Key Time Value of Money Concepts

18 Aug Key Time Value of Money Concepts

Albert Einstein said this about compound interest: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Understanding some key points about the time value of money will help you with the financial planning needs of individuals and business owners.

1. Future value of a single sum

Financial planners frequently compute the future value of a sum of money so a client can make investment decisions. You can use future value tables to make your calculations, or find a calculator online. If, for example, a client invests \$10,000 at a 5% rate of return for 10 years, the future value of the investment is \$16,288.95. This calculation is the future value of a single sum.

Compound interest means that the client earns interest on both the original \$10,000 investment and the interest earned from all prior periods. In year two, for example, the client earns interest on \$10,000 plus the \$50 in interest earned from year one.

1. Future value of an ordinary annuity

It may be more common for clients to invest a specific amount of money over a period of years, and this scenario is referred to as the future value of an ordinary annuity.

The ordinary annuity calculation assumes that the annual payment is made at the end of the year. Assume, for example, that a client invests \$1,000 at the end of each year for 10 years, and that the interest rate earned is 5%. The future value of this ordinary annuity is \$12,577.89.

1. Present value

Some financial planning situations require the ChFC to start with a dollar amount that the client needs in the future, and compute how much must be saved each year to reach the required amount.

For example, assume that one of your clients wants to accumulate \$300,000 in 10 years, so that she can buy a lake house, and your client is able to earn 5% on her investment. To reach \$300,000, the client needs to make an initial \$1,000 investment, and then contribute \$1,921.36 per month for 10 years. This analysis takes a specific future dollar amount and works backward in time to the present, using the 5% rate of return.

Financial consultants can also help business owners understand the cash flow impact of buying an asset. Say, for example, that a business purchases a machine for \$10,000, and that the machine will increase company cash inflows by \$2,000 each year. Because the new machine operates more efficiently than the old machine that was replaced, the business saves \$2,000 a year, which can be considered an increase in cash flow.

The business owner wants to know how long it will take to recover his original \$10,000 investment, assuming an inflation rate of 5%. The answer to this question is to compute the present value of each \$2,000 payment in the future. The present value of \$2,000 for six years totals \$10,152, so it takes slightly more than six years to recover the \$10,000 cash spent on the machine.

Understanding both present value and future value strategies can help your clients reach a variety of financial goals.