factors, such as interest gained and inflation must be accounted for in order to attain an accurate understanding. The time value of money along with future and present values are necessary concepts for finance professionals.