Question

What are three different financial applications of the time value of money

Answer 1

Time value of money applied to calculate either present value of future cash flows or future value of investment.

Note: PV = Present value; FV = Future value; R = Rate of Interest; N = Time in years

The following are three major financial application of time value of money:

1. Future value of investment: The investments are evaluated based on the worth they carry in future time. Worth of such investments is computed based on time value of money i.e. by equation: FV = PV x (1+R)^N

While making any investment decision the time value of money is important factor to compute the value of money that will worth in future time period. The higher future value is accepted.

2. Determining value of instruments: The value financial instruments like CD, CP and Bonds are calculated based on time value of money. For and example: The bond has streams of cash flows falling at regular time intervals and such future cash flow are discounted based on present interest rates to derive the present value of bond.

Equation:

Bond value = Cash flow’1 / (1+R)^1 + Cash flow’2 / (1+R)^2 + ……. + Cash flow’N / (1+R)^N

3. Evaluating the projects: The projects are evaluated based comparing different projects based on different cash flows the best project is to be accepted. If projects carry similar risk profiles then best projects is found out based on merit of cash flows it holds. Assuming same rate of discount is used for each project. Higher the Net Present Value or NPV better the project.

Time value of money concept is applied.

NPV = PV of cash flows – Initial Cash flows

or

NPV = [Cash flow’1 / (1+R)^1 + Cash flow’2 / (1+R)^2 + ……. + Cash flow’N / (1+R)^N] – Initial cash flow

Note: Time value of money concept remains same in all above case. The formula or equation used in each same but there is some algebraic manipulation like PV = FV / (1+R) ; rearranging > FV = PV x (1+R). Cash flows presented in point 2 and 3 are nothing but FV or say cash flow in future time period.