The time value of money concept is the basis of discounted cash flow analysis in finance. The discounted cash flow allows for the accumulation of expected interest earned on a sum.
Discounting cash flow 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.
Underlying Principle of Time Value of Money
The underlying principle is that the value of $1 that you have in your hand today is greater than a dollar you will receive in the future. Conversely, the time value of money (TVM) also 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.
When calculating the future value of money locked up in an investment, you must have a way to consider both the potential compound interest you could get by holding the investment and the risk of losing value over time to inflation or to a failed investment due to market conditions.
Using Time Value of Money in Small Business Finance
Time value of money formulas 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 lump-sum of money or a stream of cash flows that you'll receive overtime.
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.
Types of Cash Flows for TVM Calculations
There are four major types of time value of money calculations. These calculations include the future value of a lump sum, the future value of an annuity, the present value of a lump sum, and the present value of an annuity. Calculating the time value of money will include the used of discounted cash flows.
Future Value of a Lump Sum
The calculation for the 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 the 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 an ordinary annuity or an annuity due. This is true when calculating the present value of an annuity as well.
Present Value of a Lump Sum
The calculation for the 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 the present value is also called discounting.
Present Value of an Annuity
The calculation for the 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.
Formulas for Calculating TVM
Each TVM 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.
Using the TVM tables will basically give a method for using financial calculators and spreadsheet programs. However, certain professional exams and some college professors still rely on the 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.
Financial calculators were designed specifically for TVM calculations. There are five keys that you will need for these calculations.
As an example, the N key is used for the 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 based on your inputs for the other variables.
- Use the Appropriate Time Value of Money Formula
- Use the Time Value of Money Interest Factor Tables
- Use a Financial Calculator
- Use a Spreadsheet Program
Spreadsheet programs, like Microsoft Excel, are ideal for the time value of money calculations as well as most other financial calculations.
There are many types of the time value of money calculations that small businesses 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.
Also, companies apply these concepts as a component of other financial procedures like calculating net present value, profitability index, internal rate of return, and other capital budgeting procedures that make a small business successful.