Question

Consider a scenario in which you could personally use present or future value calculations to come to a conclusion. Explain the scenario, and provide calculations that show how you applied the time value of money concepts.

Answer 1

Time value of money

Time value of money measures the present value of future cash inflows by applying the opportunity cost of funds. Getting one dollar today is better than getting a dollar tomorrow, because money loses its value over time. The present value of future cash flows are calculated discount rate or cost of capital. The discount rate is determined by considering inflation as one of the factor that determines the value of money.

For example.

Your father has decided to appreciate you for the service you rendered to your family. So your father has given you two options.

Option 1: He decided to give 10,000 dollars

Option 2 He decided to give 10800 dollars one year from now.

Obviously, the option 2 gives more money which is higher than now. But the bank offers you

10% rate of interest and the inflation is 6%. If you buy 10,000 today and invest in a bank, the money will become 11000 one year from now. So, It is always better to get dollar today than tomorrow.

1. Future values

Option 2 10800

Option 1 10000

Invest in bank 10000 *10% = 1000 + 10000 = 11000

Option 1 is better than Option 2.

Formula to calculate Future value = Principal + Interest amount

Interest amount = Principal * Rate of interest/ 100

The Present value of 10,000 is equal to the future value of 11000.

2. Present Values

Sometimes, if you want to know what is present value of 10800 that your dad decided to give you as the option 2. Using the bank interest rate as the discount rate, we can find out the present value of 10800 by applying the formula.

Future cash flows/(1+i)^1 = I denotes interest rate

10800/(1+.10)^1 = 9818.18

The present value of future cash flow that your father agreed to give you as the option 2 is 9818.18

Based on the present values and future values option 1 is preferable than Option 2. Both conveys similar decision that option 1 better than option 2. This time value of money is applied for evaluating any investment proposals such as purchase of machinery, modernizing a plan, stock market investment.