Value of Money Is Perhaps the Most

¶ … value of money is perhaps the most critical concept in modern financial theory. According to Bianco & Poole (2010), "While executives and academics often disagree, they all agree that the time value of money (TVM) is the most important finance concept that should be taught in introductory finance classes" (Gup, 1994) Undergraduate business students are typically exposed to time value of money concepts in more than one course. Introductory accounting and financial management courses always cover TVM. Students are often taught this subject in mathematics and other general business courses. Many techniques are utilized for teaching and solving TVM problems including formulas, tables, financial calculators and spreadsheets." (Bianco, Poole, 2010)

In my opinion, the idea for TVM is important due to the notion that a dollar invested today increase the value of dollars earned today due to the value of receiving P + i, which is principal plus interest. According to Schwartz (1991) "The basic concept of the time value of money is that cash received at a later date is not equal to the same amount of cash which is presently on hand. The cash on hand has earning power and can be invested for growth." (Schwartz, 1991)

Schwartz is referring to the power of simple and compound interest (Croft, 2010). The TVM calculation is a function of receiving simple or compound interest payments, or a payment of (x) at a (y) future time. The payment (x) received at time (y) will be the initial principle invested added to the return on principle produced from the interest earned over the time period y-1.

Calculations

$600 USD invested over time period of five years to receive a rate of interest of 9% per annum is to say that an investor is willing to give up $600 (principle) today to receive the principle amount in 5 years in addition to the accrued simple or compound interest. The calculations will include the answer for simple and compound interest rates.

$600 USD invested over 5 years at 9% will generate $54 USD of simple interest over 1 year. The total received therefore, after one year of investment is $654 USD. However, we are looking for the return after five years. The formula to determine the amount after five years simple interest is to add the stream of one-year payments produced over a period of five years. ($600*.09) + ($600*.09) + ($600*.09) + ($600*.09) + ($600*.09)

The amount received after five years using the simple interest method is $870 USD

However, for compound interest, the amount accrued is very different. The $654 earned after year one is invested for year two. Under the simple interest method, only the initial $600 is invested at year two, year three and so on.

Therefore, the compound interest model will look like this ($600*.09) + ($654*.09) + ($712.86) + ($777.01) + ($846.95).

The final amount received after five years is $846.95

$1,750 USD invested for three years at 2% will generate: