Time Value of Money and Its Financial Applications

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Table of Contents

Introduction
Commercial banks
Insurance companies
State governments – lotteries
He says the lottery is deceptive and explains
Retirement plan financial service providers
Bibliography

Introduction

The time value of money refers to the idea that money available at the present time is worth more than the same amount in the future, due to its potential earning capacity. According to this core principle of finance, money can earn interest. This means that a given sum of money (say a cash flow of $5,500) should be valued differently, depending on when the cash flow is to occur. If the interest rate is 10% per annum, the present value of $5,500 received at the end of the first year is $5,000.

This is because $5,000 today can be invested at 10% to earn $500 interest at the end of the year. If the $5,500 is received at the end of two years from today, its present value is smaller than $5,000; it is approximately $4,546 (Dayananda et al, 2002). Thus, any amount of money is worth more the sooner it is received. This is also referred to as “present discounted value”. The main concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, it is possible to determine the value to which a single sum or a series of future payments will grow at some future date.

One can calculate the fifth value if given any four of Interest Rate, Number of Periods, Payments, Present Value, and Future Value (Gallagher and Andrew, 1996). These are the components of the time value of money. If a person had money in hand he can invest it and have more of it in the future. However, when he invests in the future, it is possible that inflation will decrease its value in the future. The further into the future one receives the money, the less valuable it becomes.

Commercial banks

The time value of money is used in many aspects of banking. One such application is in the realm of mortgage financing. If a person borrowed $100,000 to purchase a house and paid the loan back over 30 years at 10% interest, one would end up spending almost $320,000 on the loan. What makes the mortgage loan appear expensive is ignoring the time value of money. Although the mortgage load would require almost $32000 in future payments, a lender would only pay $100,000 for the loan to get a 10% return. The loan’s present value is $100,000(Kieso and Weygandt, 1993). Considering another application in commercial banks, the effect of compound interest increases the return from investment because of time value.

Credit card financial service companies: Credit card interest is the principal way in which card issuers generate revenue. A card issuer is a bank that gives a consumer a card or account number that can be used with various payees to make payments and borrow money from the bank simultaneously. The bank pays the payee and then charges the cardholder interest over the time the money remains borrowed. This is greater than the money borrowed because of the time value of money. Banks suffer losses when cardholders do not pay back the borrowed money as agreed.

Insurance companies

An insurance settlement is an amount given by the insurance company to the defendant of some kind of insurance claim. The insurance company that covered the defendant of the claim agrees to pay a settlement amount to the claimant, in return for the release of the claim. Often, the insurance company would offer a structured settlement rather than an immediate settlement when a large amount is involved. This is because of the time value of money. Under a structured insurance settlement, the insurer promises to pay money in regular installments over a period of time (Mcmenamin, 1999). According to the time value of money, any amount of money is worth more the sooner it is received and hence the delay.

State governments – lotteries

In a state lottery, unlike regulated gambling enterprises, the directors can stack the deck any way they want. People who win the jackpots are never paid in full. They have to choose between taking much smaller cash payments upfront and taking the full jackpot spread out over decades. Rev. Jesse Jackson, in his book “It’s About The Money,” says that even the “full-payment” method doesn’t guarantee full payment in dollars.

He says the lottery is deceptive and explains

A typical $1 million jackpot is taxed and paid out over a twenty-year period. Because of the time value of money, if this money were taxed at a 40 percent rate and adjusted for inflation, winners would receive only about $318,000 in real dollars (Scoppe, 2000). Thus the government fails to disclose the real interest rates and costs associated with the lottery. Sometimes, states buy annuities to cover the costs of the jackpots. And lower interest rates have forced many of them to stretch out the payment period from 20 years to 30 years. That means that a $1 million jackpot can become lower than the $318,000 calculation because of time value (Scoppe, 2000).

Retirement plan financial service providers

Retirement plan financial service providers advise people to take advantage of the time value of money. If from age 25 to 65 a person invests $300 a month (9%) at age 65 he will have 1.4 million in a retirement fund. But if he waits ten years until age 35 to start he will have only about $550,000 and if he waited twenty years until age 45 and you’ll have only $201,000 at age 65. This is because of the time value of money.

Bibliography

Dayananda, Don; Irons, Richard; Harrison, Steve and Herbohn, John; Rowland, Patrick (2002). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University Press. Cambridge, England.

Gallager, T; Andrew Jr., J. (1996). Financial Management: Principals and Practices. Prentice Hall Publishers. Upper Saddle River. New Jersey.

Kieso, D; Weygandt, Jerry (1993). Intermediate Accounting. 9th Ed. John Wiley and Sons Inc. New York.

Mcmenamin, Jim (1999). Financial Management: An Introduction. Routledge Publishers. London.

Scoppe, Ross Cindi (2000). The Way States Run Lotteries Demonstrates Contempt for Public. The State. Editorial. Web.

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