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Nov 18, 2014

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about time value of money

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about time value of money

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One of the most fundamental concepts in finance is that money has a time value. That is

to say that money in hand today is worth more than money that is expected to be received in the

future. The reason is straightforward: A dollar that you receive today can be invested such that you

will have more than a dollar at some future time. This leads to the saying that we often use to

summarize the concept of time value: A dollar today is worth more than a dollar tomorrow."

One of the biggest obstacles to correctly solving time value of money problems is

identifying the cash flows and their timing. On this page I will offer some tips that I hope will be

helpful.

Every time value of money problem has five variables: Present value (PV), future value

(FV), number of periods (N), interest rate (i), and a payment amount (PMT). In many cases, one of

these variables will be equal to zero, so the problem will effectively have only four variables. You will

always know the values of all but one of these, and it is that missing value for which you will be

solving.

Present Value

Any value that occurs at the beginning of the problem (or the beginning of a part of the

problem) is a present value. The key is that the present value occurs before any other cash

flows. Usually, when a present value is given, it will be surrounded by words indicating that

an investment happens today.

Future Value

The future value is usually the last cash flow. Obviously, it is a cash flow that occurs at some

time period in the future. The future value is a single cash flow. If it occurs more than once,

then it is probably an annuity payment.

Annuity Payment

An annuity payment is a series of two or more equal payments that occur at regular time

periods. Each payment, if taken alone, is a future value, but the key point is that the annuity

payment is a recurring payment. That is, there are more than one of them in a row.

Interest Rate

The interest rate is the growth rate of your money over the life of the investment. It is usually

the only percentage value that is given. However, some problems will have different interest

rates for different time frames.

For example, problems involving retirement planning will often give pre-retirement and

post-retirement interest rates. Frequently, when you are being asked to solve for the interest

rate, you will be asked to find the compound average annual growth rate (CAGR).

Number of Periods

The number of periods is the total length of time that the investment will be held. Typically, it

is given as a number of years, though it will often need to be adjusted to some other time

scale. For example, if you are told that the investment pays interest quarterly (4 times per

year) then you must adjust N so that it reflects the total number of quarterly (not annual) time

periods.

NOTE: The interest rate, number of periods, and annuity payment variables must all agree on the

length of a time period (a day, a week, a month, a year, etc). That is, i is always the interest rate

per period, N is always the total number of periods, and PMT is always the amount of the

payment per period. Very often, it is necessary to make adjustments to the values given in a

problem. For example, interest rates are usually given as annual rates. However, if payments

occur monthly, then the interest rate must be adjusted to a monthly rate (typically by dividing the

annual rate by 12). Similarly, the number of years would have to be changed to the number of

months.

Even after you have successfully identified the cash flows, it can be difficult to track the timing of

the cash flows in your head. This is where time lines are so important. A time line is a graphical

representation of the size and timing of the cash flows.

When you are first learning to solve time value problems, drawing time lines is a very good idea.

In the picture above, you can easily see that the problem consists of a five-year $100 annuity

(PMT), and a $1,000 cash flow (FV) that occurs at the end of the investment. The time line

helps you to see exactly when each cash flow occurs, and therefore how many periods it needs

to be moved (either forward or backwards in time). As the problems that you are solving

become more complex, the importance of drawing time lines increases.

You can see the power of compound interest in that last example. If we were dealing with

simple interest (i.e., you do not earn interest on top of interest) then you would have earned only

$80 in interest over the 10-year period. However, with compound interest, you have actually

earned $115.89 in interest. So, compounding added an extra $35.89 over 10 years. It gets even

better over longer time frames and/or with higher interest rates.

To see this even better take a look at the following chart, which shows the difference between

compound and simple interest over long periods. Notice how the future value grows

exponentially with compound interest. The dotted line shows the difference in future values over

30 years.

The interval at which is paid also has an effect on the final result. As an alternative to

interest being paid annually it may be paid monthly, quarterly or half yearly. The more frequently

the interest is compounded with a year, the higher the end result.

The rate of interest which is payable more frequently than yearly is called nominal rate of

interest, while the actual rate of interest is called the effective rate of interest.

The formula for converting nominal rate into an effective rate is as follows:

Effective rate= [(1+i/m)^m]-1

While i=nominal rate

M=no.of compounding periods in a year

EXAMPLE:

Effective rate is=(1+10%/4)^4-1=10.38.

Des: Go to CNVR menu

N=No. of compounding in a year=4

I=10

EPF=SOLVE=10.38

The Rule of 72

The Rule of 72 is an often useful tool that can be used to approximate how long it will take to

double your money at a particular interest rate:

Years to double money = 72 interest rate

So, using the rule we can see that at 8% it will take about 9 years to double your money:

Years to double money = 72 8% = 9 years:

If you were to invest a certain dollar amount today, it would grow to a larger

(hopefully!) value at some point in the future. The value at the future point in time is called

the future value. In order to calculate the future value we must know the rate at which the

investment will grow (called the interest rate or discount rate) and the length of time that the

investment will be held (number of periods).

Suppose that you invest $100 today at an interest rate of 8% per year and expect to

hold the investment for one year. How much will the investment be worth at the end of this

period? In other words, what is the future value?

grow at the rate of 8% per year for a period of one year. So, the future value is equal to

the present value plus the interest earned over the course of the year. In other words:

100 + 100 * 0.08 = 108

So, the future value will be $108 at the end of the year. We can express the above equation

algebraically as: In this problem, the $100 that is invested today is known as the present value,

and your investment will

FV1 = PV + PV * i

Example:

interest annually at the rate of 9 percent for seven years.

Solution: N = 7,

I = 9,

PV = 12,000,

PMT = 0 ,

P/Y = 1,

FV = $21,936.47

The present value is the current value of a stream of cash flows. Thus the name: Present value

means "what is it worth right now?" To solve for the present value, we merely rearrange our

basic time value formula:

PV = FVN/(1 + i)N

So, to find the present value we take the future value and divide it by (1 + i)N where N is the

period where the future value is located. Note that since we are dividing the future value, the

present value will always be less than the future value.

EXAMPLE:

An investor can make an investment in a real estate development and receive an expected

cash return of 45,000 after six years. Based on a careful study of other Investment alternatives,

she believes that an 18 percent annual return compounded quarterly is a reasonable return to

earn on this investment. How much should she pay for it today?

SOLUTION: N = 6 4 = 24,

I = 18,

PMT = 0,

FV = 45,000.

P/Y = 4,

PV = $15,646.66.

In the previous sections, we have seen how to calculate present values and future

values of lump sum cash flows. However, in many cases you may need to solve for the number

of periods or the interest rate. The purpose of this section is to show exactly how to do that.

It is important to remember that we are using the basic time value of money formula:

FVN = PV(1 + i)N

All that we need to do is to solve that equation, algebraically, to find either N or i. We will solve

for the interest rate first since it is a more common need and also a bit easier mathematically.

EXAMPLE1: Suppose you have the opportunity to make an investment in a real estate

venture that expects to pay investors 750 at the end of each month for the next eight

years. You believe that a reasonable return on your investment should be 17 percent

compounded monthly. What will be the final value?

SOLUTION: SET=END

N = 8 12 = 96,

I = 17,

PMT = 750,

P/Y = 12,

FV = 0 39,222.96.

EXAMPLE2:

Suppose you deposit 5,000 into an account earning 4 percent interest, compounded monthly.

How many years will it take for your account to be worth 7,500?

SOLUTION: PV = 5,000,

I = 4,

PMT = 0,

FV = 7,500

C/Y = 12,

N = 121.84, or 10.15 YEARS

EXAMPLE3:

You have just borrowed 10,000 and will be required to make monthly payments of 227.53 for the

next five years in order to fully repay the loan. What is the implicit interest rate on this loan?

SOLUTON: N = 5 12 = 60,

PV = 10,000,

PMT = 227.53,

FV = 0

P/Y = 12,

I = 13%

As noted above, according to the principle of value additivity, we can treat an annuity as

a series of lump sum cash flows. Well, we have already seen how to calculate the future value

of a lump sum. All that we need to do is apply this formula to each of the cash flows individually,

and then sum the results:

Using the example shown in the time line (above), and a 9% per period interest rate, we get:

FVA = 100*(1.09)2 + 100*(1.09) + 100 = 327.81

EXAMPLE:

If one saves Rs.1000/- a year at end of every year for three years in an account earning 7% intrest,

compounding annually, how much will one have at the end of thried year?

SOLUTION:

N=3

I=7

PMT=-1000

FV=3215

The internal rate of return (IRR) is a rate of returnused in capital

budgeting to measure and compare the profitability of investments. It is also called

the discounted cash flow rate of return (DCFROR) or simply the rate of return

(ROR).[1] In the context of savings and loans the IRR is also called the effective interest

rate. The term internal refers to the fact that its calculation does not incorporate

environmental factors (e.g., the interest rate or inflation).

EXAMPLE:

What is the internal rate of return of an investment with the following cash

flows? n $

0 (1,000)

1 300

2 300

3 300

4 200

5 100

SOLUTION: goto CASH menu

I0= -1,000,

I1 = 300,

12 = 300,

I3 = 300,

I4 = 200,

I5 = 100,

solve for IRR

In finance, the net present value (NPV) or net present worth (NPW)of a time

series of cash flows, both incoming and outgoing, is defined as the sum of the present

values (PVs) of the individual cash flows of the same entity.

EXAMPLE:

If suppose an investment promises a cash flow of Rs.500 in one year,Rs.600 at the end of

two years and Rs.10,700 at the end of thired year. If discount rate is 5%, what is the value of this

investment today?

SOLUTION:

I=5

FLOW=0=EXE

FLOW1= 500=EXE

FLOW2=600=EXE

FLOW3=10,700=EXE

ESE

NPV=SLOVE=10,263.47

BY

Arun Chowdary

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