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Time Value of Money
MEMORANDUM
To: Mr. Hill Brandt, Chief Executive Officer, ABC Golf Equipment Limited
From:
Date: 18th January 18, 2017
Re: Time Value of Money
Introduction
            The concept of time value of money is essential in making decisions on capital projects and deciding amongst competing projects. The value of cash and financial assets is determined by inflation rates, government policies, international market changes, and various changes in global trade patterns. Due to the unstable nature of the aforementioned factors, the future real value of cash is bound to change. Therefore, it has some element of uncertainty. In addition, inflation causes the value of currencies to decrease and there is always the tendency of people preferring current consumption to future consumption (Miller-Nobles, Mattison, & Matsumura, 2015). Factors such as inflation and desire for present consumption make the determination of the value of money essential since a dollar today is more valuable than when earned in future.
Calculation of Time Value of Money
At the most basic level, the time value of money aims at comparing the future value of cash with its present value. Due to the risk component in future cash flows and also factors such as inflation and foregone opportunities, a discount rate is used to cater for these factors. Therefore, the future value of cash is equal to the present value of cash multiplied by the discount rate and then adjusted to cater for the time required to earn this cash (Carther, 2015). The time value of money can be represented using the following equation.
Future Value (FV) = Present Value (PV)* (1+r)n
r = discount rate
n = time required to earn future cash
Importance of Time Value of Money
Generally, companies use the concept of time value for money to make decisions on capital projects and when deciding between competing projects. In capital projects, the time value for money enables the business to determine if a particular project is profitable or not. If the projected rate of returns from the project is lower that the discount rate used in the determination of the future value of cash flows, then the project is not profitable. If the returns are higher than the discount rates, it is profitable. Therefore, time value of money enables a business to decide on the project that it should start and those that should not be done (Warren, Reeve, & Duchac, 2015). When deciding between two competing projects, the concept of time value of money establishing the project with the highest and positive rate of return on investment.
Interpretations of the Results
            In the attached example I have given you calculations on how to determine present value given future value, determining the future value from a lump sum deposit, the present value of ordinary annuities, the future value of ordinary annuities, and finally the value of the present value of annuities to perpetuity.
In the calculation of present value give future value $100,000 received at the end of each year in a market that has a discount rate of 5% is equal to a present amount of $78,352.62. Similarly, $200,000 received at the end of each year for 10 years in a market that has a discount rate of 10% per annum is equal to a present amount of $77,108.66.
In the determination of future value in lump sum deposits, the present value of $100,000 in an economy that has a discount rate of 5% is equivalent to $127,628.16 in 5 years’ time. Similarly, $200,000 is equivalent to $518,748.49 in 10 years if the discount rate is 10%.
In the calculation of ordinary annuities, $100,000 received at the end of each year for five years and in a market that has a discount rate of 5% is equivalent to $432,947.67 at present. $200,000 received at the end of each year for 10 years in a market that has a discount rate of 10% is equivalent to $1,228,913.42 at present (Financial calculators, 2015).
In the calculation of the future value of ordinary annuities, $100,000 received at the end of each year for five years in a market that has a discount rate of 5% is equivalent to $552,563.13 at the end of the 5 years. $200,000 received at the end of each year for 10 years in a market that has a discount rate of 10% is equivalent to $3,187,484.92 at the end of the 10 years.
In the calculation of present value of annuities to perpetuity, $100,000 received at the end of each year forever in a market that has a discount rate of 5% is equivalent to $2,000,000 at present. $200,000 received forever at the end of each year in a market that has a discount rate of 10% is equivalent to $2,000,000 at present.
Conclusion
To sum up, there are two critical factors that affect the value of money; the discount rate and time. Generally, a discount rate represents the cost of foregone opportunities. Therefore, if the rate is high, the expected future returns will be high to compensate for this loss. Accordingly, a small discount rate will be associated with low expected future returns. Time determines the period within which the future cash flows will be earned. If repayment time intervals are short, a low discount rate may still earn high future values. In line with this, long repayment time intervals may result in low future values. Therefore, the knowledge of how to determine the future value of money is essential in enabling a financial analyst to make prudent and informed financial decisions.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
References
Financial calculators. (2015). Calculator Soup. Retrieved from http://www.calculatorsoup.com/calculators/financial/
Carther, S. (2015). Calculating the present and future value of annuities. Investopedia. Retrieved from http://www.investopedia.com/articles/03/101503.asp
Miller-Nobles, T., Mattison, B., and Matsumura, E. (2015) Horngren’s financial & managerial accounting (5th Ed), New York, NY: Pearson.
Warren, C., Reeve, J., and Duchac, J. (2015) Accounting (26th Ed.), New York, NY: Cengage Learning.