Even though we may or may not notice, but the concept of time value of money surrounds us all the time in the form of compounding. The concept of time value of money asserts that the present value of a dollar received today is more than the one to be received in the future. In other words, money has the power of compounding and no rational person will forego his consumption without being compensated for it in the form of interest. For instance, if a person invest his funds in bonds, he is rewarded with fixed coupon payments on a timely basis and is eventually returned his principal amount at the time of bond maturity. Therefore, understanding the concepts of time value of money and learning more about the importance of compounding is crucial for all of us.
Hailing from a financially literate family, I have always been keen to participate in the world of compounding. However, I got my first hand experience in applying the techniques and knowledge of the time value of money concepts at the time of deciding for funding my college education along with my dad. By the time I entered the penultimate year of my high school, me and my father sat down to discuss as how my yearly education fees for my bachelors degree will be funded. Since he did not want me to work on a part-time basis and rather focus on my studies, it was very clear that the majority of the fees will be funded through his personal savings.
While we shortlisted some of the colleges, it was clear that we will need approximately $35000 every year to cover my college fees, and with only $95000 in savings, some investment should be made in order to cover shortfall of $25000. Therefore, with little knowledge of investment products and learning from his experience with smart investments, I invested $70000 in Vanguard Corporate Fund with a coupon rate of 5.8%. Apart from this, I invested $25000 in saving account offering an interest rate of 1.04%.
a) Vanguard Corporate Fund:
Present Value= $70000
Term= 2 years
Coupon Mode= Semi-Annual
Yield= 5.55%
Future Value= Present Value(1+Yield/2)N*2
= 70000(1.02775) 4
= $78099.45
Coupon Payments in two years= 70000* 0.058*2
= $8232
Total Gain= 8099+8232= $16331
b) Gain from Saving Account:
Present Value= $25000
Interest Rate= 1.04%
Term= 2 years
Future Value= Present Value(1+Yield)N
= 25000*(1.0104)2
= $25522.70
Therefore, I am fortunate that I understood the importance of learning time value of money concepts and invested my funds appropriately and on time. It was because of the power of compounding that I amassed 16.19% of my three year college on interest and capital gains from my investment.
References
Vanguard High-Yield Corporate Inv VWEHX . (2016). Retrieved July 17, 2016, from Morningstar: http://www.morningstar.com/funds/XNAS/VWEHX/quote.html
