Time Value of Money

Topics: Time value of money, Time, Rate of return Pages: 2 (530 words) Published: February 14, 2013
The time value of money
A rupee today is more valuable than a rupee a year hence. Thus money has time value this is because of several reasons:-1) Individuals, in general prefer current consumption to future consumption.2) In an inflationary period, a rupee today represents a greater real purchasing power than a rupee a year hence.3) Capital can be employed productively to generate positive returns. An investment of one rupee today would grow to (1+r) a year hence (r is the rate of return earned on the investment. The process of investing money as well as reinvesting the interest earned thereon is called compounding.The future value of a compounded value of an investment after n years when the interest rate is r percent is: FVn=PV(1+r)n

In this equation (1+r)n is called the future value interest factor or simply the future value factor. The difference between compound and simple interest is Compound interest means that each interest payment is reinvested to earn further interest in future periods whereas if no interest is earned on interest the investment earns only simple interest. According to the rule of 72, the doubling period under compounding is obtained by dividing 72 by the interest rate. For example if the interest rate is 8% the doubling period is 9 years (72/8) According to the rule of 69 the doubling period is equal to 0.35 +69/interest rate.The rule of 69 is more accurate than rule of 72 though it involves more calculation. An annuity is a stream of constant cash flows (payments and receipts) occurring at regular intervals of time. The premium payments of a life insurance policy, for example are an annuity.When the cash flows occur at the end of each period, the annuity is called an ordinary annuity or a deferred annuity.When the cash flows occur at the beginning of each period, the annuity is called an annuity due. The future value of an annuity- FVAn=A(1+r)n-1+A(1+r)n-2+…..+A =A[(1+r)n-1]/r...
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