The Time Value of Money
My name is Michael Onuorah. I am first and foremost…
Good Morning Thomas, please can I get a loan of one thousand naira from you asked Michael?
Sure responded Thomas. When do you need it and when will you pay me back my money?
I need it tomorrow. Michael stated, but I will pay back in three years.
That means in three years, Michael, you will pay me one thousand two hundred and seventy naira because I will be charging you a 9% interest rate per annum.
Hey Thomas, I am your friend Michael Chanted. Why should I pay you back with interest?
My friend, money has value and money either loses or gains value over time. Thomas explains.
If you plot a graph that depicts Value on the Y axis and Time on the X axis over a one year period of a loan without interest, the graph will be a flat graph with no activity.
However, if you plot the same graph with an interest component, you will see there would be a regular increase in the value of money over time. Therefore there is a time value of money.
For example, if I borrow you a thousand naira and you have to pay me 9% interest over a three year period. If we compute simple interest on the principal, we will get the following.
Hey Thomas, Michael yells. Please before you continue, what is Simple Interest? What is Principal? What is interest and why is the interest simple?
Simple Interest can be defined as the interest paid or earned on the original amount borrowed.
Principal is the loan amount that is borrowed. In your case, the principal is One thousand naira.
Rate is the interest rate that you will be paying over the period of borrowing time.
Interest is money paid for the use of money.
For example, if you agree to take my loan of 1,000 Naira at rate of 9% repayable in 3 years. Then the interest you will be paying will be computed as follows:
Simple Interest (SI) = Principal * Interest Rate * Number of Time Periods
Simple Interest (SI) = 1000 * (0.09) *(3) = 270
Ah! I see how this works now. Nevertheless, I want to negotiate that you give me the loan at 5% interest rate, Michael Pleads.
It sounds like a reasonable request. Let me review my books and revert.