Time Value of Money
As the name suggests it implies money valued with reference to time which may be present or future. “Time” allows the prospect to earn interest and defer consumption. Present Value (PV) – it means the current value of money in future measured at a particular interest rate. Future Value (FV) – it means the value of present money at some point of time in future measured at a particular interest rate. The value of dollar is more as of today than in future. This is due to the following reasons: •
Risk/Uncertainty about the receipt of money in future
Preference for current consumption.
Present money offers investment opportunities to earn additional cash flows. Example – If you offer someone $5000 today or $5000 after a year, he would prefer $5000 today as that money can then be invested and one can earn interest on it. •
At the time of inflation, the value of dollar as of date represents more purchasing power than the value of dollar after an year. Concept of Time Value of Money.
FV of a single cash flow.
FV of periodic cash flows.
PV of a single cash flow.
PV of a periodic cash flows.
FV of single cash flow equals the principal amount invested plus interest component. Interest can be in the form of compounded interest (C.I) or simple interest (S.I). Formula:
FVn = PV (1+i)n
FVn = future value
PV = present value
I = interest rate
N= time period
For Example: What will be the FV of $2000 I deposit today at 5% compound interest after a period of 4 years? FV4
= 2000 (1+ 0.05) 4
Series of equal cash flows in regular intervals is known as an Annuity. An example of the same would be premium paid for a LIP. Formula:
FVAn = A[(1+i)n-1/i]
FVAn = future value of series of cash flows
A = series of constant cash flow
I = interest rate
N = time period
PV of single cash flow equals the current discounted value of the cash flow. Formula:
PV0 = FVn[1/(1+i)]n
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