Question

View the video “The Time Value of Money”. This video will walk you through present and future values of money. How are the concepts of PV and FV important when we talk about your personal financial management of money? What is the importance of creating a budget? How can you make changes in your personal routine in order to stick to a budget—what challenges might you face?

Answer 1

The time value of money (TVM) is an important concept to investors because a dollar on hand today is worth more than a dollar promised in the future. The dollar on hand today can be used to invest and earn interest or capital gains. A dollar promised in the future is actually worth less than a dollar today because of inflation.

Provided money can earn interest, this core principle of finance holds that any amount of money is worth more the sooner it is received. At the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.

The time value of money sounds like one of those boring economic concepts that a small business owner doesn't have time for – but that would be wrong. Future value and present value are monetary concepts that a business owner uses every day, whether he realizes it or not. The idea is simple: Money in your pocket today is worth more than the same amount received several years in the future. The difference is the effect of inflation and the risk that you may not actually receive the money you expect in the future.

What Is Future Value?

Future value is the amount of money that an original investment will grow to be, over time, at a specific compounded rate of interest. In simpler terms, an investment of $1,000 today in an account paying 4 percent interest will be worth $1,217 in five years. That's an example of the time value of money.

Example of Future Value

How is this concept of time value useful in managerial decision-making? Suppose you have an old piece of machinery that you would like to replace, but a replacement will cost $50,000. You don't want to borrow the money, so you decide to save enough each month for three years to pay cash. How much will you need to save each month to reach the goal of $50,000?

Let's assume the current interest rate for savings is 4 percent. A future value calculator shows that 36 payments of $645 per month will yield $50,051 in three years. If you work this monthly payment into your company's budget, you can replace the obsolete equipment in three years, paying cash and not taking on additional debt.

What Is Present Value?

Present value is a measure in today's dollars of the receipts from future cash flow. In other words, it is a comparison of the purchasing power of a dollar today versus the buying power of a dollar in the future. For clarity, consider this example. Suppose someone offered to pay you $1,000 today or $1,100 in five years. Which would you take?

With a discount rate of 4 percent, an $1,100 payment in five years would have a present-day value of $904. Therefore, taking the $1,000 payment today is the better choice.

Example of Present Value

Managers and analysts use present value calculations to determine the attractiveness and viability of a project. If the net present value of future cash flow from a project exceeds the original investment, then the project could be accepted.

As an example, suppose you have a proposal to invest $30,000 in a new piece of equipment that will improve production efficiency. This new machine will reduce operating costs by $10,000 per year for at least five years. You require that all new projects produce a minimum return of 11 percent. The financial calculator shows that the present value of $10,000/year discounted at 11 percent yields a present value of $36,959. Because this present value exceeds the original investment of $30,000 by $6,959, this investment in the new machine should be accepted.

The time value of money is an economic concept that small business owners must use when evaluating investments and projects. The financial consequences are significant. Calculations of future and present values provide basic data on which to make rational business decisions.

Following are the importance of budget which is discussed below as follows in point wise:

1. It Helps You Keep Your Eye on the Prize

A budget helps you figure out your long-term goals and work towards them. If you just drift aimlessly through life, tossing your money at every pretty, shiny object that happens to catch your eye, how will you ever save up enough money to buy a car, take that trip to Aruba, or put a down payment on a house?

A budget forces you to map out your goals, save your money, keep track of your progress, and make your dreams a reality

2. It Ensures You Don't Spend Money That You Don't Have

Far too many consumers spend money they don't have – and we can owe it all to credit cards. As a matter of fact, the median credit card debt per household reached $2,300 in June 2019

Before the age of plastic, people tended to know if they were living within their means. At the end of the month, if they had enough money left to pay the bills and sock some away in savings, they were on track. These days, people who overuse and abuse credit cards don't always realize they're overspending until they're drowning in debt.However, if you create and stick to a budget, you'll never find yourself in this precarious position. You'll know exactly how much money you earn, how much you can afford to spend each month and how much you need to save.

3. It Leads to a Happy Retirement

Let's say you spend your money responsibly, follow your budget to a "T" and never carry credit card debt. Good for you! But aren't you forgetting something? As important as it is to spend your money wisely today, it's also critical to save for your future.

4. Emergencies

Life is filled with unexpected surprises, some better than others. When you get laid off, become sick or injured, go through a divorce, or have a death in the family, it can lead to some serious financial turmoil. Of course, it seems like these emergencies always arise at the worst possible time – when you're already strapped for cash. This is exactly why everyone needs an emergency fund.

5.  It Sheds Light on Bad Spending Habits

Building a budget forces you to take a close look at your spending habits. You may notice that you're spending money on things you don't need. Do you honestly watch all 500 channels on your costly extended cable plan? Do you really need 30 pairs of black shoes? Budgeting allows you to rethink your spending habits and re-focus your financial goals.

6. It's Better Than Counting Sheep

Following a budget will also help you catch more shut eye. How many nights have you tossed and turned worrying about how you were going to pay the bills? People who lose sleep over financial issues are allowing their money to control them. Take back the control. When you budget your money wisely, you'll never lose sleep over financial issues again.

Following are the changes to stick on a budget :

1. Track how much money you have coming in

Take the time to understand all the money you have coming in, and that it all matches what you should be getting. In addition to your day job, do you have any other income on a monthly basis? Do you freelance or contract work with clients? Do you have a side business that brings in money? Consider these income avenues if they bring in steady cash flows.

2. Know your recurring monthly bills and expenses

List out all your monthly recurring bills, even the ones that are bi-annual or quarterly. This could include your monthly rent or mortgage, utility bills, cell phone bill, internet bill and any known medical bills. This will help you manage and you’ll be able to see where you need to re-allocate your money.

3. Live within your means

Review your expenses and make sure they’re in line with you make. If you’re spending more than you make, it’s time to reassess what you are spending. Spending less than what you make is the definition of “living within your means.” Use an app like Ask Trim to scan your bank accounts and credit cards. The app will analyze your recurring expenditures and subscriptions to determine where you can save more money or eliminate expenses.

4. Write down your personal finance goals

Create a simple spreadsheet with your expenses and income. Statistics show that people who write down their goals have an 80 percent chance of achieving them. So, why not type or write down your personal finance goals, too. Take a hard look, then ask yourself, do you have any savings or any leftover money? If the answer is no, go back and trim your expenses until you can save some money each week or month. Write down what you would like to save each month, whether it’s 10% of your paycheck or 30%.

5. Get an app to help you with your budget

You want to stay on track and on budget. Try Mint. It allows you to add budgets in different buckets such as food expenses, rent or mortgage and medical expenses. The app also warns you when you exceed them. You also have the option to automatically import your bank and credit card transactions, making it much simpler to stay on track.

6. Be realistic! Set yourself up for success

Don’t expect to be saving large amounts of money right away. Start small, and build up to more.

7. Set 1–3 “SMART” financial goals

Use the SMART method of goal setting. Your financial goals should be Specific, Measurable, Achievable, Realistic and Time Bound. Your financial goal could be saving for a trip or even paying off debt such as student loans. Achieving a small goal will give you confidence to set bigger goals.

8. Carry — and use — cash

Not using your debit or credit cards will help you stick to your budget. You’ll be more intentional about what you purchase and how much you want it or not. Using cash for your weekly errands and expenses will make you consider if you really need that latte or if you would rather add it to your savings account.

9. Crush your goals, take them to the next level

Once you’ve achieved something small, dream bigger! Goals can be as basic as adding to a savings account each month or as complicated as different amounts going into different accounts for vacations, savings, retirement, emergency funds .

Here are a few challenges you’ll face when building a budget for your business:

1. Your information is inaccurate. The larger a business becomes, the more challenging it is to pull in the right information. With multiple departments spending money in various ways, you may find that the numbers in your budget don’t reflect how money will actually be spent.
2. You don’t have the right tools. There are plenty of software platforms that can help you create and analyze your budget, but finding the right one in a sea of choices can be tough.
3. Budgeting takes time, and time is money. Adding to any other budget difficulty you could possibly have is the fact that you simply must take time out of your busy schedule to put the budget together. Even if you have a staff member who takes care of it, that’s time that could be allocated to other duties.
4. A budget is only as useful as you make it. If you create a budget every year and set it aside, it won’t help your business at all. It’s important that you not only follow that budget closely throughout the year but pay close attention to how accurate your forecasting was. Otherwise, you’re simply wasting valuable time.