Question

How does TVM affect management decisions regarding special terms, such as “no payment due for 6 months, interest free,” or “buy a gift card for $50 and get $5 off your next purchase?” What TVM calculations would have to be considered in offers like these? What other business applications of TVM can you think of that were not directly discussed in class?

Answer 1

The money is having a time value. That is why money in hand today is worth more than that money in the future. If you keep hold on to that money without using it properly you will lose the opportunity to make more money. If we invest it properly in any kind of investments we will make money due to the time value.

Different companies provide promotions like “no payment due for first 6 months” to make you buy the item. That is we only need to pay the money after 6 months without any interest. But the actual thing is no one will give anything to us for free in this world. These companies should include the time value of that money in these pricing.

The other scenario is buy a gift card of 50$ so that we will get 5$ off on next purchase. This promotion also make you to buy from that shop for the second time to avail that offer.

So here we can check how the management is deciding on these offers regarding time value of money. The most important thing is that we have to consider the average interest rate. ie If you invest the same you will get the interest for the same. So company will consider how much interest they are losing for these 6 months due.

Let us consider interest rate is 10%, amount is 10000 and payable after 1 year.

We have to first find out the present value

Present value index = 1/(1+interest rate) = 1/(1.1)= .91

Present value of money = .91 * 10000 = 9100.

So 9100 should be the value of the item if we purchase now.

So that management will set the amount payable by considering interest rate and present value.

In the case of gift card also, the present value of amount of 5$ off will be included in the first purchase. For ex, if the second purchase are generally made after one year then 5* .91 = 4.55 will be included in the first purchase. Simply speaking 50$ - 4.55$ = 45.45$ should be the actual purchase value of that product.

Practical Applications

Time value of money concepts can be applied in many different areas of business. Let’s say you run a TV shop and are running into cash flow problems. Your customers take six months to pay for their purchases, meaning you have to go into your overdraft to cover your costs while you’re waiting.

A quick time value of money calculation can show you a potential solution. If the bank charges you 15% interest on your overdraft, then checking the numbers into the calculator reveals that the present value of a $100 payment received six months from now is $92.82.

In other words, better to give off to your customers a 5% discount if they pay upfront. That way, you’d only get $95 on every $100 sale, but having that $95 immediately is worth more than getting $100 six months from now.

You could also use the time value of money to decide whether it’s worth paying for equipment upfront or via a payment plan, to evaluate the merits of different products you’re developing, or in more or less any situation that involves comparing amounts of money paid and received at different times.