Time value of money is a financial management concept which deals with the amount calculation of interest that a given amount of money is capable of earning or accumulating over a given period of time. Time value of money is based on the theory of finance (Besley & Brigham, 2008). Various financial calculations that can be derived from the concept of time value of money, for instance, determination of the present value of a given amount of money, calculating the future value of a fixed amount of money as well as calculation of both present value and future value of an annuity and perpetuity. Keown (2010) defines an annuity as a series of equal payments or receipts made at equal intervals over a given period of time whereas perpetuity is an indefinite and regular stream of receipts of money. Time value of money explores why it is worthwhile to receive a given amount of money now rather than in future.
It is a financial concept which explains the relationship between the value of money and time (Petreson & Fabozzi, 2009). The time value of money concept also involves an opportunity cost in which the value of a given amount of money now is traded off with the value of the same amount of money in future.
The concept of time value of money can be applied in various fields, such as calculation of insurance premiums that a person has to pay over a given period of time, in determining the most suitable type of investment to make as well as in calculation of premiums and pensions during the retirement planning.
For my part, I would like to retire with fifty five million U.S. dollars. I would achieve this retirement goal by investing money into a bank account that would earn interests on a yearly basis. In order to attain this goal, I would invest a lump-sum amount of money of ten million dollars at an interest rate of twelve percent per annum now, so that it accumulates to fifty four million, seven hundred and thirty six thousand U.S. dollars.
Using the future value formula: Future Value (FV) = P*(1 + i) n, where P* is the original value, i is the interest rate per period and n is the number of periods. Assuming the bank offers an interest rate of twelve percent (12%) per annum, the future value of this amount of money would be calculated as follows. Future Value (FV) = ?10,000,000 ? (1 + 0.12)15 = ?54,736,000.
This would ensure that by the time I will be retiring, after fifteen (15) years, I would have 54,736,000 US dollars in the account. Moreover, the investment would enable me earn an interest of approximately forty four million, seven hundred and thirty six thousand (?44,736,000) U.S. dollars over a period of fifteen years before my retirement.
After retirement, I would, thus, be able to receive an equal payment of one million, four hundred and sixty eight thousand two hundred and fifty U.S. dollars every year from the bank. The payment shall be in a form of ordinary annuities and the amount of each receipt can be calculated as follows.
Future of Ordinary Annuity (FVA) = C* [ {(1 + i)n – 1} ? i], where C* is the cash inflow per period/annual receipt, i is the interest rate per annum and n is the number of receipts to be received per annum. In this forecasting, I will require an interest rate of twelve percent per annum. I would further assume that I shall live for approximately fifteen years after retirement, and hence I would require an annuity for a period of 15 years.
C* = FVA ? [ { (1 + i)n – 1} ? i]
C* = 54,736,000 ? [ { (1 + 0.12)15 – 1} ? 0.12]
C* = 54,736,000 ? 37.2797
C* = 1,468,251.60
Therefore, the annual receipts would be approximately ?1,468,250 per annum.
In my opinion, the answers and the forecasted amounts of money in the above calculations are feasible. This is because I would be able to earn a huge amount of interest from the investment in the first fifteen years while I am still in employment. I shall then be able to receive a certain fixed amount of constant income from the bank from the accumulated interests plus the initial principal investment after retirement. The concepts of time value of money have proved to be useful tools during retirement planning.
