Review Understanding The Time Value of Money

Time Value of Money

INTRODUCTION

Time value of money (TVM) is a financial or monetary concept which suggests that money in its prevailing value is worth greater than the same amount of money to be received sometime in future. The money that an individual holds currently can be invested so that an income or return is earned at the end of a specified duration. This simply means that little money can generate a large sum of money in future (Wee and Law, 2001). But then it is important to consider that fact that losses can be experienced and money might never be received in future. The possibility of making more money or losses depends on how the money is invested and the strategies adopted. TVM is commonly known as the Net Present Value of cash flow or money, the (NPV) (Shrieves et al., 2001). TMV is reflected in various aspects of business and finance for example purchasing power and inflation. The two factors are often considered when it comes to the determination of the discount rate or the rate of return on capital invested.

SOLUTIONS

FV= PV (1+I/n)^(n*t)

FV denotes the future value of the investment

PV stands for the Present Value of future cash flow

I represent the interest rate

(n) is the number of the compounding period

(t) is the number of years considered

These formulae can be used to find solutions to the given problems as shown below:

1^St problem: PV=$500 I= 8% t=1 and n=1

Therefore FV=500(1+0.08/1)^(1*1)

                                  =540

2^nd problem: PV=$500 I= 8% t=5 and n=1

Then FV=500(1+0.08/1) ^(1*5)

=734.66

Net Present value of money to be received in future can be calculated using the following formulae

DCF = CF _a /(1+r)¹ + CF _b /(1+r)² + CF _c /(1+r)³ …+ CF _n /(1+r)ⁿ.

Where DCF means discounted cash flows

CF represents cash flows at the end of the specified period (often a year)

a,b,c,d….n denotes the number of years

r denotes the opportunity cost rate/discounting rate

3^rd problem: CF =$500 no of years =1 r =8%

DCF= $500/(1+0.08)¹

=$462.963.

4^th problem   CF=$500 no of years =5 r =8%

DCF= $500/(1+0.08)⁵

=$340.29

ASSESSMENT OF THE 1^ST AND THE 2^ND PROBLEM

The calculation and solution presented above reveal that the future value for $500 to be invested at a rate of 8% for 1 year will be $540. This means that the investor will have earned a return of $40 ($540-$500) from his investment or rather the value of money would have increased by $40. Conversely, the present value of the cash that is expected to be received at the end of one year is $462.963, a value that is lower than $500. This shows that the value of money changes over time (Shrieves et al., 2001). The present value, $462.963 has been arrived at after considering different factors like financial risks, inflation among others. The current value of cash flows to be received and the future value of capital to be invested affect financial statements thus the budget and the balance sheet of an organization (Shrieves et al., 2001). Revenue recognition and the cost principle state that all transactions must be recorded at their real/cash value when the transactions are being made. This means that money that will be received in future must be discounted and future values must be recorded based on the values to be received.  What are the effects of the calculated values on the sheet and the budget balance?

In the statement of financial position, the current value of the amount of money to be received in future will be recognized as an asset. For instance, the $462.963 will be included in the accounts or note receivable at the end of the financial year before the year that the cash would be received. The same amount will be considered as income or revenue in the budget while the balance will be treated as interest earned (Kahraman and Ulukan, 1997). The same applies to the $500 to be received in 5 years. But then, an accountant will recognize $340.29 as a note receivable in the statement of financial position and treat the remaining balance as interest income. Conversely, 340.29 will be treated as an income in the present year’s budget.

Future values are recognized as an asset in the balance. A one-year investment of $ 500 would be regarded as a short term investment and treated as a current asset in the statement that indicates the financial position of a firm at the end of the period. Thus, $500 would be included in the current asset in the (balance sheet) statement of financial position while the interest earned ($40) would be accounted for as revenue in the budget and the profit and loss account. For the 4^th case where $500 is invested for 5 years, $500 will be recognized as long term investment in the statement of financial position while the balance will be considered interest income on an annual basis in the budget.

CONCLUSION

Undoubtedly, the value of capital or money changes with time. This is evidenced by the discussion and the calculations presented above. The present and future values have an impact on financial statements. Accountants need to compute the current value of future cash flow or the future value of an investment to take into account possible vicissitudes in the financial market and prepare a financial statement that reflects the true position of an organization.

REFERENCES

Wee, H. M., & Law, S. T. (2001). Replenishment and pricing policy for deteriorating items taking into account the time value of money. International Journal of Production        Economics, 71(1-3), 213-220.

Shrieves, R. E., & Wachowicz Jr, J. M. (2001). Free Cash Flow (FCF), Economic Value Added (EVA™), and Net Present Value (NPV):. A Reconciliation of Variations of Discounted-       Cash-Flow (DCF) Valuation. The engineering economist, 46(1), 33-52.

Kahraman, C., & Ulukan, Z. (1997, July). Continuous compounding in capital budgeting using a fuzzy concept. In Proceedings of 6th International Fuzzy Systems Conference(Vol. 3, pp.           1451-1455).             IEEE.