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A key concept behind Time Value of Money is that a single sum of money or a series of
equal, evenly spaced payments or receipts promised in the future, can be converted to an
equivalent value today. Conversely, you can determine the value to which a single sum or
a series of future payments will grow to at some future date. The former is called Present
Value of Cash Flows and the later is called Future Value of Cash Flows.
Important Terms
• Time line
• Discounting
• Compounding
• Principal amount
• Simple interest
• Annuity
• Amortized loan
SIMPLE INTEREST
This is where any interest earned is NOT added back to the principal
amount invested.
COMPOUND INTEREST
Time Line
Discounting
Annuity
The most common form of annuities are certain and ordinary. That is
the annuity is paid at the end of the payment interval and will begin
and end on fixed dates. Personal loans and most domestic hire
purchase are paid off in a similar manner but normally without the
initial deposit.
Annuities that are being invested however are often due, that is paid
of ‘in advance’ of the intervals
The present value (PV) of an annuity could be found as for any cash
flow by discounting each return individually, but there is a more
economical method. Consider the case of an annuity of K10,000 that
runs for four years at 10% interest. Assume that the first payment will
be made after one year. Using the discount factor table the PV is:
Sinking Fund
1. Repayment of debts.
2. To provide funds to purchase a new asset when the existing
asset is fully depreciated.
That is the annual payment into the sinking fund is K106,627.8 (which
will produce, 9.5%, K251,232 at the end of 3 years).
Perpetuities
A Mortised Loan
Examples:
Interest Rates
1. Nominal rates
The rate which is quoted or stated on loan or investment.
2. Effective annual rate
The rate, which would produce the same ending (future), values
if annual compounding had been used.
3. Periodic rate
The rate charged by a lender or paid by a borrower each period.
It can be rate per year, per six-month period, per quarter, per
month or per day.
The time value of money is the value of money figuring in a given amount of interest
earned over a given amount of time.
For example, 100 dollars of today's money invested for one year and earning 5 percent
interest will be worth 105 dollars after one year. Therefore, 100 dollars paid now or 105
dollars paid exactly one year from now both have the same value to the recipient who
assumes 5 percent interest; using time value of money terminology, 100 dollars invested
for one year at 5 percent interest has a future value of 105 dollars.[1] This notion dates at
least to Martín de Azpilcueta (1491-1586) of the School of Salamanca.
The method also allows the valuation of a likely stream of income in the future, in such a
way that the annual incomes are discounted and then added together, thus providing a
lump-sum "present value" of the entire income stream.
All of the standard calculations for time value of money derive from the most basic
algebraic expression for the present value of a future sum, "discounted" to the present by
an amount equal to the time value of money. For example, a sum of FV to be received in
one year is discounted (at the rate of interest r) to give a sum of PV at present: PV = FV −
r·PV = FV/(1+r).
Present Value The current worth of a future sum of money or stream of cash
flows given a specified rate of return. Future cash flows are discounted at the
discount rate, and the higher the discount rate, the lower the present value of the
future cash flows. Determining the appropriate discount rate is the key to properly
valuing future cash flows, whether they be earnings or obligations[2].
Present Value of an Annuity An annuity is a series of equal payments or receipts
that occur at evenly spaced intervals. Leases and rental payments are examples.
The payments or receipts occur at the end of each period for an ordinary annuity
while they occur at the beginning of each period for an annuity due[3].
Present Value of a Perpetuity is an infinite and constant stream of identical cash
flows[4].
Future Value is the value of an asset or cash at a specified date in the future that
is equivalent in value to a specified sum today[5].
Future Value of an Annuity (FVA) is the future value of a stream of payments
(annuity), assuming the payments are invested at a given rate of interest.
Calculations
There are several basic equations that represent the equalities listed above. The solutions
may be found using (in most cases) the formulas, a financial calculator or a spreadsheet.
The formulas are programmed into most financial calculators and several spreadsheet
functions (such as PV, FV, RATE, NPER, and PMT)[6].
For any of the equations below, the formula may also be rearranged to determine one of
the other unknowns. In the case of the standard annuity formula, however, there is no
closed-form algebraic solution for the interest rate (although financial calculators and
spreadsheet programs can readily determine solutions through rapid trial and error
algorithms).
These equations are frequently combined for particular uses. For example, bonds can be
readily priced using these equations. A typical coupon bond is composed of two types of
payments: a stream of coupon payments similar to an annuity, and a lump-sum return of
capital at the end of the bond's maturity - that is, a future payment. The two formulas can
be combined to determine the present value of the bond.
An important note is that the interest rate i is the interest rate for the relevant period. For
an annuity that makes one payment per year, i will be the annual interest rate. For an
income or payment stream with a different payment schedule, the interest rate must be
converted into the relevant periodic interest rate. For example, a monthly rate for a
mortgage with monthly payments requires that the interest rate be divided by 12 (see the
example below). See compound interest for details on converting between different
periodic interest rates.
The rate of return in the calculations can be either the variable solved for, or a predefined
variable that measures a discount rate, interest, inflation, rate of return, cost of equity,
cost of debt or any number of other analogous concepts. The choice of the appropriate
rate is critical to the exercise, and the use of an incorrect discount rate will make the
results meaningless.
For calculations involving annuities, you must decide whether the payments are made at
the end of each period (known as an ordinary annuity), or at the beginning of each period
(known as an annuity due). If you are using a financial calculator or a spreadsheet, you
can usually set it for either calculation. The following formulas are for an ordinary
annuity. If you want the answer for the Present Value of an annuity due simply multiply
the PV of an ordinary annuity by (1 + i).
[edit] Formula
[edit] Present value of a future sum
The present value formula is the core formula for the time value of money; each of the
other formulae is derived from this formula. For example, the annuity formula is the sum
of a series of present value calculations.
The present value (PV) formula has four variables, each of which can be solved for:
1. PV is the value at time=0
2. FV is the value at time=n
3. i is the rate at which the amount will be compounded each period
4. n is the number of periods (not necessarily an integer)
The cumulative present value of future cash flows can be calculated by summing the
contributions of FVt, the value of cash flow at time=t
Introduction
Time Value of Money (TVM) is an important concept in financial management. It can be
used to compare investment alternatives and to solve problems involving loans,
mortgages, leases, savings, and annuities.
TVM is based on the concept that a dollar that you have today is worth more than the
promise or expectation that you will receive a dollar in the future. Money that you hold
today is worth more because you can invest it and earn interest. After all, you should
receive some compensation for foregoing spending. For instance, you can invest your
dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the
year. You can say that the future value of the dollar is $1.06 given a 6% interest rate
and a one-year period. It follows that the present value of the $1.06 you expect to
receive in one year is only $1.
A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced
payments or receipts promised in the future can be converted to an equivalent value
today. Conversely, you can determine the value to which a single sum or a series of
future payments will grow to at some future date.
You can calculate the fifth value if you are given any four of: Interest Rate, Number of
Periods, Payments, Present Value, and Future Value. Each of these factors is very briefly
defined in the right-hand column below. The left column has references to more detailed
explanations, formulas, and examples.
Interest is a charge for borrowing money, usually stated as a
Interest percentage of the amount borrowed over a specific period of
time. Simple interest is computed only on the original amount
• Simple borrowed. It is the return on that principal for one time period.
In contrast, compound interest is calculated each period on the
• Compound original amount borrowed plus all unpaid interest accumulated
to date. Compound interest is always assumed in TVM
problems.