TIME VALUE OF MONEY.
time value of money
is the premise that an investor prefers toreceive a payment of a fixed amount of money today, rather than anequal amount in the future, all else being equal. In other words, thepresent value of a certain amount
of money is greater than thepresent value of the right to receive the same amount of money time
in the future. This is because the amount
could be deposited in aninterest-bearing bank account (or otherwise invested) from now totime
and yieldinterest. Consequently, lenders acting atarm's length
demand interest payments for use of theircapital.Additional motivations for demanding interest are to compensate forthe risk of borrower default and the risk of inflation (as well as someother more technical factors).All of the standard calculations are based on the most basic formula,the present value of a future sum, "discounted" to a present value. Forexample, a sum of
to be received in one year is discounted (at theappropriate rate of
) to give a sum of
at present.Some standard calculations based on the time value of money are:
(PV) of an amount that will be received in thefuture.
(FV) of an amount invested (such as in a depositaccount) now at a given rate of interest.
(PVA) is the present value of astream of (equally-sized) future payments, such as a mortgage.
Future Value of an Annuity
(FVA) is the future value of astream of payments (annuity), assuming the payments areinvested at a given rate of interest.
is the value of a regular streamof payments that lasts "forever", or at least indefinitely.
There are several basic equations that represent the equalities listedabove. The solutions may be found using (in most cases) a financialcalculator or other means.For any of the equations below, the formulae may also be rearrangedto determine one of the other unknowns. In the case of the standardannuity formula, however, there is no closed-form algebraic solution