Unit 2 – Time Value of Money
Lesson 2.2: Financial Planning Using Time Value of Money
Time Value of Money (TVM) is a crucial concept that can be used as a tool during financial planning to develop appropriate strategies that account for current circumstances and future objectives. As a reminder of our last week’s Lesson 2.1: Time Value of Money, TVM allows analysis in comparing financial options by incorporating the influence of Inflation and Opportunity Cost. More specifically, situations that involve comparing wealth accumulation opportunities, developing retirement planning, evaluating investment versus paying down debt, or assessing the financial risk of a taxpayer’s death all rely on the use of the TVM.
The five components that make up a TVM calculation are:
- Present Value
The initial principal amount invested or borrowed at the beginning of the calculation.
- Number of Payments or Compounding Periods
Often determined as the number of years or months for which a financial situation will play out. Simply, this component accounts for time, a significant factor in any financial situation.
- Annual Nominal Interest Rate
Interest Rate, expressed as a percentage, is the amount of return an investor will receive, or the amount a borrow will have to pay, in relation to the principal amount invested or borrowed. This percentage is usually expressed on an annual basis (ex: 5% Interest Rate per Year).
- Amount of the Periodic Payment
The amount of money that an investor saves periodically, per time-period (month or year) or the amount of money a borrower repays per time-period (month or year). For example, an investor who, in addition to saving a lump-sum, also contributes $200 per month to his or her account.
- Future Value
The total amount an investor grows their assets to at the end of the exercise. Alternatively, this can be the amount of money the borrower owes at the end of the time-period (usually $0 for loans as they would be fully paid off in the end).
Financial Planning Implications of the TVM
The reason the TVM is so crucial to financial planning, is that so long as any four of the components are known, the fifth can be calculated. At this point, all we need to do is isolate the one variable that we do not know and calculate it based on the four that we do.
For example, for an investor that knows:
- The amount of money they currently have (Present Value)
- How long they will save for (Number of Compounding Periods)
- The rate-of-return they will receive from their investment (Interest Rate); and,
- How much they will save per compounding period (Periodic Payment)
- Then they would be able to determine what Future Value they can expect their portfolio to grow to.
The same can be true for any other combination of 4 components that are known and one that is determined. You can see how crucial this tool can be for financial planning as it allows for the appropriate allotment of an individual’s assets or monthly contributions to accomplish their financial objectives.
Whether it is determining how long you have to save to buy a car, or what interest rate you will need to meet your retirement goals, financial planners can lean on the TVM calculations to aid them in the determination of the most appropriate strategies that you can implement in your own financial planning.
Obviously, there are other factors involved in the creation of financial strategies, however, TVM can be thought of as providing the structure of what the eventual implementation of strategies may look like to satisfy specific objectives.
In the next couple Lessons our attention will turn to one of the components in the TVM Calculation: Interest Rate. Lesson 2.3 will first describe what interest is, and Lesson 2.4 focuses on incorporating inflation within the interest rate, and how this may affect the results in the TVM Calculation.
