Time Value of Money, Essay Example

The concept of time value of money implies that a nominal or stated amount of money has more value now than in the future because inflation erodes the value of money over time as goods and services usually become expensive over time. Thus, for a stated amount of money to maintain its value, the interest rate has to equal the inflation rate and an interest rate greater than inflation rate means the money will grow over time and an interest rate less than the inflation rate means the opposite will be true. Thus, it only pays to lend or deposit money if the interest rate is at least equal to the inflation rate.

An example that demonstrates the time value of money may be a decision regarding a trip to Spain. I have determined that I can either go to Spain during Christmas this year or in 2014. If I go in 2014, I expect the trip to cost 2 percent more than what it may cost this year. My total budget for the trip is $1000. In other words, I would have to spend $1020 in 2014 but the opportunity cost of going on trip this year would also involve the annual 3 percent interest I could earn on $1000 by depositing in a local bank’s checking account. If I do so, the trip may prove to be cheaper next year because while the cost of the trip would go up by 2 percent, my interest income would be 3 percent which means the trip next year may actually be cheaper by 1 percent or $10.