Time value of money is useful in making informed business decisions. For example the "net present value method" can be used to help decide the best alternative among multiple alternative uses of a firm or personal financial resources. By discounting various alternatives to their "present value" one can compare the alternatives. Time value of money can also answer such questions as what one's investment will be worth at a certain point of time in the future, assuming a certain interest rate. Time value of money can also be used to compute such useful information as car, mortgage and other loan payments. Another use of time value of money in accounting is reporting of certain long-term assets and liabilities.
Time value of money is based on the principle of compound interest. Each time there is a compounding period the new principal is increased by the interest from the previous period.
Converting Before Using the Tables
When using the tables, you may need to convert if, for example, in a lump sum situation there are more than one compounding periods in a year. Or you may need to convert (to monthly compounding) if, for example, you are working with an annuity situation involving a car loan that involves monthly rather than annual periodic payments.
You often need to convert whether it is a lump sum or an annuity situation. Do the following conversions before using the tables. See some of the examples which follow these notes.
For semi-annual compounding [or for deposits every six months in an annuity], take the annual interest rate and divide it by 2. Take the number of years and multiply by 2.
For quarterly compounding [or for quarterly deposits in an annuity] take the annual interest rate and divide it by 4. Take the number of years and multiply by 4.
For monthly compounding [or for monthly deposits in an annuity] take the annual interest rate and divide it by 12. Take the number of years and multiply by 12.
Lump Sum Amounts
Future Value of $1 = Present Value X Future Value of $1 Table Factor
Present Value of $1= Future Value X Present Value of $1 Table Factor
Use the $1 table when you are dealing only with a lump sum amount. (However when you have an annuity in the problem, do not use the lump sum table; instead use the annuity table. Use the annuity table even if you are looking for a lump sum, as shown in No. 4 which follows these notes.)
Notice that there are four variables with lump sum situations: Present Value, Future Value, Interest Rate, and Period. You need to know three out of the four to figure out an unknown. You saw above how to compute Present Value and Future Value. Now suppose you want to find the interest rate.
Present Value Approach: PV / FV = computed PV Table factor Go to the PV table. Where the table factor and periods intersect is the interest rate.
Use this same approach to figure the number of periods when you know the interest rate and PV and FV.
An annuity means a series of equal periodic "deposits," or "rents" which can be either payments or receipts; they are made at equal periodic intervals. Use the annuity tables when you are dealing with equal periodic payments or receipts at equal periodic intervals.
Use Ordinary Annuity table for payments made at the end of the period. Use Annuity Due table for payments made at the beginning of the period.
Future Value of an Annuity = Annuity Deposit X Future Amount of an Annuity Table factor.
Present Value of an Annuity = Annuity Deposit X PV of Annuity Table Factor Note the Annuity Deposit may be either a payment or receipt.
Now say you wish to find the amount of the deposit, which could be either a periodic payment like a car or mortgage payment, or a periodic receipt such winnings from the lottery or more...