Future Value the Time Value of Money Essay

Future Value

The time value of money is a financial concept that relates to the earning power of money. When money is held over a period of time, it can be invested so that the value of that money grows. This can be interest earned in a bank account, or earnings from investments. Similarly, the value of money that is not earning will erode over time, because of inflation that weakens the purchasing power of money. Thus, financial managers will take these factors into account when calculating cash flows -- money in the future is not worth as much as money today (Investopedia, 2013).

The time value of money therefore reflects two key variables -- time and interest. The interest or discount rate is the prevailing rate of interest in the economy, or for the company. This combines with time to increase or decrease the value of money. For financial managers and for those who are studying finance, it is essential to understand how these two variables affect the value of money.

It is critical for financial managers to understand the time value of money for a few reasons. The central concept is purchasing power, and the idea that a dollar in the future will buy less than a dollar today -- or a pound, or a euro, wherever the manager works. When working with clients, the manager operates based on the idea that their money will be used to purchase goods and services, and therefore the manager's job is to preserve or improve the purchasing power of the money, rather than its nominal value.Financial managers must therefore take into account that they must convert all cash flows into today's dollars. This is done with things like retirement planning, where future cash flows need to be understood in terms of their purchasing power. This is also done at the corporate level, where a company makes an investment today and wants to know the value in today's dollars of the expected cash flows that they will receive in the future.

If the financial manager does not take into account the time value of money, it will be much more difficult for anybody to understand the figures that are presented. Consider for example in retirement planning. The customer will receive figures from the financial manager about how many dollars that person will be able to spend annually in retirement. What will not be easy to understand is what one might be able to purchase in the future for those amounts. The financial manager needs to use a discount rate -- probably in this case based on inflation -- in order to fully illustrate what the client's expected lifestyle in retirement will be. Incorporating the time value of money into the analysis will allow both the manager and the client to have the necessary context to make better decisions. Time value is therefore a critical component of the financial analysis.

Merritt (2013) notes that businesses also use the concept of time value of money to make investment decisions. Where businesses want to maximize their return on investment, they need to have a….....