Complete Guide To Corporate Finance


Time Value Of Money - Introduction To The Time Value Of Money

In addition to being able to understand financial statements, it's important to be able to estimate the value of an investment in the present and in the future.

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity is called the time value of money. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Thus, at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.

But why is this? A $100 bill now has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can earn more interest on your money.

By receiving $10,000 today (Option A), you are poised to increase the future value of your money by investing and gaining interest over a period of time. If you receive the money three years down the line (Option B), you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you choose Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth compared to Option B? Let's take a look.

Future Value Basics
If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:

Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450

You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation:

  • Original equation: ($10,000 x 0.045) + $10,000 = $10,450
  • Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
  • Final equation: $10,000 x (0.045 + 1) = $10,450

The manipulated equation above is simply a removal of the like-variable of $10,000 (the principal amount) by dividing the entire original equation by $10,000.

If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920:

Future value of investment at end of second year:
= $10,450 x (1+0.045)
= $10,920.25

The above calculation is then equivalent to the following equation:

Future Value = $10,000 x (1+0.045) x (1+0.045)

Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:

We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:

This calculation means that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

For related reading, see Time Value Of Money: Determining Your Future Worth.

Future Value And Compounding
Related Articles
  1. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  2. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  3. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  4. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  5. Forex Education

    Explaining Uncovered Interest Rate Parity

    Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
  6. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  7. Economics

    Understanding Tragedy of the Commons

    The tragedy of the commons describes an economic problem in which individuals try to reap the greatest benefits from a given resource.
  8. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  9. Forex Education

    Time Value Of Money: Determining Your Future Worth

    Determining monthly contributions to college funds, retirement plans or savings is easy with this calculation.
  10. Markets

    Operating Cash Flow: Better Than Net Income?

    Differences between accrual accounting and cash flows show why net income is easier to manipulate.
  1. Accountant

    A professional who performs accounting functions such as audits ...
  2. Rule Of 72

    A shortcut to estimate the number of years required to double ...
  3. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  4. Personal Finance

    All financial decisions and activities of an individual or household, ...
  5. Audit

    An unbiased examination and evaluation of the financial statements ...
  6. Put-Call Parity

    A principle that defines the relationship between the price of ...
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. What’s the difference between the two federal student loan programs (FFEL and Direct)?

    The short answer is that one loan program still exists (Federal Direct Loans) and one was ended by the Health Care and Education ... Read Full Answer >>
  6. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center