8/26/2015

Time Value of Money


A time value of money calculation is one which solves for one of several variables in a financial problem.

In a typical case, the variables might be:
  • a balance amount
  • a periodic rate of interest
  • the number of periods
  • a series of cash flows

More generally, the cash flows may not be periodic but may be specified individually. Any of the variables may be the independent variable (the sought-for answer) in a given problem. For example, one may know that: the interest is 0.5% per period (per month, say); the number of periods is 60 (months); the initial balance (of the debt, in this case) is 25,000 units; and the final balance is 0 units.

The unknown variable may be the monthly payment that the borrower will need to pay.

So, how does this work?

Let's suppose that you had $100 and you invested it for one year at 5%... at the end of that year you would have $105...

Now, think about it this way... supposed (with the same $100) you expected a 10% return on your money but only received 5%... You would have $105 after one year but you expect to have $110... so, the value of that money is not the same as what you had hoped it to be.

But, suppose you did not invest it at all, you just held onto it for that one year; you would still have that $100 but your purchasing power would only be $99 as opposed to a purchasing power of $100 a year ago... so, by simply holding onto your money... the value of that money decreases over time.

Let,'s take a few years and using $1 compare to 2014 since we are still in 2015:
  1. 1950 – $1 2014 – $.10
  2. 1960 – $1 2014 – $.13
  3. 1970 – $1 2014 – $.16
  4. 1980 – $1 2014 – $.32
  5. 1990 – $1 2014 – $.54
  6. 2000 – $1 2014 – $.72
  7. 2010 – $1 2014 – $.92
What does this mean?

Well... simply put... if you were born in 1950, your parents could take an American dollar and buy $1 worth of stuff with it... but, in 2014, your parents would still have one American dollar but it would only buy $.10 worth of stuff with it 64 years later.

And, as you can see that the purchasing power of a dollar increases as we move closer and closer to 2014, but even between 2010 and 2014 (4 years) the American dollar could only purchase $.92 worth of stuff... so, during each one of those 4 years, the American dollar lost $.02 worth of value...
Now, this may seem like it is not much but what if we were dealing with millions and billions and trillions of dollars as is the case with our business, industry, and government? Those 2 pennies would add up to “big” dollars.

Let me share this with you...
In the decade of the 1960's, I could buy:
  • a Mcdonald's hamburger for $.15
  • a gallon of gasoline was $.18
  • a pack of cigarettes was $.20 or $.25 from a machine
  • a movie ticket was $.10 during day and $.15 at night
In 1960, I could buy 6 hamburgers, large fries 2 and a drink for $1 but in 2014, it would cost me $7.89 for a drink, fries, and a hamburger.

Now, let's look at saving your money in a passbook savings account but in order to prevent fees from being assessed on your money, you will need to start that account with $5,000 which does not sound like too much money does it?

And, the rates will vary depending upon State and geographic location within that State, but I would suspect that the bank will offer to pay you 1.35% to leave your money in their bank. So, for your first year, it will be $5,000 X .0135 which will be 67.50 and your money will have increased to $5, 067.50, but once inflation is factored into the situation which was just under 2% for 2014, which would have been somewhere between $90 to $100 (so I will average to $95), you money is now worth, after sitting in the back for 12 months, $4,972.50.

How do banks stay in Business?
How do banks make money?

Well, Banks loan out money (your money actually if your money is at that bank) at a rate of 3-4% and sometimes higher depending upon how good/bad your credit rating is and depending upon what type of loan you are seeking. It does not take a brain surgeon to see that if back pay you 1.35% and loan at 4%, that they are making 2.65% profit or gross margin as they say which is profit before expenses.

So, what else do banks do with your money?

Well, banks may group monies together and invest one big lump sum in a Mutual Fund that is paying anywhere from 8-10%. And, this is the same money that they are paying you 1.35% to use. Obviously, their profit margins increase substantially.

Of course, you as an individual could invest in these Mutual Funds too, but you would simply not command the buying power that these banks have in comparison your your return would be substantially less, plus there is typically and annual service change of about $1,500 annually to manage your money leaving you with very little capital gains (profit) after that is extracted from your so-called earnings.

Banking can and does get lots more complicated than this, but these are the basics of the World of Finance around which our economy revolves.

Incidentally, the reason why inflation is not any higher than it is... well, that's because our American Economy is hardly growing although it is moving along like a snail that encounters bumps and holes in the ground. And, you should be thankful for that because with today's wages, a 3% inflation would put a huge dent in one's pocketbook.

Oh yes... almost forgot... interest income shows up as ordinary income on your Income Taxes, so you are going to have to deduct Uncle Sam's cut of your profits as well, planting your ass deeper into that hole... and, pretty soon we will have you down deep enough where we can cover you up with dirt and a manure and sprinkle a little water on your head to see if you will grow... just kidding about sprinkling the water on your head... sorry.

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