Time value of money is an important aspect of money management. Why is it import

Question

Time value of money is an important aspect of money management. Why is it important to know what interest rates, terms of an agreement, and present value are in relationship to future value when making financial decisions? In perspective, if you won a $25 million lottery, would you take the lump sum prize of $17 million immediately or the annual annuity of $1 million dollars for the next 25 years? Your response should be based on what you know about present value and future value as well as include your personal opinion.

Explanation / Answer

Time value of money is an important aspect of money management. $1 worth today would be less as compared to its value after three years. It is because of interest rate that is given by banks for keeping money with them.For example, If we invest in a project where our capital outflow is $ 100 & capital inflow over the years is $ 250. Apparently, it appears to be a viable investment proposal as we are getting $ 150 over & above our initial investment. But actually, $150 is the amount we would be getting over the years. What is the present value of $ 150.

Present Value of Investment Return =Inflows - cost of outflow ( cost of raising funds like interest)

Now if we consider cost of outflows to be $ 50.

So the present value of $ 150 would be $150- $50= $100

Now if the same $100 is invested in bank for a period of three years which by the end of three years would fetch $300, we would certainly avoid investing in the above investment proposal and in turn deposit in bank to get us higher return. Now in the event of winning a lottery worth $ 25 million, we should certainly take lump sum prize of $17 million immediately because as per the time value of money, an annual annuity of $ 1 million each year would give us far lesser return in terms of money value as progress ahead successively (based on the above explanation) and on the other hand, $ 17 million, if invested in a bank,would get us far bigger return if the money remains deposited in the bank for a period of 25 years.Hence, Lump sum prize should be taken.

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