Question

Explain the concept of time value of money, including compounding and discounting. Consider how time value of money applies to your personal life by addressing the following:

• Describe at least one specific personal situation in the past where the use of time value of money concepts would have helped you make a better decision. Explain how time value of money applies to this situation.
• Describe at least one specific personal situation that you expect to encounter in the future where you will use time value of money concepts to help you make a better decision. Explain how time value of money applies specifically to this situation.
• 250 words

Answer 1

ANSWER:

Time Value of Money is the effect of application of interest. An amount received today is worth more than the same amount received on a future date. Because the money received or paid today will earn interest for the interim period and will grow in volume during that period. Inversely, the amount received or paid on a future date is equivalent to a lesser amount today, the difference being interest during this period.

Compounding is the process of charging interest on the amount of interest applied for the previous period. For example, for a loan or deposit for one year, if interest is to be compounded and at monthly rests, interest is calculated at the end of every month and added to the principal so that interest for next month is calculated on the combined sum (principal and interest for the earlier month) and so on.

Discounting is the process by which Present Value (PV) of a sum is ascertained. PV is today’s equivalent of a sum received or paid on a future date. It is the future sum, net of interest during the interim period. Since interest fetches interest applicable for earlier period (compound interest), interest reduced from the future sum, for arriving at the present value, is the interest compounded at specified intervals.

Illustration of Time Value of Money- Personal finance

1. A friend owed a sum of $ 1,000 to me one year ago. I agreed that he need pay it only now, that is, after one year. My Savings account was getting interest at 6% per year, compounded quarterly. Had I insisted on getting the amount one year ago and deposited in the Savings account, it could have grown to $ 1,061.36 as follows:

$1,000 * (1+6%/4)^4 = $1,061.3636

2. I am offered a gift of $1,200 by a relative. He promised to either pay it in lump sum after one year or in monthly installments of $100 each from current month on wards. The monthly payments, from now, if opted, will fetch interest if deposited on receipt, in interest bearing deposit accounts. Hence I shall prefer the monthly payments option.