Time value of money paper Essay Example for Free

Time value of money paper Essay Introduction   Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚   Before dwelling on the various applications of Time Value of money paper, it is imperative to clearly understand what the whole concept of time value of money is all about.   The whole concept is based on the premise that all investors prefer receiving a certain amount of money today rather than the same amount in future, while holding everything else constant. Money in actual sense has a time value, which is an economic theory brought about by three reasons that include inflation, liquidity and risk. (Tuller, Lawrence W.1997)    This is based on the argument that if the investor receives the money today, he/she can earn interest on that amount until the specified future date.   For example earning $100 today is preferable than earning this same amount in one years time. This is because choice of either spending the money today or investing it for future.   Thus if one chooses to earn $100 one year from now, spending is also deferred for a similar period and will miss out on the opportunity to invest it. (Tuller, Lawrence W.1997) Financial application of the time value of money The Time Value for money is a very fundamental principle of investing and budgeting and all standard calculations are based on the basic formula of the present value of a future sum that is discounted to the present. The concept is fundamental in many aspects of finance; this is because it has an impact on consumer finance, business finance and government finance. (DeThomas, A 1992). The Time value of money concept has much valuable financial relevance. The concept finds some of its major and important uses in the measurement of various trade-offs in spending and saving (DeThomas, A 1992).   On a personal budgeting level, it has important consequences. For example one may make the decision to invest because the time value of money is greater in the future if the market interest rates stand at say 6% which is considered a high rate, however if the rates are much lower than this say between 1%- 2%, one may opt to spend the money because the time value of money today is higher. (DeThomas, A 1992). The time value of money is extremely useful in the following sectors of business: Commercial banks Credit card financial service companies Insurance companies d. State governments lotteries   Retirement plan financial service providers The basic concept of time value for money that includes compounding, discounting and annuities are frequently used in the retirement savings plan to determine the amount of the deposit that is needed to accumulate a certain future plan.   Commercial banks Commercial banks extensively find great use of time value for money; on a daily basis they use various time value of money formulas. It is used to calculate the amortization of loans for home mortgages that is described as present value of an annuity. In the calculation of mortgages, the future value of the annuity formula is used to determine monthly payments that the borrower is supposed to make. The concept is also used in the calculation of the future value of all the savings in the fixed deposit ( Crosson, S.V. Needles, B.E. 2008) Credit card financial service companies Under normal circumstances credit card financial services issue loans to the card holders, towards this end the time value of money formula is used to determine the schedules for loan repayment and also used in calculating the future value of the loan which is the ending balance. ( Crosson, S.V. Needles, B.E. 2008) Insurance Companies To illustrate how the insurance companies make use of the time value of money is when and one buys a life insurance. He/she gives money to the insurance company which doesn’t have to pay the beneficiaries the sum accruing until the principal dies, this can translate into many years. On the other hand the insurance company decides to invest the money in various instruments with the hope there value will increase. The insurance company is bound to benefit greatly the longer it has to invest the money, which it uses to pay back the benefit. The longer the insured lives the more the time the insurance company has to invest the money before paying up. ( Crosson, S.V. Needles, B.E. 2008) Thus if you buy the insurance when you are older it means that your lifespan is shorter, this also applies to those people with ailments or are unhealthy. That is the reason why the older or unhealthy people pay more in premiums compared to the young and healthy; the time value of money is applied the insurance company earns more money the longer the premium stays. ( Crosson, S.V. Needles, B.E. 2008) State governments lotteries Lottery is one of the methods that the government utilizes to provide funding for education in America. However those oppose the government for raising such money through lottery argue that the government takes advantage of the ignorance of the laymen of the time value of money with lotteries that hit a million dollars. The winner of such a lottery does not get the million dollars upfront; rather one receives $ 50,000 per annum for the next 20 years. The state cannot pay that money upfront because of the time value of money where a million dollar now is more worth a million dollars in future. ( Crosson, S.V. Needles, B.E. 2008) Components of a discount/interest rates   A sum of five different components makes up the rate of return at which an investment trades in financial theory; the five components are discussed here below and include: a) The real risk-free interest rate   This forms the basis at which all other investments are analyzed and compared. It is basically the rate of return an investor would expect to earn in risk less environment devoid of any form of inflation. (Carl S. W et al 2001) b) An Inflation Premium To adjust an investment’s expectation for a future inflation a certain rate is added towards this purpose; this is what is termed as the inflation premium. (Carl S. W et al 2001) c)   Liquidity Premium Liquidity premium is required in circumstances where investors are not willing to pay for the full value of the stocks or assets especially if there is a possibility of not selling them as quickly as they would wish because of buyer scarcity. The liquidity premium serves the purpose of compensating the potential loss. How big a liquidity premium is, is dependent on the investors perception of the activity of the market. A good example of where the liquidity premium is required is in such investments as family controlled company with thinly traded investments like bonds and stock. (Carl S. W et al 2001) d) Default risk premium Default risk premium indicates how investors perceive the likelihood of a company defaulting to meet its obligation or the likelihood of it going bankrupt. In most cases when there are telltale signs of a company in trouble, the investors demand a default risk premium which eventually leads to the collapse of the company.  Ã‚   (Carl S. W et al 2001) e) Maturity Premium The maturity premium commonly refers to the difference that exits between the interest rates of a short term default free bond and a longer maturity default free bond. The price fluctuation of the interest rates change is determined by how further in the future the bonds of the company have matured which in turn determine the price.   (Carl S. W et al 2001) REFERENCES Carl S. Warren, James M. Reeves, Philip E. Fess, James M. Reeve (2001): Financial and  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚   Managerial Accounting: South-Western College Crosson, S.V., and Needles, B.E. (2008): Managerial Accounting (8th Ed). Boston:  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚   Houghton Mifflin Company. DeThomas, Art (1992): Financing Your Small Business: Techniques for Planning,  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚  Ã‚   Acquiring Managing Debt: Oasis Press, Tuller, Lawrence W. (1997): Finance for Non-Financial Managers and Small Business   Owners: Adams Media