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Wednesday, May 20, 2009

Time Value of Money

Simply put, time value of money is the value of money figuring in a given amount of interest for a given amount of time. For example 100 dollars of todays money held for a year at 5 percent interest is worth 105 dollars, therefore 100 dollars paid now or 105 dollars paid exactly one year from now is the same amount of payment of money with that given intersest at that given amount of time. This notion dates at least to Martín de Azpilcueta of the School of Salamanca.

All of the standard calculations for time value 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).

Some standard calculations based on the time value of money are:

  • 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.
  • Present Value of a 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.
  • Present Value of a Perpetuity is a constant stream of identical cash flows with no end.
  • 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.
  • 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.

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