Time Value of Money Analysis: Rule of 72
The ability to estimate time value of money, i.e. to figure out how long it will take to receive a certain return on a given investment is essential both for businesses and daily life. In this context, ‘Rule of 72’ is a useful tool for determining time value of money as it does not require complicated calculations to be done while provides the user with accurate results.
The Rule of 72 is a simplified mathematical model to determine the time needed for doubling the initial investment. (Gapenski, 2012) It is necessary to divide 72 by the given interest rate and the result would represent the approximate time (in years) for initial lump sum to double. (Gapenski, 2012) For example, imagine the company is considering to invest into shares with an annual interest rate of 9%. According to the rule, it would take 72 ÷ 9 = 8 years to double the initial investment.
As we see from the example above, the calculation is user-friendly and, unlike in compounding calculation method, does not require the use of complex logarithmic functions. (Investopedia, 2017) Further, the result turns out to be very accurate: with the use of the logarithmic function, the result would be ln(2) ÷ ln(1.09) = 8.04.
The important concept to bear in mind in this regard is that the value of money decreases over time. Money available at current point of time is worth more than the same amount in future simply because the former is available for immediate usage. (Gapenski, 2012) The time value analysis might be as well used for inflation determination, which makes it useful for daily life employment. (Investopedia, 2017) Whenever a person is considering several options of making a certain purchase or simply putting money on a bank deposit or investing into securities, Rule of 72 can be used for both comparing the available investment options and determining whether it is reasonable to make a purchase now or postpone it for later.
Therefore, time value analysis can be used in daily life for personal financial planning and exploring the most profitable investment options available. In order to avoid complex mathematical equations and still receive accurate calculations, Rule of 72 well serves the purpose.
References
Gapenski, C., L. (2012). Healthcare Finance: An Introduction to Accounting and Financial Management, 5th Edition. [Bookshelf Online]. Retrieved from https://bookshelf.vitalsource.com/#/books/9781567935301.
Investopedia,. (2017). Rule Of 72. Investopedia. Retrieved 6 February 2017, from …
