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Time Value

# Time Value

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09/29/2010

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TIME VALUE OF MONEY.
The
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
a
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
a
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
FV
to be received in one year is discounted (at theappropriate rate of
R
) to give a sum of
PV
at present.Some standard calculations based on the time value of money are:
Present Value
(PV) of an amount that will be received in thefuture.
Future Value
(FV) of an amount invested (such as in a depositaccount) now at a given rate of interest.
Present Value of anAnnuity
(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.
Present Value of aPerpetuity
is the value of a regular streamof payments that lasts "forever", or at least indefinitely.
Calculations
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

for the interest rate (although financial calculators can readilydetermine solutions). These equations are frequently combined for particular uses. Forexample,bondscan be readily priced using these equations. A typicalcoupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sum return of capital at the end of the bond'smaturity- that is, a future payment. The two formulas can be combined to provide a present value for thebond.An important note is that the interest rate
is the interest rate for therelevant period. For an annuity that makes one payment per year, rwill be the annual interest rate. For an income or payment stream witha different payment schedule, the interest rate must be converted intothe relevant periodic interest rate, for example, a monthly rate for amortgage with monthly payments (see the example below). Seecompound interestfor details on converting between different periodicinterest rates. The rate of return in the calculations can be either the variable solvedfor, or a predefined variable that measures a discount rate, interest,inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is criticalto the exercise, and choice of the wrong discount rate can make theresults meaningless. In most cases, however, the mathematics aresimilar, if not identical.For calculations of annuities, you must decide whether the paymentsare made at the beginning of each time period, or (as in the formulasgiven) at the end. The calculator you use will allow the input somehow.
FormulasPresent value of a future sum
The present value formula is the core formula for the time value of money; each of the other formulae is derived from this formula. Forexample, the annuity formula is the sum of a series of present valuecalculations.
Thepresent value(PV) formula has four variables, each of whichcan be solved for:1.PV the value of a dollar at time=02.FV the value of a dollar at time=n in the future

3.r equals the interest rate that would be compounded foreach period of time4.n is the period of time you want to equate.
Future value of a present sum
Thefuture value(FV) formula is similar and uses the samevariable.
 Present value of an annuity
The present value of anannuity(PVA) formula has four variables,each of which can be solved for:1.PVA the value of the annuity at time=02.A the value of the individual payments in eachcompounding period3.r equals the interest rate that would be compounded foreach period of time4.n is the number of payment periods.
Future value of an annuity
The future value of anannuity(FVA) formula has four variables,each of which can be solved for:1.FVA the value of the annuity at time=n2.A the value of the individual payments in eachcompounding period3.r equals the interest rate that would be compounded foreach period of time4.n is the number of payment periods.
Present value of a growing annuity