part 2 1-2 example

Suppose you set aside 2000 annually for 50 years(that will be the typical work life span in the future as people are continuing to  live longer according to the department of labor). your total contributions will be 100,000. keep in mind that each annual contribution is assumed to grow in value if you invest it wisely. If you get a 6 percent return on your annual contribution over 50 years, you will have accumulated 580680 at which point the government will probably take one third in taxes. The huge gain in value from 100000 to 580680 is all due to the time value of money compounding effect. 

While not all examples are this dramatic, the time value of money applies to many day to day decisions. Understanding the effective rate on a business loan, the mortgage payment in a real estate transaction , OR THE TRUE RETRUN ON AN INVESTMENT DEPENDS ON UNDERSTANDING THE TIME VALUE OF MONEY. AS LONG AS AN INVESTOR CAN MAKE A POSITIVE RETURN ON IDLE DOLLARS, DISTINCTIONS MUST BE MADE BETWWEN MONEY RECEIVED TODAY AND MONEY RECEIVED IN THE GURTURE. THE INVESTOR OR LENDER ESSENTIALLY DEMANDS THAT A financial“rent” be paid on his or her funds as current dollars are set aside today in anticipation of higher returns in the future.

Relationship to the capital outlay decision

The decision to purchase new plant and equipment or to introduce a new product in the market requires using capital allocating or capital budgeting techniques. Essentially we must determine whether future benefits are sufficiently large to justify current outlays. It is important that we develop the mathematical tools for the time value of money as the first step toward making capital allocation decisions. Let us now examine the basic terminology of time value of money.