Why does money have a time value? Can you provide at least one real-life scenario in which you can apply the concept of “time value of money”?
To give you some idea of how TVM applies in daily life in a firm, consider the following scenario:
Suppose a local car dealer has an idea to attract customers by offering them a "Tires for Life" incentive program. The way it would work is when a customer buys a car from the dealership, the dealership agrees to replace the tires on the car whenever needed at no charge for as long as the customer owns the car.
The program would have a cost to the dealership, of course, so to offset that cost, the CEO proposes that the cost of the program be added to the price of each car they sell. In this way the program wouldn't cost the dealership anything.
Now imagine that you are a financial analyst working at the car dealership and the CEO has approached you with this question:
“How much does the dealership have to add to the price of a car to cover the cost of the incentive program?”
For example, let’s assume the following:
One customer is going to take advantage of the deal, and the car purchase is to take place today.
The length of time the car is expected to be owned is 9 years.
Replacement tires will be needed every 3 years.
A set of replacement tires costs $400.
Funds set aside to finance the incentive program can be invested at 3%
The CEO has asked you to brief him on how much they need to add to the price of a car to finance this initiative by the end of this week. What will you tell him?