Before making anyfinancial decision, it is very important to calculate the cash flowsyielding from that decision. However, the figures themselves are notenough to help make proper and efficient decisions. According to theprinciples of ‘Time Value of Money’ $1 today is worth more than$1 tomorrow because of its future earning potentials (Biswas andPramanik, 2011). Both time and the prevailing interest rate playgreat roles in the time value of money. The basic principle here isthat money earns interest or a certain rate of return. As a result,the present value (what money is worth today) and future value (whatmoney will be worth at any time in the future) play very significantroles in finance and in making financial decisions as well.Therefore, the main purpose of this report is to demonstrate howinterest rates, as well as time, impact the value of money by usingexamples.

In this report,Present Value (PV) and Future Value (FV) analysis were done by takingdifferent interest rates and time periods into consideration. Threeexamples were used to illustrate these facts. The calculations areshown below-

Future Value(FV) Calculations

Number of Years

PV

Interest Rate

FV

10

100,000

0.02

$121,899.44

10

100,000

0.05

$162,889.46

10

100,000

0.08

$215,892.50

10

100,000

0.10

$259,374.25

In thecalculations above, the amount invested today (PV) and the durationof the investment (number of years) are the same in all instances.But the interest rates are different. As a result, it can be seenthat $100,000 invested today will be worth more in the future if theunderlying interest rate is higher. For example, when the interestrate is 2%, then $100,000 invested today will be worth $121,899.44in 10 years from now. But the same amount will be worth $259,374.25if the interest rate is 10%.

Present Value(PV) Calculations

Number of Years

FV

Interest Rate

PV

1

100,000

0.08

$92,592.59

2

150,000

0.08

$128,600.82

3

200,000

0.08

$158,766.45

4

200,000

0.08

$147,005.97

5

150,000

0.08

$102,087.48

6

100,000

0.08

$63,016.96

7

100,000

0.08

$58,349.04

8

100,000

0.08

$54,026.89

9

100,000

0.08

$50,024.90

10

100,000

0.08

$46,319.35

On the otherhand, the present value calculations done in the table above shows adifferent scenario. Here, we see that the same amount of money($100,000) will have decreased value with the passage of time, evenif the interest rate remains the same. For example, $100,000 (FV)will be worth $92,592.59 if it is discounted by8% interest rate after 1 year. But the same amount will be worth wayless ($46,319.35) if it is discounted by the same interest rate after10 years.

Present Value(PV) with different Interest Rates

Number of Years

FV

Interest Rate

PV

1

100,000

0.08

$92,592.59

2

150,000

0.06

$133,499.47

3

200,000

0.10

$150,262.96

4

200,000

0.04

$170,960.84

5

150,000

0.06

$112,088.73

6

100,000

0.04

$79,031.45

7

100,000

0.04

$75,991.78

8

100,000

0.04

$73,069.02

9

100,000

0.04

$70,258.67

10

100,000

0.04

$67,556.42

From the tableabove it can be clearly seen how different interest rates, as well asdifferent time periods, impact the value of money. For instance, fromyear 6 to 10, the future value of money ($100,000) and the interestrate (4%) are the same. However, this $100,000 is worth less and lesstoday as time goes by (the number of year increases). Anotherinteresting fact that can be noticed from the calculations above isthat, when the amount remains the same in two different time periods(given that there is no significant change in the time periods), butthere is a noticeable change in the interest rate, then both presentvalue and future value changes. The same thing can be said aboutsignificant changes in time periods and holding the other things (theamount and the interest rate) unchanged or slightly changed. Forexample, in year 3 and 4, the cash flow was the same ($200,000). Timechanged a little bit (from 3 to 4), but there was a noticeable changein the interest rate (10 percent in year 3, and 4 percent in year 4).That means the same amount was discounted by an expressively lowerinterest rate. And because of this, the same $200,000 was worth morein year 4 even though one year has passed.

The discussion,examples and calculations above plainly illustrates that both timeand interest rates can have different kinds of impacts on the valueof money. This is the underlying notion of time value of money andany financial decision should be made based on considering theeffects of time and interest rate on money. There are other complexand more elaborate financial calculations (such as Net Present Value,Internal Rate of Return etc.) available to make the process offinancial decision making easier. But all of them consider the timeand interest rate (or required rate of return) in their calculations.

References

Biswas, P. and Pramanik, S. (2011). FuzzyApproach to Replacement Problem with Value of Money Changes withTime.&nbspInternational Journal ofComputer Applications, 30(10),pp.28-33.