Time Value of Money Essay Example | Topics and Well Written Essays - 750 words

Time Value of Money - Essay Example Therefore, to make a certain investment, the opportunity costs should be low (David, 1984). Time value of money shares a direct relationship with the prevailing interests in a market. As the interest rates rise, the value of a dollar today will rise accordingly. When the interest rates follow the decreasing pattern, the value of money also sees a down sliding. This is because the interest rates play a very important part in determining the future value of a lump sum or the present value of a future lump sum; it is dependent on the interest rate. Therefore, they are directly related to each other. There are many other aspects which are related to the time value of money. The future value of an amount of money can also be calculated keeping in mind the time value of money. Making it simpler, the future value of a dollar is the dollar or any other amount that it earns with the help of an interest over a period of time (David, 1984). For example, if $1000 are invested today for an year at 5% interest rate, after an year it will give us $50 dollars and the total received would be $1050. However, if the same amount is invested in the long run for years, compounding will take place and at the end of second year, the interest will be earned on $105. This compounding will go on for the number of years the investment is made. If P is considered the principle amount of money that is invested, i is termed as the interest rate at that time, then the future value of a dollar would be given as P(1+i). When compounding for two years, the equation changes to P(1+i)(1+i) or, FV=P (1+i)n Where P is the principal amount, i is the interest rate and n is the periods for which the investment is made. With increasing interest rates, the future value also keep on increasing. With changing interest rates, the above formula would be applied separately for the different rates. Present Value The present value of a future investment can also be calculated keeping in mind the time value of money. The present value of a future investment is the current value of that payment that is to be received in the future. Discounting is the process that is employed in this case. This is the opposite of finding the future value of a present sum (Gary, 1978). Simply, it is calculated by dividing the future value with the same interest factor which was multiplied in the first case. PV=FV/(1+i)n Where FV is the future value, PV denotes present value, and (1+i)n is the interest factor. In finding out the present value, discounting is being done, therefore, this concept shares and inverse relationship with the time value of money. As the interest factor that determines the time value of money is divided, the value of the present value decreases resulting in the inverse relationship. Opportunity Costs Opportunity costs are the benefits that a person is giving away in spending the money in a certain kind of way. In other words, it is the benefit lost in choosing one alternative over another alternative. For this to be true, the opportunity costs should be really low for an alternative to be chosen. Higher the opportunity costs, lesser are the chances that the alternative may be chosen by a risk aversive personality. It can be termed as the basic relationship that exists between shortage and selection. Rule of '72 Rule of '72 is a simple mathematical shortcut that is used in finance in order to find out when