Time Value of Money

Time value of money is a fundamental financial concept that states that a sum of
money is worth more today than the same sum in the future. This is due to its
potential earning capacity in the interim

Money is worth more today than it will be tomorrow.

Why is Money Worth More Now?

 Investment Potential: Money you have now can be invested to earn

interest, dividends, or capital gains, increasing its value over time
 Inflation: The purchasing power of money tends to decrease over time
due to inflation, reducing the value of future money
 Uncertainty: There's always a risk that something might happen in the
future that prevents you from receiving the money, making it less
certain and therefore less valuable.

Key TVM Concepts

 Present Value (PV): The current worth of a future sum of money or stream of
cash flows, given a specified rate of return.
 Future Value (FV): The value of a current asset at a specific point in the
future, based on an assumed rate of growth.
 Discount Rate: The rate of return used to calculate the present value of
future cash flows.
 Compounding: The process of earning interest on both the principal amount
and the accumulated interest.
 Discounting: The process of determining the present value of future cash
flows.

Applications of TVM

The time value of money is crucial in various financial decisions, including:

 Investments: Evaluating the profitability of different investment options.

 Loans: Calculating loan payments and interest costs.
 Savings: Determining the future value of savings and retirement planning.
 Real Estate: Analyzing property values and investment returns.
Simple Interest

Simple interest is a straightforward way to calculate interest on a loan or

investment. It's based solely on the original amount borrowed or invested (the
principal).

Key points:

 Only the principal earns interest.

 Interest is calculated on the original amount, not on the accumulated
interest.
 It's a basic method often used for short-term loans or investments.

Formula:

 Simple Interest (SI) = (Principal * Rate * Time) / 100

o Principal (P): The initial amount borrowed or invested.
o Rate (R): The interest rate per year (expressed as a percentage).
o Time (T): The time period in years.

When is simple interest used?

 Short-term loans
 Savings accounts (though often compound interest is used)
 Basic financial calculations

Important note: Simple interest is a basic concept, and in most real-world financial
situations, interest is calculated using compound interest, which is more complex.

Compound interest

Imagine your money making money. That's compound interest in a nutshell.

Unlike simple interest, where you only earn interest on the original amount you
invested, compound interest lets your money grow exponentially.

Here’s how it works:

 You invest money: Let's say you invest $100.

 You earn interest: Your money grows, let's say by 10%, giving you
$110.
 The magic happens: The next time interest is calculated, it's not just
on the original $100, but on the new amount of $110.

So, your money grows faster and faster over time.

Compound Interest Formula

A = P(1 + r/n)^(nt)

Where:

 A is the final amount (including principal and interest)

 P is the principal amount (initial investment)
 r is the annual interest rate (as a decimal)
 n is the number of times interest is compounded per year
 t is the number of years

Present Value

Imagine you're promised $1,000 in five years. While that sounds good, the
question is: what is that $1,000 worth to you today? This is where present
value comes in.

To determine the present value, we need to consider:

 Future Value (FV): The amount you'll receive in the future.

 Discount Rate (r): This is essentially the rate of return you could earn
on your money if you invested it today.
 Number of periods (n): The time period between today and the future
date when you'll receive the money.

-of 1 amount

Present Value of a Single Amount

Present value is the current worth of a future sum of money or stream of cash
flows, given a specified rate of return. In simpler terms, it tells you how much
a future amount of money is worth today.

Formula for Present Value

 PV = FV / (1 + r)^n

Where:

 PV is the present value

 FV is the future value
 r is the discount rate (or interest rate)
 n is the number of periods
-of ordinary annuity

An ordinary annuity
is a series of equal payments made at the end of each period. The present
value of an ordinary annuity is the current value of those future payments.

Formula

 PV = PMT * [(1 - (1 + r)^-n) / r]

Where:

 PV = Present value of the annuity

 PMT = Payment made each period
 r = Interest rate per period
 n = Number of periods

-annuity due/advance

An annuity due
is a series of equal payments made at the beginning of each period. To
calculate its present value, we adjust the formula for an ordinary annuity.

Formula

 PV = PMT * [(1 - (1 + r)^-n) / r] * (1 + r)

Notice the extra (1 + r) at the end compared to the ordinary annuity formula.
This accounts for the fact that the first payment is made immediately.

How it Works

1. Discounting Future Payments: Each payment in the annuity is discounted

back to its present value using the discount rate.
2. Summing Up Present Values: The present values of all individual
payments are added together to determine the total present value of the
annuity.

Understanding the Difference

As mentioned, the primary difference between an ordinary annuity and an

annuity due is the timing of the payments.

Ordinary annuity: Payments occur at the end of each period.

Annuity due: Payments occur at the beginning of each period.
Because the first payment in an annuity due is made immediately, it earns interest
for an entire period, making its present value higher than that of an ordinary annuity
with the same terms.

The Extra (1+r) Factor

The (1+r) factor at the end of the annuity due formula accounts for the interest
earned on the first payment. Essentially, it's like treating the first payment as if
it were an immediate lump sum investment that earns interest for one period.

When to Use Annuity Due

Annuity due calculations are often used for:

 Lease payments: Rent is typically paid at the beginning of a lease period.

 Loan payments: Mortgage and car loan payments are often made at
the beginning of the month.
 Insurance premiums: These are usually paid in advance.

Future Value

-of 1 amount

Future value is the value of a current asset at a specific point in the future, based on
an assumed rate of growth (interest rate). In essence, the future value formula helps
you project the growth of your money over time, considering the effects of interest
and compounding.

Formula

 FV = PV * (1 + r)^n

Where:

 FV is the future value

 PV is the present value (initial amount)
 r is the interest rate per period
 n is the number of periods

-of ordinary annuity

Future value of an ordinary annuity is the total amount of a series of equal

payments and the accumulated interest at a specific future date.

Formula

 FV = PMT * [(1 + r)^n - 1] / r

Where:

 FV is the future value of the annuity

 PMT is the payment made each period
 r is the interest rate per period
 n is the number of periods

Difference Between Future Value of a Single Amount and

Ordinary Annuity

Future Value of a Single Amount

 Involves a lump sum invested at a specific point in time.

 Calculates the total value of that lump sum at a future date, considering
interest earned.
 Uses the formula: FV = PV * (1 + r)^n

Future Value of an Ordinary Annuity

 Involves a series of equal payments made at the end of each period.

 Calculates the total value of those payments and the interest earned on
them at a future date.
 Uses the formula: FV = PMT * [(1 + r)^n - 1] / r

Key Differences:

In essence:

 Future value of a single amount focuses on the growth of a one-time

investment.
 Future value of an ordinary annuity focuses on the growth of a series
of regular investments.