Monday, October 31, 2011

Finance: Time Value of Money

When Jose received 200,000 pesos in full from a buyer of fruits. He was happy. Jose is the owner of an orchard and usually every year, he spent more than the amount of fruits he sold that varies from 30,000 pesos to 40,000 pesos. This is because of Climate Change, the change in temperature and weather determines the amount of fruits not to mention the calamities such as typhoon and earthquake, which is rampant in the Philippines.

Jose received 200,000 pesos for the fruits that will be harvested for each year within 5 years. This is his first time move and considering the cost of it today is different after 5 years. From the book Financial Management principles and applications, the amount of money today is worth more than a dollar received a year from now because for instance a peso today can be invested and earn interest. The economist calls an “opportunity cost” of passing up the earning potential of the peso today. The opportunity cost is the time value of money.

Compound Interest and future value is very important in realizing the significance of the value of peso today. Since Jose received 200,000 pesos today and that value on the other hand is not sure on the buyer who paid him in full because of Climate Change and the risk he took which could be favorable or not, the luck is with Jose and the opportunity cost if he will use it well will be resulting to an earnings. Say, Jose invested that money in full in a sure business, he could earn more, that is the opportunity we are talking about.

If that 200,000 pesos earns 10% every year, the compound interest will be 20,000 pesos and for the next year will be 22,000 pesos because we add the principal and the interest for the first year which became the principal on the second year or present value, and the interest we earned the first year, in effect we are now earning interest on interest, this is the concept of compound interest.

This is a discussion I have with my mother today, the “Time Value of Money” which is the money is more important today than in the future because of the “opportunity cost” and the value. This is to understand the best options if there are choices and decisions to make in terms of getting the money right now in full or wait for it every month. From this computation, I will stick to the full amount received today than a staggered payment that in five years, the risk is still there.

To make decisions, financial managers must compare the costs and benefits of alternatives that do not occur during the same period. Whether to make the profitable investments or to take advantage of favorable interest rates, financial decision-making requires an understanding of the time value of money. Managers who use the time value of money in all their financial calculations assure themselves of more logical decisions.


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