Time_Value_of_Money

Running head: TIME VALUE Time Value of Money Vicki Quantilias University of Phoenix Quantitative Reasoning for Business QRB/501 Robert Williams February 21, 2008 Executive Summary This paper examines the effect that time has on money in terms of worth and value. By explaining the variables inflation and compound interest, a better understanding is gained of money’s purchasing power over time. Examples of each variable will be given along with equations to better illustrate how time is the one constant that affects the value of money and why money is the dependent variable. Compounded interest helps people compensate for the loss inflation brings to their personal earnings. The importance of this compounded interest will demonstrated throughout this paper. Table of Contents Executive Summary 2 Introduction 4 Present Value of Money 4 Compound Interest 6 Inflation 7 Conclusion 7 References 9 Time Value of Money No matter where or when an individual grows up in the United States, that person will hear the phrase that “Time is money.” Money makes the world go round and it is a constant focus of a capitalist nation such as America. People not living in this country will understand that the currency they use makes their world turn. People strive for it every second of every day. Individuals are judged by their determination to get money and how much of it they currently have. People constantly use the term mentioned earlier because it is always changing. Time effects money constantly and continuously. As time increases money decreases in value. We have t understand this relationship to invest and trade responsible and in order to steer clear of being taken advantage of. In the United States the money we had last week or last month is not worth the same as the money we have currently nor whatever we may possess in the future. This value of the money of past present and future is caused from two separate variables. Interests accrued from current balances and principles along with inflation dictate how much our dollar is worth here in the United States. This paper will describe these two specific variables, inflation and compound interest and how time affects their values. Before this can occur we must first understand the present value of money and how it became that way. Present Value of Money Many people who have won the Lottery’s Powerball Jackpot have decided to opt for the lump sum rather than wait for yearly payments, taking 10 or 20 years to receive their winnings. These lucky people have decided to take their winning today and forfeit half of their winnings or more to avoid time and all that can occur from now until tomorrow. Time has affected the present value of their rightful earnings. Penalties and taxes are far less severe for those who wait. Time value of money was demonstrated by taking this lump sum out because many people go to their instincts for large decisions; many feel that it is always better to have money now rather than the future. The money is not worth double from what it typically is the following day, so why do so many people want the money now' $1,000,000 today will not go nearly as far as that same million 30 years down the road based on inflation rates. Time changes values of currency very quickly. People like the guarantee however of receiving their winnings because time is money. Who really knows how long they will be here anyways so this occurrence is common practice. The future value of money is understood by calculating the value of an investment in the future. “The present value of money represents the amount of money that would be required today to equal a desired future sum of money that has been discounted by an appropriate interest rate”(Newton,2008). Money today is always worth more than money tomorrow because it is a certainty that the money will be received. Time again has affected money; the rule that applies here is that the longer time that accrues the less value in the same amount of money. This is why interest and inflation have occurred, to lessen this loss of value in present money. People commonly use mathematics to predict the future through trends and tendencies that arise through calculations. Graphs help illustrate these equations for people so the trends are known to be good or slowly regressing allowing investors to make better more educated decisions. Equations are also able to predict the present value of currency. “The present value of a future sum of money is inversely related to the length of time being calculated. The present value of money decreases as the length of time increases.” This should make a lot of sense since the more time something has to grow the larger it will become. This interest is added to the principal or present value to calculate the future value of money for people who need to know. The more principal one may have the less interest is needed to make that value greater. People often want to understand how much money is needed presently to obtain the future desired currency. People who plan on retiring comfortably often do these equations. People usually want to retire around 60 depending on their profession, motivation and career goals. Many understand how much interest they are receiving on a savings account. “The common equation is FV = PV * (1 + r)n where FV= future value, PV= present value, n currently represents the years until retirement and r represents the interest rate that the savings is growing at”(McKracken,2009). Compound Interest For many of us the term compound interest strikes fear because its relationship with debt especially recently with the housing market. When discussing retirement plans, the interest is hopefully high, making the need for large principles minuscule. Others that may be discussing their current mortgage or financial aid loans do not like the term so much. This is for the simple fact that increased interest means higher minimum payments and larger amounts owed in the long run. “Compound interest is interest that is earned on both the principal and on any accrued interest”. Time periods dictate how often interest gets compounded, many of us are used to annual compounded interest or every twelve months making it a yearly occurrence. Lenders and banks have the ability to compound interest as they feel fit. The faster these lenders want a return on their investment the more they will compound or calculate the interest. This gives the barrower an incentive to hurry up and pay the principal amount back so that they do not pay double or triple the amount initially barrowed. The use of compound interest is always assumed in time value of money calculations. Compound interest grows exponentially because the interest of each time period gets added to the principal and with time the interest is being added to a now higher interest. $100 dollars with 10% interest compounded annually will end up being $162 dollars after just five years. 10% of $100 dollars is $10 dollars so after one year a barrower owes $110 dollars for barrowing just $100 dollars. 10% of $110 Dollars is now $11 dollars added to the $110 from the previous year. This makes $122 dollars at the end of just two periods. The exponential growth is amazing for those getting their return on the original investment. Compound interest is needed for savings and retirement funds to keep up with inflation. Inflation makes money less valuable so people allow their money to grow over time as a reward for not spending it all presently or in the past. This also allows ones money to be worth the same or more than what they originally placed in the fund as the principal in terms of overall value. Inflation Inflation is able to affect the time value of money because as it rises, inflation decreases the purchasing power of money. Inflation occurs each year, or at least that is how often the government measures it here in America with economist, so time affects inflation as the annual inflation rate. Inflation is defined as the “sustained increase in the general level of prices for goods and services”(Newton,2008). When inflation increases as it so often does the dollar is able to purchase a smaller amount of goods or services from the year before. When goods like automobiles increase in cost each year, inflation is increasing. The Camry from Toyota may have cost $20,000 in 2005. The same car in 2010 cost $25,000 because of inflation with the same upgrades and options. This means that the Camry has increased its value 25% in five years or 5% each year since 2005. The dollar in 2005 is only worth .75 cents five years later because of the inverse relationship that time has on the value of the dollar. As time increases, the value of the dollar decreases from inflation. Conclusion Currency has made the world go round for thousands of years now. As time increases the currency from the past is worth far less from its original amount as inflation has occurred. As an evolved species we have compensated for this lack of value with interest to help our money grow as we do so that our earnings can assist us even while this inflation occurs. We increase our earnings with compound interest in savings and retirement funds. We also afford the nicer things life has to offer with loans that come with this same compounded interest. Time forces us to purchase things before we can afford them because no one wants something that they cannot enjoy in their youth or with their health. The lender has incentive to lend money from interest and the interest gives the barrower the incentive needed to pay back the loan in a timely manner. Life is able to happen and everyone is able to win because inflation and interest that occur from time that never stops. Money is only as valuable during the time it is being sent, making the value directly dependent to the time it is being used. References Finance professor. (2007). Financeprofessor.com. Retrieved from http://www.financeprofessor.com/financenotes/timevalueofmoney.htm  Investopedia. (2010). understanding the ime value of money. Retrieved from http://www.investopedia.com/articles/03/082703.asp McKracken, M. (2009). teachmefinance.com. Retrieved from http://www.teachmefinance.com/timevalueofmoney.html Newton, H. (2008, summer). Time value of money. Money markets, 38(15), 14.