The time value of money is a paramount financial concept, according to which a certain amount is now worth more than the same amount in the future. This is due to the possibility of investing at the moment and generating income, which will lead to an increase in the amount of money in subsequent years. Another reason is that the expectation of cash flows in the future always carries the risk of default. Schmidt (2021) highlights two methods for determining the time value of money – discounting and compounding. Discounting is used to calculate how much money needs to be invested currently to get a given amount in the future. Compounding, the inverse of discounting, is done to determine how much money can be received in the future if they are invested a certain amount presently.
When assuming the time value of money, one must always consider inflation and the corresponding adjustment in purchasing power. Inflation hurts the ability to buy goods. By reducing the value of money, this economic phenomenon reduces purchasing power without changing the amount of money available. If the estimated return is less than inflation, it may turn out that money is made, but purchasing power is lost.
There are five main components of the time value of money: rates, periods, present value, future value, and payments. Schmidt (2021) notes that by knowing any 4 of the five components, one can easily find the fifth one. Based on this, the author highlights the practical problems of the time value of money. According to Schmidt (2021), there are three main types of compounding problems and three basic types of discounting problems, which form 6 dollar functions.
The author distinguishes three basic types of compound tasks: the future value of a single sum, the future value of a series of payments, and the amount of payment required to achieve the future value. In turn, the other half of the six functions of the dollar is related to discounting. These time value of money issues include determining the present value of a single sum, the present value of a series of payments, and the amount of payment required to amortize the present value, such as a loan. The author provides a decision table containing answers to the above six problems. Because these fundamental time value of money issues crop up in finance and commercial real estate, mastering them is essential to improving skills.
Reference
Schmidt, R. (2021). What you should know about the time value of money. Property Metrics. Web.