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Don CPA-CFO, Certified Public Accountant (CPA)

Category: Finance

Satisfied Customers: 17

Experience: Licensed CPA, CFO of Businesses from $10-200 mil., Entrepreneurial coach & consultant - 17 yrs exp.

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How do you explain the use of time value of money (TVM) in

Customer Question

How do you explain the use of time value of money (TVM) in business? What considerations are made when calculating TVM? How may you use TVM to create your own, or someone else’s, retirement plan?

TVM is used in business for several purposes. It is used for calculating the expected return on capital projects (investments). It is also used to calculate cash flows for bonds (debt) issued or purchased.

When performing TVM calculations one must know at least 3 of the following four variables:

Interest rate, period of time, present value/future value, cash flow amount per period (payment).

Considerations given to any calculation are:

1) Whether cash flows are consistent or vary each period

2) The interest rate (discount rate)

3) Other cash flows related to the calculation

4) The units of measure (months, years, quarter) - these must be consistently applied

A TVM calculation is often used in retirement planning. Basically, one should determine the amount of money that must be saved each period to reach some pre-determined level of savings in the future (point of retirement). And then, based on some amount of cash outflow while in retirement, one has to determine how long the savings will last.

Here is an example;

If a person is 40 and has $50,000 saved now, how much must he save each month if he wishes to retire at 60 with enough money to have a monthly income equivalent to $1,000 in today's dollars that will last until he is 85?

A TVM calculation is used calculate the Present Value of an annuity that will pay out $1,000 monthly for 25 years.

A separate TVM calculation will be used to calculate how much must be saved to reach that amount in 20 years.

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Thanks!!

Don CPA-CFO and 2 other Finance Specialists are ready to help you

In determining present and future problems, we sometimes run across problems that compounds more than one per year. How do we in general adjust for problems that compound semi-annual, quarterly, month, or daily?

I believe that you are referring to how to make sure that if the compounding periods (or payment periods) are other than annually, how is the TVM calculation affected?

When you have periods other than annually, you must adjust the interest rate accordingly. For instance, if you are calculating payments on an annuity or loan that compounds or has payments monthly, you would do the same calculation as normal, but your periods would be 12 per year and you would also make sure your interest rate (which is typically expressed an an annual percentage like 7%) is 1/12 of its annual rate.

So heres an example:

Lets say you have to calculate the payment on a 5 year $10,000 loan with annual payments and a 7% interest rate. Your factors are: PV = $10,000, Periods = 5, Int rate = 7% per period. Then solve for for Payment.

Suppose the exact same factors exist, but your payments are monthly. Now the factors are: PV = $10,000, Periods = 5 x 12 or 60, Interest Rate = 7% / 12 or .583% per period. Then solve for Payment.

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