Principles of Time Value of Money and the Discount Rate

There are three ways to compute time value of money problems:

1. The algebraic (or formula) method
2. The financial table method
3. The financial calculator method
Compound Interest Rate
Compound interest results when the interest paid on the investment during the first period
is added to the principal sum and during the second period the interest is earned on the
original principal sum plus the interest earned during the first period.
Present Value
Present Value is the value in today's dollars of a sum of money to be received in the future,
which involves nothing other than inverse compounding. The differences in these techniques
come about merely from the investor's point of view.
Present value results when the opportunity cost of having to wait for future consumption
is factored into the amount to be received in the future.
Present value reflects the discounting of a sum of money to be received in the future.
Mathematically, the present value of a sum of money to be received in the future can be
determined with the following equation:

The present value of a future sum of money is inversely related to both the number of years
until the payment will be received and the opportunity rate.
At a positive rate of interest, present value will be less than future value with the difference
reflecting the opportunity cost of funds given up.
Future Value
Future value reflects appreciation of a present lump sum over time so as to return to the
lender principle plus interest.
Money has future value because resources relinquished today will grow at the real rate
lenders require to forego present consumption.
Annuity
An annuity is a series of equal dollar payments for a specified number of years.
A. Ordinary Annuity
This assumes that payments are paid or received at the end of the period.
Note: Both FVIFA and PVIFA tables assume ordinary annuities where payments are paid or
received at the end of the period.
B. Annuities Due
Assumes that payments are made/received at the beginning of the period
Note: The number of payments, n, is the same as an ordinary annuity
Perpetuities
A perpetuity is an annuity with an infinite number of payments (PMT)
or
A perpetuity is an annuity that continues forever, that is every year from now on this
investment pays the same dollar amount.

Present Value of Uneven Cash Flows (PVUCF)

Note: Unless we can find an "embedded annuity" in a stream of uneven cash flows, each
cash flow must be discounted separately in order to obtain the present value. The FVIFA
and PVIFA tables assume equal cash flows and will not work. These problems are best
handled via calculator or the use of spreadsheets. Just enter the cash flows, the interest
rate, and request the present value.

Spreadsheets and the Time Value of Money

While there are several competing spreadsheets, the most popular one is Microsoft Excel.
While working with Microsoft Excel, you can easily perform most common financial
calculations. Listed below are some of the most common functions in Excel for calculating
the elements of an annuity: