The concept of the time value of money is the foundation of discounted cash flow analysis in finance. Discounted cash flow allows for the accumulation of expected interest on a certain amount.
The Basic Principle of Time Value of Money
The basic principle is that a dollar you have in hand today is worth more than a dollar you will receive in the future. Conversely, the time value of money also encompasses concepts of future value and present value.
For example, if you have the money in hand today, you can save it and earn interest on it, or you can spend it now. If you do not receive it until some time in the future, you lose the interest you could have earned, and you cannot spend it now.
When calculating the future value of money reserved in an investment, you need a way to consider the potential compounded interest you could earn by holding the investment and the risk of losing value over time due to inflation or unsuccessful investment due to market conditions.
Using Time Value of Money in Small Business Financing
Time value of money formulas is used to calculate the future value of a sum of money, such as money in a savings account, a money market fund, or a certificate of deposit. It is used to calculate the present value of either a lump sum or cash flow you will receive over time.
If cash flows are expected to be received in the future from a company investment, such as an investment in a building or equipment, the time value of money is used to calculate the present value (value now) of those cash flows.
Types of Cash Flows for Time Value of Money Calculations
There are four main types of cash flows for time value of money calculations:
- Future value of a lump sum
- Future value of a series of equal deposits
- Present value of a lump sum
- Present value of a series of equal payments
Note: Time value of money calculations will involve the use of discounted cash flows.
Methods of Calculating Time Value of Money
Each time value of money calculation has a formula used to find the time value of money. The more complex the calculation, the more complex the formula.
Time Value of Money Factor Tables
Time value of money tables provide a way to use financial calculators and spreadsheet programs. Some professional exams and some university professors still rely on time value of money tables. The tables are a series of multiples derived from the appropriate formula for time value of money to facilitate time value of money calculations.
Financial Calculators
Financial calculators are specifically designed for time value of money calculations. There are five keys you will need for these calculations.
- The N key is used for the number of time periods.
- The I/Y% key is used for the interest rate per period.
- The PV key is used to enter the present value and must be entered as a negative number using the +/- key only.
- The PMT key is used in the equal payment series problem if you have a series of equal payments. Otherwise, it is 0.
- The FV key is the variable for the future value you are solving for, which will change based on the other inputs.
Spreadsheets
Spreadsheet applications like Microsoft Excel and Google Sheets are ideal for time value of money calculations as well as most other financial calculations.
Other Methods
There are many types of time value of money calculations that small businesses use in their financing operations. Some include solving for interest rates, solving for the number of years, solving for the present value of ordinary annuities and due bonds, solving for the future value of ordinary annuities and due bonds, solving for bond payments, and solving for the present value of irregular cash flows.
Additionally, companies apply these concepts as part of other financial procedures such as calculating net present value, profitability index, internal rate of return, and other capital budgeting procedures that make small businesses successful.
Questions
Frequently Asked Questions (FAQs)
What is the time value of money?
The time value of money is a principle that states that the money you have now is worth more than the money you will receive in the future. For example, you can invest the money you have now and theoretically earn a return over time.
How do you calculate the time value of money?
You can calculate the time value of money by determining the cash flow you wish to analyze, then using a spreadsheet or a financial calculator formula that accounts for the period of time, interest during that period, present value or bond payments, and future value.
Source: https://www.thebalancemoney.com/time-value-of-money-393498
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