Discuss about the Savings and Time Value for Money.
The expression of the time value of money has a lot of attention since according to Louise’s article and what have been learnt in class. Louise’s primary concern was on the importance of saving. He argued that money saved increases in value. For example, if $100 is invested today it will increase in value. This is because interest will get earned. By the year end, the amount that will get accredited to the $ 100 will be more than the currently the value of the cash. If it happens that the inflation rate is higher than the rate of interest that will be experienced, then the $100 invested would have a little purchasing power at the year end. It is crucial to get a note of the inflation rate in making decisions on invest savings.
In places where the inflation rate is high, or is expected to go up; this mostly happens when there is a currency devaluation, it would be more advisable to invest the cash in buying valuables whose value would remain high even when inflation is high. Some of the valuables include upscale chains and expensive objects for decorations which are not for resale. This is because their relative value would still be high. Although times brings out the opportunity to increase the amount of cash held, inflation reduces the value of this money. For example, money invested in a small business, shares purchased from a company or even bonds and securities purchase, could result in losses in investment with the presence of a significant financial setback (Louise, 2016).
The other way in which time value of money can be can get recognized is by noticing that each and every service or work consumes time. The more the time spent on the job, the higher the amount that will get rewarded to the worker. Taking into consideration time and cash, there will be a tremendous increase in the value of cash as time passes by. Let’s say that someone was to save around $ 100 on a monthly basis and invest the $ 1200 at every year end for 25 years while earning 5% interest rate per annum, instead of one having the $30,000 invested, one would have a total of up to $ 46,206 by the end of the 25 years. If one were to let the money accumulate for 40 years, the money would yield $ 325,292. The longer the time, the more the value of the money increases. The earlier one starts making his saving, the greater the grand sum received after a period of time (Louise, 2016).
Time value of money is a very crucial concept when it comes to financial management. This is because it can be used in comparing the alternatives of various investments and help to solve problems. Some of the issues that the study of time value of money can assist in resolving are loans, mortgages, leases, savings, and annuities among others. Time value of money is based on the concept that the dollar one has on a particular time has more value towards its future. The value of the dollar today is not the same value it will have tomorrow, the value of the dollar tomorrow will be much higher. This is because, the money held today could be invested to generate some profit. This profit will have increased the value of the money. A primary concept in time value of money is that a single sum of money or a series of similar and equally-placed payments or receipts that have been promised in the future can get converted to an equivalent absolute value today. One can also calculate the value that the amount one has today will be worth in the future. To calculate the value, the following are important;
- Interest rate
- The number of the periods
- Present value
- Future value
Any of the five elements can get calculated provided the values of the other four are provided. (Schmidt, 2016)
Interest is the amount one is charged for borrowing money when paying back. It is the additional amount that one will payback when repaying the loan borrowed. Interest is also the extra payment on saving deposits made into a bank. There are two types of interests; the simple interest and the compound interests. When calculating the value of simple interest, it is only calculated from the principal amount that was borrowed. Compound interest is calculated after each period on the original amount that was borrowed in addition to all the unpaid benefits accumulated to date.
Number of Periods
Periods are the equal intervals of time. They are not necessarily in term of years, but they have to be equal. This is because each interval should rhyme with a compounding period of the annuity.
Payment is the series of equally determined cash flows. Payments can be made as a single sum or can be paid in time periods. Single sums are known as lump sums, whereas periodic payments are referred to as annuities.
The current value is that amount that is today equivalent to the future payments that will get made that has been discounted at an agreed rate.
Future value can get described as the value the money today is expected to yield after it has been subjected to a fixed compounded interest. (Peterson Drake and Fabozzi, 2009, 23)
Financial Issue Analysis
When dealing with time value of money, it is important to take note of the opportunity cost. A dollar received today can get invested at the moment for it to earn an interest which will increase its value in the future. Contrary, a dollar received in the future cannot start earning its interest until the time it’s received. This lost opportunity to earn interest is known as the opportunity cost. Due to opportunity cost, time value of money is founded on two principles.
More is better that Little
Sooner is better than Later
These principles are rise to the two-time value of money techniques that are compounding and discounting (Gregory and Wang, n.d.).
Compounding is all about moving money forward to the future. It is the general method of determining the amount of interest that will be earned when an investment is made today.
Discounting is all about moving money backward in time. It can be described as the process by which there is the determination of the present value of money that will get received at a future date. The current value is determined by applying a discount rate to the sums of money to be received in the future.
Similarities and Differences
The variables used by Louise in the consideration of the time value of money have the same variables as those learnt in class. These variables are those that have been named earlier. However, there have been some differences in the results arrived at. Investing $1200 at the end of every year for 25 years at an interest rate of 5 %. Louise noted that the future value would be $ 46,206. However using the formula below learnt in class, the result is different.
Future value ordinary annuity
= 1200 * 47.7271
= $ 52,273
Also, Louise noted that when the same amount is saved for 40 years, the future value will be $ 325,292. The formula gives a different result.
= 1200 * 120.80
= $ 144,960
Despite having the same variables, the results given by Louise after calculating the future value of the saved money, are different from what is obtained by using the formula learnt in class. Time value is an important factor for making savings investment decisions.
Gregory, A. and Wang, Y. (n.d.). Cash Acquirers: Free Cash Flow, Shareholder Monitoring, and Shareholder Returns. SSRN Electronic Journal.
Peterson, P. and Fabozzi, F. (2009). Foundations and applications of the time value of money. Hoboken, N.J.: John Wiley & Sons
Schmidt, R. (2016). What You Should Know About The Time Value of Money. [Online] Propertymetrics.com. Available at: https://www.propertymetrics.com/blog/2014/06/17/time-value-of-money/.
Louise, F. (2016). LOUISE FAIRSAVE: Time value of money. [Online] www.nationnews.com. Available at: https://www.nationnews.com/nationnews/news/76797/louise-fairsave-value-of-money [Accessed 24 May 2016].