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I have been under a situation when I have used time value of analysis when deciding
to buy a car or continue transportation through the public transportation .I compared the
overall net present value associated with buying out with the car and the net present
value of going through the public transportation and then I decided not to buy the car
because it will have the Limited life and limited benefits and the net present value was
also not favourable as against the public transportation net present value. I have used
the net present value by discounting all the future benefits associated with buying out
of the car and compare it against, continue using the public transportation. Cash flow
was impacted due to change in the inflation and it also was impacted due to change in
the benefits which were associated in relation to depreciation and growth and savings
as well. For example, I mostly focused upon the savings due to going through public
transportation instead of car and then discounting those savings at the current value to
arrive at decision. TVM stands for Time Value of Money and it is the concept that a
sum of money is worth more now than the same sum will be at a future date due to
its earning potential in the interim. It is the core principal of finance. TVM is a very
useful tool in helping understand the worth of money in relation to time. A
hypothetical example of when someone might use TVM is if someone would like to
buy your tv and they can offer you $800 for it today or $900 if they can pay you six
months from now. TMV basically teaches us that $800 today is is worth more than
$900 in six months. The TVM calculation that can be used to support that financial
decision would be PV=FV/(1=r). Cashflow has a positive impact by my decision to
take the money for the TV up front verses waiting 6 months to take the money
although in six months it would've been more money for me. I don't know what could
occur within those six months where the $900 for the TV would have not benefited me
like the $800 for the TV would benefit me up front. Time Value of Money (TVM)
indicates that a dollar in hand today is worth more than a dollar promised in the future.
Hypothetically, if I inherit $75,000 from my grandmother and I decide that I will not
spend it until after I graduate with a Master’s degree in 3 years, I will need to invest
or deposit the money for this three-year horizon. I have decided that once I deposit the
money I will not touch it again until the three years have passed. After investigating 5
different banks, I have 5 different interest rates with 5 varying compounding patterns.
I can use the Future Value Formula, FV = PV(1+i)n , to help me to analyze the
investment options. Each time the present value will be $75,000. However, the variable
I will be adjusted by dividing it by the number of compounding periods in each year.
The variable n would have to be adjusted each time by multiplying it by the number of
compounding periods per year.
The cash outflow of $75,000 would occur once the computations indicate which
investment or deposit would give the highest future value.
I first had to understand what is meant by TVM, which stands for Time value of
money (TVM) and is the idea that money you have now is worth more than money
you will have in the future because of its earning potential. This basic financial
principle states that, if money can collect interest, any quantity of money received
sooner is worth more.
Personally, I used time value of money calculations to make more informed decisions
about what to do with my money; it helped me knowing what the best option to
undertake based on interest, risk, and rate of return. I invested $1,000 and it earns 10%
compounding interest every year for five years, the compounding period would be one
year. That means in the first year I have earned $100 in interest (10% of $1,000), in
that second year I'm earning interest on the total amount from the previous
compounding period, which would be $1,100 (the original $1,000 plus the $110 in
interest earned in year one). By the end of year two, I'd have earned $1,210 ($1,100
plus $110 in interest). By the end of year five, I would have turned that $1,000 into
approximately $1,610. An important part of finance is understanding for what types of
factors investors require compensation. A common list includes: time, inflation, re-
payment risk, pre-payment risk, and uncertainty risk. As each of these rise they will
contribute to an increase in the discount (interest) rate used in our TVM analysis. If
you look at the "yield curve" for US treasury bonds you will see the interest rate the
market requires steadily rise from less than 1% for 1 and 3 month bonds to 4% for 20
and 30 year bonds. If we assume the market believes the US government will always
pay these monies back (which they will, since the goverment could simply print money
if it really got into a bind) then this difference in interest rates on government bonds
reflects inflation risks only. That is, these long-term investors simply don't want to lose
their purchasing power over time. Each of the risk parameters I've just mentioned has
its own logic to help "unpack" how to think and estimate its contribution to the
denominator of the TVM.
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