FIN 370 Week 2 - DQ 3 - 7623

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Time value of money is an important element in managerial finance, especially in financial management. The concept behind the idea states that as time passes by, money tends to loose value or purchasing power. Put simply, it means that a dollar today will be worth, say $.90 a year later, $.85 two years later and so on. So if you want to have the same purchasing power of $1 in current terms one year later, how much dollars should you earn? This is where the time value of money comes in handy.

 

The importance of time value of money is that it helps in calculating the present value and future value of money. We shall now explain both of these concepts in detail.

 

The future value of money is the value of an asset or cash that would be receivable or payable at a specified date in the future, compounded at the company's interest rate, or its cost of capital, that is equivalent to a sum specified today. As an example, let us suppose that we have spare $10,000 and want to invest it in a venture with a bank that would pay us 11% per annum on the amount invested. The venture would last for 5 years. How much would we have at the end of the venture?

 

This question involves calculating the future value of the money. It would be:

 

Future value= Present value*(1+r)n

 

Where,

 

R=rate of return, or cost of capital

 

N= number of years

 

So

 

FV=10000*(1+0.11)5

 

FV=10000*1.69

 

FV=$16850

 

It means that the $10000 we have today are equal to $16850 five years later, if we want to keep the same purchasing power at 11%.

 

The present value of money is the future value of a sum receivable or payable, discounted at the cost of capital. Put simply, it is the current value of sum of money, and is the opposite of compounding. As an example, let's say that we need to have $20,000 5 years later in order to finance an expansion. How much do we need to put in the bank now if the bank offers an interest rate of 10% per annum?

 

This question involves calculating the present value of the money. It would be:

 

Future value= Present value*(1+r)n

 

Where,

 

R=rate of return, or cost of capital

 

N= number of years

 

So

 

20000=PV*(1+0.10)5

 

20000=PV*1.61

 

PV=20000/1.61

 

PV=$12418

 

This means that we need to put $12418 into the bank now in order to have $20000 after five years.

Solution Description

 

 

 

Time value of money is an important element in managerial finance, especially in financial management. The concept behind the idea states that as time passes