Compounding
In scenario 1 and 2, the future value is calculated using the following formula (Heyford, 2019): Future value = Present value (1 + Interest rate)Number of years compounded
However, according to Heyford (2019), in scenario 3 and 4, the future value will be calculated as: Present value = Future value (1 / (1 + Opportunity cost rate)Number of periods)
Scenario 1
Present value = $500
Interest rate = 8% = 0.08
Number of years compounded = 1
Future value = 500 (1+0.08)1 = $540
Scenario 2
Present value = $500
Interest rate = 8% = 0.08
Number of years compounded = 5
Future value = 500 (1+0.08)5 = $734.66
Scenario 3
Future value = $500
Opportunity cost rate = 8% = 0.08
Number of years = 1
Present value = 500 (1 / (1+0.08)1) = $462.96
Scenario 4
Future value =$500
Opportunity cost rate = 8% = 0.08
Number of years = 5
Present value = 500 (1 / (1 + 0.08)5) = $340.29
Implications of the Present and Future Value on the Balance Sheet and the Budget of an Organization
The concept of the time value of money upholds that the value of the dollar today is higher than the value of the dollar in the future. This is based on the fact that cash today can be used in earning more in the future (Franklin et al., 2019). Moreover, the presence of other forces, such as inflation, might lead to a reduction in the value of the dollar; hence, decreasing the economic buying power. Therefore, businesses factor this concept, with regards to the present and future value, when making investment decisions, and this is reflected in the budget. The present and future values are time value-based factors that play an essential role in the creation of financial statements, for example, balance sheets. The assets and liabilities displayed in this financial tool are evaluated in terms of several attributes, which include the historical and current replacement cost, current market and net generalizable values, and the present value of future cash flows (Franklin et al., 2019). Therefore, this suggests that the time value of money influences the amount and types of assets and liabilities presented in balance sheets.
On the other hand, capital budgeting entails the design of a financial and master budget. The former plans on the usage of assets and liabilities in a projected financial statement. The information presented in the financial plan and the ending balance sheet from the previous year is usually used to create the budgeted balance sheet (Franklin et al., 2019). Therefore, this insinuates that the financial plan, with regards to the projected balance sheet, considers the present and future value of money. Moreover, the implication of the measurement of the time value of money is evident during capital costing. The present and future values are often utilized during the initial screening process when companies are choosing between alternatives; hence, they help make investment decisions. In capital budgeting, they are presented in the form of the net present value (NPV) and internal rate of return (Franklin et al., 2019). The NPV translates future cash flow into present values to establish whether the future returns exceed the initial investment. Conversely, the internal rate of return weighs the future cash flow against the initial investment to determine the investment’s rate of return (ROR). The aim is to get an interest rate that exceeds the predetermined ROR.
References
Franklin, M., Graybeal, P., & Cooper, D. (2019). Principles of accounting: Managerial accounting. OpenStax.
Heyford, S. C. (2019). Understanding the time value of money. Investopedia. Web.