Time Value of Money and its Importance
Discuss time value of money and its importance. Explain the relationship of discounting and compounding. Suppose you were considering depositing your savings in one of three banks, all of which pay 5 percent interest; bank A compounds annually, bank B compounds semiannually, and bank C compounds daily. Which bank would you choose? Why?
The value of money should continue to grow with time. If you have the option of depositing your money in three banks with bank A compounding interest annually, bank B compounding interest semiannually, and bank C compounding interest daily, you should always choose bank C. Your money will be worth more while it’s interest is compounding daily compared to semiannually or annually. When an investment compounds daily it gains a small amount of value daily. This increasing value continues to grow more and more each day. Instead of compounding at a bigger percent annually or semiannual, it compounds more often at a smaller rate. This smaller rate being compounded daily ends up being worth more than the bigger rate once or twice a year.
Understanding the time value of money is important. The time value of money can make a large difference in the savings of one person or the profits of a company. The concept is based on interest. If a certain amount of money stays in one account that pays a high amount of interest than in a few years the money can double or even triple. The relationship between compounding and discounting is that they are opposites. Compounding is determining the cash flow at some point in the future. Discounting is finding the current cash flow. If I was to choose between bank A, B or C, I would pick bank C. I would select bank C because personally I like to see positive changes daily but also because the interest would stack. I would be earning interest on the interest that I was paid yesterday and the day before.