ROCHESTER INSTITUTE OF TECHNOLOGY

MEMORANDUM
Date: October 4, 2006
To: Sharon Warycka, Instructor, Technical Writing
From: Karyn Lewis, Student, Technical Writing
Subject: EXPANDED DEFINITION ASSIGNMENT

Audience and Use Profile

The following definition is written for students studying finance or business and adults learning to
manage their personal finances and obtain the greatest return from their investments. The
concepts of Interest, Future Value, Present Value, Annuity, Investment and Compounding are
vital to understanding and calculating Time Value of Money. They must have some knowledge
and experience with handling expenses and saving money, preferably owning a personal savings
or checking account themselves or looking into it.

TIME VALUE OF MONEY

Introduction
Time Value of Money is the core principle of finance that money available at the present time is
worth more than the same amount in the future, due to its potential earning capacity. This idea
holds that—provided money can earn interest—any amount of money is worth more the sooner it
is received.

The time value of money serves as the foundation for all other notions in finance. It impacts
business finances, consumer finances and government finances. Time value of money results
from the concept of interest. It can be used to compare investment alternatives and to solve
problems involving loans, mortgages, leases, savings, and annuities.

Example
Time value of money can be illustrated by the fact that a dollar received today is worth more than
a dollar received a year from now because today's dollar can be invested and earn interest as the
year elapses.

For example, assuming a 5% interest rate, $100 invested today will be worth $105 in one year
($100 multiplied by 1.05). Conversely, $100 received one year from now is only worth $95.24
today ($100 divided by 1.05), assuming a 5% interest rate.

These calculations demonstrate that time literally is money. The value of money now is not the
same as it will be in the future, and vice versa. So, it is important to know how to calculate the
time value of money in order to distinguish between the worth of investments that offer returns at
different times.
Operating Principle
The time value of money is based on the premise that people prefer to receive a certain amount of
money today, rather than the same amount in the future, all else equal. As a result, you demand
interest, paid either along the way or at the end. The interest compensates you for the time in
which the money could be put to productive use, the risk of default, and the risk of inflation.

Implicit in any consideration of time value of money are the rate of interest and the period of
compounding. Time Value of Money is determined by the mathematics of Compound Interest—
the difference between the value of a sum of money at one point in time and its value at another
point in time.

Three formulas are used to calculate the time value of money:

NOTE:
r = the required rate of return per time period
n = the number of time periods.

1. The present value formula is used to discount future money streams: that is, to convert
future amounts to their equivalent present day amounts. The following factors can convert
between present value and future value:
 ( Future Value / Present Value ) = ( 1+r )n
 ( Present Value / Future Value ) = 1 / ( 1+r )n

2. The future value formula is used to compound today's money into the equivalent amount at
some time in the future (i.e., to compound money in either a lump sum or streams of
payments). The following factors can be used to convert between future value and annuity
amount:
 ( Future Value / Annuity ) = [( 1+r )n – 1] / r
 ( Annuity / Future Value ) = r / [( 1+r )n - 1]

3. The present value of an annuity formula is used to discount a series of periodic payments of
equal amounts to the present day. Variations of this formula can find the future value of the
annuity, or solve for the annuity given the present value (for example, finding monthly
mortgage payments) or find the annuity given the future value (for example finding a
monthly payment needed to reach a retirement savings goal). The following factors can
convert between present value and annuity:
 ( Present Value / Annuity ) = ( 1+r )n - 1 / ( 1+r )n
 ( Annuity / Present Value ) = r ( 1+r )n / ( 1+r )n - 1

NOTE:
Time Value of Money Tables, Financial Calculators, Spreadsheet Software, and Time Value of
Money Software can also be used to calculate the Time Value of Money.

Special Conditions
Time Value of Money also takes into account risk aversion—both default and inflation risk. 100
monetary units today is a sure thing and can be enjoyed now. In five years, however, that money
could be worthless or not returned to the investor. There is a residual time value of money,
beyond compensation for default and inflation risk, which represents simply the preference for
consumption now versus later. Inflation-indexed bonds notably carry no inflation risk. In the
United States for instance, Treasury Inflation-Protected Securities carry neither inflation nor
default risk, but pay interest.

References
Kapoor, Dlabay, and Hughes. Personal Finance 8e. New York: McGraw-Hill/Irwin, 2007.

―Time Value of Money.‖ AOL Money & Finance. 2006. http://money.aol.com/basics/3canvas/_a/time-

value-of-money/20060609125509990001.