Tyler Toro May 13, 2011 ECO 389

The Time Value of Money

When thinking of money, does one readily believe and fully understand the triviality of monetary notation? Civilizations through human history have printed colorful pieces of paper and minted small metal coins with the intention of creating a monetary tool for exchange with an exact value. One piece of money equates to a particular good or service. Unfortunately, for better or for worse, the value of money changes over time. A unit of money decades ago could purchase more compared to today. For example, using a calculator from the Bureau of Labor Statistics, $0.25 in 1959 had the same purchasing power as $1.92 in todays terms1. While this is an example of the negative aspects of money over time, a positive example would be saving and investing. Money saved today can become a larger amount in the future. These both cases help explain how time can affect the value of money. When we consider analyzing a particular investment or amount of money throughout time to determine its value, there are two stages to keep in mind; Present Value (PV) and Future Value(FV). As their names apply, present value represents how much value the investment or amount money initially has and future value represents how much value the investment or amount of money will have at a later date. There is a generic formula to determine what the future value of an investment or amount of money is; as long as time, interest rate, and present value are given.

http://www.bls.gov/data/inflation_calculator.htm

FV = PV (1+ interest rate)time

As seen in the equation, the only way for an investment or amount of money to increase in value is if the interest rate is larger the zero. Interest is the reason money grows. In our textbook we are made aware of two types of interest: Simple and Compound. Simple is the case in which an interest payment is derived from only the initial investment. Compound interest is the case where there is an Earning of interest on interest. Two stress the difference between both types of interest; let us look at an example. If there is an initial amount of money of $1000.00 this would give us a Present Value of $1000.00. For argument sake, let the interest rate equal 10%. In the case of simple interest, there is no need to take time into consideration because only the initial amount will earn interest. The interest payment ( PV interest rate) would be (1000.00 0.10) = $100.00 , which would make the FV of the amount of money to $1100.00 With the case of compounding interest, unlike the simple interest, time does affect the Future Value. But is simple interest different from compounded interest for the first year? The answer is no because compounded interest is acquired through the passing of more than one period. To reiterate the point let us mathematically examine case with more than one period. At the start of the saving, the Present Value is still $1000.00; let us represent this Present Value as PV1 . To calculate the FV1 we will use the previous formula: FV = PV (1+r)t . This gives us a Future Value of [1000 (1.10)1 = $1100.00]. Of course this is the same value as calculated with simple interest, but when we calculate with a larger year amount (t) there will b a larger

interest payment. The new Present Value for the second period will be the Future Value of the previous period. This is because the entire cash flow is similar to a timeline, a linear path. To calculate the new Future Value ( FV2) , we use the same formula and increase t from 1 to 2, representing the second period. Future Value FV2 = FV1 (1+r)t or FV2 = 1100.00 (1.10)2 = $1331.00 It is also possible to calculate the time needed to acquire some Future Value amount. Let the interest rate for this example still equal 10% (r=.10), and the Present Value equal $3000.00 (PV = 3000). If we eventually would like to have $4000.00, (FV = 4000), how many years would it take? We can manipulate the formula and isolate the t exponent. FV = PV(1+r)t 4000 = 3000(1 + .10)t 1.33 = 1.1t If t=3 then 1.13 1.33

4000/3000 = (1.10)t If t = 1 then 1.11 = 1.1

If t=2 then 1.12 = 1.21

With these formulas, we can see how time directly affects the value of money. In order for there to be any increase in a savings investment or amount of money there must be some sort of interest accumulated. It is a phenomenon to create money out of thin air, but with interest gained on a saving investment or amount of money, one could increase the value of money over time. Time plays a crucial role because according to Suzan Murphy time allows one the opportunity to postpone consumption and earn interest.

Work cited

United States Department of Labor. CPI Inflation Calculator. , Web. 13 May 2011. <http://www.bls.gov/data/inflation_calculator.htm>.

Brealy, Myers, and Marcus. Fundamentals of Corporate Finance. 6th. New York, NY (USA): McGraw-Hill Irwin , 2009. 112-123. Print.

Murphy, Suzan. 2000. The Time Value of Money. University if Tennessee Department of Finance. itc.utk.edu/spotlight/archive/murphy/MBA_Prep_Summer_Tech.ppt