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Time value of money is a very practical concept which can be applied to any financial feasibility done over time. Since the value of money keeps changing due to inflation of currency, $1 today is usually equivalent to lesser that $1 after a year. This paper discusses the various applications of time value of money. (Cedar Spring, 2002)

Applications

The best and most commonly cited example of application of time value of money is in investment. Take an example of a person wants to invest in a project that would get him 10% increase of value if the project goes well and 7% if the project doesn’t go well in the next five years. The project does not go well and the rate the investor got at the end of five years is only 7%. Since there was risk attached to he investment and the investor doesn’t get the maximum rate of return, the investor loses his/her money in comparison if he/she had invested somewhere else where there was a guarantee of an eight 8% return. (Kieso & Weygandt, 1993)

Time value of money can also be used to see the inflation and interest rate correlation. If a person decides to put $1000 in the bank today, that person would expect that $1000 to gain value in that one year to become $1100. However due to inflation, the purchasing power of that $1100 decreases and now that person can buy from $1100 what he could buy from $1000 a year ago. Thus in reality the amount invested in the bank hasn’t gained any real value. The bank’s interest rate only covers the inflation impact. (Kieso & Weygandt, 1993)

Another application of time value of money lies in the calculation of annuities. Annuities are a stream of fixed periodic payments over a specified time frame. Here a person who wants to invest for his child’s education of a total of $25,000 in 5 years, needs to invest more than $5000 each year to make the real value of the ending money bank to $25,000 due to inflation. (Kieso & Weygandt, 1993)

Another application of time value of money is the capital recovery problem or loan amortization payment problem. A person who needs to pay off the loan needs to pay off money each year including the interest charged per period. (Sherrick, Ellinger & Lins, 2000)

References

Cedar Spring (2002). Time Value of Money. Get Objects. Retrieved March 24, 2009 from http://www.getobjects.com/Components/Finance/TVM/concepts.html

Kieso, D. and Weygandt, J. (1993). Intermediate Accounting, 9th Ed., New York: John Wiley & Sons, Inc.

Sherrick, B. J., Ellinger, P. N. and Lins, D.A. (2000). Time Value of Money and Investment Analysis. Retrieved March 24, 2009 from http://agmarketing.extension.psu.edu/Business/FinancialTools/TimeValueMoneyP1.PDF