Functions for Personal Finance
Time Value of Money Concepts
In reviewing the Budget Summary worksheet in Figure 11,
you will notice that the range B9:D14 contains data that can be used to
assess a savings plan. We can project how much money can be
saved over a specific period given set contributions and a
rate of return. This calculation is accomplished through the future
value, or FV, function. We will use the FV function in cell D10 of the Budget Summary
worksheet
to calculate our savings plan projection. However, before we use the
FV function, it is important to review a few basic concepts regarding
the time value of money, as shown in Table 3.
| Argument | Definition |
|---|---|
| Annuity | An investment that is made in regular payments over some time. For example, depositing $100 monthly into an interest-bearing bank account or mutual fund is considered an annuity. |
| Bonds | An investment in which you lend money to a company or government entity. The borrower agrees to pay you interest over a specific period. At the end of the bond agreement, the amount borrowed or your initial investment is returned to you. Most bonds are considered lower-risk investments but offer lower returns than stocks. |
| Mutual Funds | A collection of similar investments managed by a financial professional (a fund manager). Mutual funds allow you to invest in several stocks or bonds without making many individual investments. They also allow you to reduce your risk and take advantage of the investment expertise of a professional. |
| Rate of Return | The percentage gained or lost on an investment. Investments that offer a high predicted rate of return often carry a higher risk of losing money. Investments that offer a lower predicted rate of return often carry a lower risk of losing money. |
| Stocks | An investment in which you own a portion of a company. The value of this investment increases as the company produces higher profits. Most stocks are expected to generate a higher rate of return than bonds generate. However, the risk of losing money on a stock investment is much greater than bond risk. |
Table 3 provides definitions for several terms used when addressing the time value of money concepts. The time value of money is the opportunity to grow your
money over time, given a constant or average rate of return. For example, consider the data shown in Figure 12.
This data assumes that a person makes a one-time investment of $100
in a bond mutual fund that returns five percent interest annually.
Notice that the interest paid in Column E increases every year. This is
because the interest is reinvested in the mutual fund, which increases
the total value of the investment.
For
example, the interest earned in year one is based on a $100
investment. Therefore, the interest paid is $5.00, or five percent\ of
$100. However, in year \two, when the $5.00 interest payment is
reinvested, the total investment increases to $105.
Therefore, in year two the interest paid increases to $5.25, or five
percent of $105. The value of the investment at the end of five years
is $127.63. This is the value that can be calculated using the FV
function.
Figure 12 Time Value of Money Example for a One-Time Investment
Figure 13 shows
another example demonstrating the time value of money concept. Instead
of making a one-time investment, we will assume that a person invests
$100 at the beginning
of every year in the same bond mutual fund. This is called an annuity because the person makes reoccurring
investments over a specific period. Notice that the value of
this investment after five years is $580.19.
Also, the total interest earned on this investment is $80.19 as
opposed to the $27.63 earned on the one-time investment in Figure 12.
Figure 13 Time Value of Money Example for an Annuity Investment