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Time Value of Money - An Overview of Discounted Cash Flow Analysis

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What is Time Value of Money?:

Time value of money is the basis of discounted cash flow analysis in finance. It is one of the core principles of small business financing operations. It has to do with interest rates, compound interest, and the concepts of time and risk with regard to money and cash flows. The underlying principle of time value of money is that the value of $1 that you have in your hand today is greater than a dollar you will receive in the future. Time value of money includes the concepts of future value (compounding) and present value (discounting). For example, if you have money in your hand today, you can save it and earn interest on it or you can spend it now. If you don't get it until some point in the future, you lose the interest you could earn and you can't spend it now.

How is Time Value of Money Used in Small Business Finance?:

Time value of money calculations are the backbone of financial calculations. Time value of money is used to calculate the future value of a sum of money, such as money in a savings account, money market fund, or certificate of deposit. It is used to calculate the present value of both a sum of money or a stream of cash flows. If cash flows are scheduled to be received in the future from a company's investment, such as an investment in a building or piece of equipment, time value of money is used to calculate the present value (the value now) of those cash flows.

What are the Major Types of Time Value of Money Calculations:

There are four major types of time value of money calculations:

Future Value of a Lump Sum:

The calculation for future value of a lump sum is used when a business wants to calculate how much money it will have at some point in the future if it makes one deposit with no future deposits or withdrawals, given an interest rate and a certain period of time. Calculating future value is also called compounding.

Future Value of an Annuity:

The calculation for future value of an annuity is used when a business wants to calculate how much money it will have at some point in the future if it makes equal, consecutive deposits over a period of time, given an interest rate and a certain period of time. Annuities can be in the form of ordinary annuity or an annuity due. This is true when calculating present value of an annuity as well.

Present Value of a Lump Sum:

The calculation for present value of a lump sum is used when a business wants to calculate how much money it should pay for an investment today if it will generate a certain lump sum cash flow in the future, given an interest rate and a certain period of time. Calculating present value is also called discounting.

Present Value of an Annuity:

The calculation for present value of an annuity is used when a business wants to calculate how much money it should pay for an investment today if it will generate a stream of equal, consecutive payments for a certain time period in the future, given an interest rate and a certain period of time.

Calculating Time Value of Money:

There are four ways of making time value of money calculations:

  1. Use the Appropriate Time Value of Money Formula
  2. Each time value of money calculation has a formula that you can use to make the calculation. The more complicated the calculation gets, the more unwieldy the formula gets. Using one of the other methods of calculation is usually best.

  3. Use the Time Value of Money Interest Factor Tables
  4. Using time value of money tables have basically given way to using financial calculators and spreadsheet programs. However, certain professional exams and some college professors still rely on time value of money tables. The tables are a series of multipliers that are derived from the appropriate time value of money formula to make time value of money calculations easier.

  5. Use a Financial Calculator
  6. Financial calculators were designed specifically for time value of money calculations. There are five keys that you will need for these calculations.

    As an example, the N key is used for number of time periods; I/YR key is used for interest rate per period; PV key is used to enter present value which must be entered as a negative number only by using the +/- key; PMT key is used in an annuity problem if you have a series of equal, consecutive payments. Otherwise, it is 0; FV key or the 5th key is the variable you are solving for which will, of course, change.

  7. Use a Spreadsheet Program

Spreadsheet programs, like Microsoft Excel, are ideal for time value of money calculations as well as most other financial calculations. The beauty of the spreadsheet program is that it can also be used to illustrate the concepts of time value of money like a word processing program with things like time lines.

There are many types of time value of money calculations that small businesses have to use in their financing operations. Some of them include solving for the interest rate, solving for the number of years, solving for the present value of ordinary annuities and annuities due, solving for the future value of ordinary annuities and annuities due, solving for annuity payments, and solving for the present value of irregular cash flow streams.

In addition, we apply these concepts to financial procedures like calculating net present value, profitability index, internal rate of return, and other capital budgeting procedures that make a small business successful.

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