The Time Value of Money

blakfyahking

Do you know what it is?

Do you know why it's important if you want to become a successful investor/business owner?


Understanding this concept is the basis of figuring out the value of anything related to investing..............

valdez21

nope, please fill us in..

blakfyahking

Time value of money (TVM) is the basis of all financial concepts

TVM is the idea that a dollar today is worth more than a dollar in the future................or what most people know as "a bird in the hand is worth two in the bush"


what that means is that a person should prefer to have their money now vs. waiting til later to receive it

a dollar in the future is worth less because a dollar in hand right now could be currently used to invest

if you lend someone money, you miss out on any opportunities to use that lent money to invest it in something possibly more profitable



so whenever a person borrows money from a lender, the borrower will have to pay back the money he/she borrowed (the principal), plus a charge for the lender being without their money until they finally get it back (this charge is the interest rate)

TVM explains why lenders charge interest to lend money, and why lenders expect a higher payback from someone who is more riskier to lend to

blakfyahking

TVM explains the purpose behind compounding interest (otherwise known as Future Value)

and discounting (otherwise known as Present Value)


everyone understands the idea of leaving your money in the bank for a long time, and the amount put in the bank grows because of compounding interest.................the bank pays you an interest rate for being allowed to hold on to money



Future Value (FV) is mathematically expressed as a principal multiplied by an interest factor:

the principal - is the initial amount loaned or invested

the interest factor - in the interest rate plus one exponentially grown by the number of compounding periods

ex: $100 invested at an interest rate of 5% for 3 years = $115.76

$100 (the principal) x [1 + .05]^3 (the interest factor) = $115.76



Present Value (PV) is the same as FV except the principal is divided by the interest factor to discount:

ex: to find out how much money should put in a bank account today so that $100 will be there after 3 years of earning 5% interest = $86.38

$100 (the principal) / [1 + .05]^3 (the interest factor) = $86.38


you would need to put $86 dollars in an account paying 5% interest in order to have $100 after 3 years

blakfyahking

FV and PV is used for all financial valuations..............and there are several applications of FV and PV ie. annuities, perpertuities, amortization, mixed funds, etc


mainly try to understand the interest rate you expect to receive as payment for giving a person your money is known as the "return" on your investment


TVM implies that a rational person would demand a higher return for lending their money to someone with more risk (risk = the threat that you may not receive all of your money back)


for investors, any potential investment should be analyzed by valuing the investment using TVM techniques: this helps you decide which investments to make over others based on which investment gives you higher returns


for business owners, the cash flows from profits your business creates are evaluated using TVM techniques by potential investors, and internal/external advisors and analysts..............you can't properly identify how well your business is actually doing if you can't show specifically how much return your business gives investors in comparison to other competitors

rational investors are always looking for the least risky/highest return investment............your job as a manager of your business is to minimize risk and at the same time amplify your returns: this is the key to running a successful business

High Revolutionary

Nice drop.

MzKB

good read!