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Time Value of Money

Time Value of Money

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Published by: Muhammad Bilal Israr on Mar 02, 2012
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Understanding the Time Value of Money
 
Time Value of Money
Introduction
Time Value of Money (TVM) is an important concept in financial management. It can be used tocompare investment alternatives and to solve problems involving loans, mortgages, leases,savings, and annuities.TVM is based on the concept that a dollar that you have today is worth more than the promise orexpectation that you will receive a dollar in the future. Money that you hold today is worth morebecause you can invest it and earn interest. After all, you should receive some compensation forforegoing spending. For instance, you can invest your dollar for one year at a 6% annual interestrate and accumulate $1.06 at the end of the year. You can say that the
future value
of the dollaris $1.06 given a 6%
interest rate
and a one-year
period
. It follows that the
present value
of the$1.06 you expect to receive in one year is only $1.A key concept of TVM is that a single sum of money or a series of equal, evenly-spacedpayments or receipts promised in the future can be converted to an equivalent valuetoday. Conversely, you can determine the value to which a single sum or a series of futurepayments will grow to at some future date.You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods,Payments, Present Value, and Future Value. Each of these factors is very briefly defined in theright-hand column below. The left column has references to more detailed explanations,formulas, and examples.
Cash Flow Diagrams
 
A cash flow diagram is a picture of a financial problem that shows all cash inflows and outflowsplotted along a horizontal time line. It can help you to visualize a financial problem and todetermine if it can be solved using TVM methods.
Constructing a Cash Flow Diagram
The time line is a horizontal line divided into equal periods such as days, months, or years. Eachcash flow, such as a payment or receipt, is plotted along this line at the beginning or end of theperiod in which it occurs. Funds that you
pay out
such as savings deposits or lease payments are
negative cash flows
that are represented by arrows which extend downward from the time line
 
with their bases at the appropriate positions along the line. Funds that you
receive
such asproceeds from a mortgage or withdrawals from a saving account are
positive cash flow
srepresented by arrows extending upward from the line.
Example:
You are 40 years old and have accumulated $50,000 in your savings account. Youcan add $100 at the end of each month to your account which pays an annual interest rate of 6%compounded monthly. Will you be able to retire in 20 years?The time line is divided into 240 monthlyperiods (20 years times 12 payments per year) since the payments are made monthly and the interest is also compounded monthly. The $50,000 that you have now(present value)is a negative cash outflow since you will treat it as though you were just now depositing it into the account. It is represented with a downward pointing arrowwith its base at the beginning of the first period. The 240 monthly $100 deposits are alsonegative outflows represented with downward pointing arrows placed at the end of eachperiod. Finally you will withdraw some unknown amount (thefuture value)after 20 years. Represent this positive inflow with an upward pointing arrow with its base at the veryend of the last period.This diagram was drawn from your point of view. From the bank's point of view, the presentvalue and the series of deposits are positive cash inflows, and the final withdrawal of the futurevalue will be a negative outflow.
Identifying TVM Problems
For a financial problem to be solved with time value of money formulas:
 
the periods must be of equal length
 
payments, if present, must all be equal and be all inflows or all outflows
 
payments must all occur either at the beginning or end of a period
 
the interest rate cannot vary along the time line
 
Annuity
 
The term annuity is used in finance theory to refer to any terminating stream of fixed payments over a specified period of time. This usage is most commonly seen in discussions of finance,usually in connection with the valuation of the stream of payments, taking into accounttimevalue of money concepts such as interest rate and future value  Examples of annuities are regular deposits to a savings account, monthly home mortgagepayments and monthly insurance payments. Annuities are classified by the frequency of paymentdates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any otherinterval of time.
An
 annuity
is a series of payments at equal time intervals
 
An
 ordinary annuity
assumes the first payment occurs at the end of the first year
 
An
 annuity due
assumes the first payment occurs at the beginning of the first year
 
Ordinary annuity
An
ordinary annuity
(also referred as
annuity-immediate
) is an annuity whose payments aremade at the end of each period (e.g. a month, a year). The values of an ordinary annuity can becalculated through the following:
 
Let:
= the yearly nominal interest rate. 
= the number of years.
m
= the number of periods per year.
i
= the interest rate per period.
n
= the number of periods.Note:Also let:
P
= the principal (or present value).
S
= the future value of an annuity.
 R
= the periodic payment in an annuity (the amortized payment).

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