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Published by: Rahul Kapale on Sep 25, 2012
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Present Value Annuity Factor The present value annuity factor is used to calculate the present value of futur

e one dollar cash flows. This formula relies on the concept of time value of money. Time value of money i s the concept that a dollar received at a future date is worth less than if the same amount is received today. An amount received today can be invested towards future earnings or receive sooner utility. For this particular formula, the pres ent value of one dollar periodic cash flows is to be used for simplifying the ca lculation of payments larger than one dollar. An example of this equation in pra ctice is determining the original amount of a loan. Use of Present Value Annuity Factor Formula The present value annuity factor is used for simplifying the process of calculat ing the present value of an annuity. A table is used to find the present value p er dollar of cash flows based on the number of periods and rate per period. Once the value per dollar of cash flows is found, the actual periodic cash flows can be multiplied by the per dollar amount to find the present value of the annuity . For example, an individual wants to calculate the present value of a series of $ 500 annual payments for 5 years based on a 5% rate. By looking at a present valu e annuity factor table, the annuity factor for 5 years and 5% rate is 4.3295. Th is is the present value per dollar received per year for 5 years at 5%. Therefor e, $500 can then be multiplied by 4.3295 to get a present value of $2164.75. Present Value Present Value (PV) is a formula used in Finance that calculates the present day value of an amount that is received at a future date. The premise of the equatio n is that there is "time value of money". Time value of money is the concept that receiving something today is worth more than receiving the same item at a future date. The presumption is that it is pre ferable to receive $100 today than it is to receive the same amount one year fro m today, but what if the choice is between $100 present day or $106 a year from today? A formula is needed to provide a quantifiable comparison between an amoun t today and an amount at a future time, in terms of its present day value. Use of Present Value Formula The Present Value formula has a broad range of uses and may be applied to variou s areas of finance including corporate finance, banking finance, and investment finance. Apart from the various areas of finance that present value analysis is used, the formula is also used as a component of other financial formulas. Example of Present Value Formula An individual wishes to determine how much money she would need to put into her money market account to have $100 one year today if she is earning 5% interest o n her account, simple interest. The $100 she would like one year from present day denotes the C1 portion of the formula, 5% would be r, and the number of periods would simply be 1. Putting this into the formula, we would have When we solve for PV, she would need $95.24 today in order to reach $100 one yea r from now at a rate of 5% simple interest. Alternative Formula The Present Value formula may sometimes be shown as Future Value Future Value (FV) is a formula used in finance to calculate the value of a cash flow at a later date than originally received. This idea that an amount today is worth a different amount than at a future time is based on the time value of mo ney. The time value of money is the concept that an amount received earlier is worth

If one w anted to determine what amount they would like to receive one year from now in l ieu of receiving $100 today. an annuity in the form of regular deposits in an interest account wou ld be the sum of the future value of each deposit. if the accoun t is compounded daily. then one month would be one period. corpora te finance all may use the future value formula is some fashion. The future value formula also looks at the effect of compounding. Due to being compounded monthly. Putting these vari ables into the compound interest formula would show The second portion of the formula would be 1.5%).more than if the same amount is received at a later time. Rate and Period in Compound Interest Formula The rate per period (r) and number of periods (n) in the compound interest formu la must match how often the account is compounded. the individual would use the future value formula. By reinvesting the amo unt earned.12683 minus 1. notice that 6% of $1000 is $60. As a side note. Likewise. if on e earns interest of $40 in month one. the number of periods f or one year would be 12 and the rate would be 1% (per month). would be $1000.5% per month and is compounded monthly. This is known as compound interest. The original balance on the account is $1000. Alternative Formula The Future Value formula may also be shown as Compound Interest The compound interest formula calculates the amount of interest earned on an acc ount or investment where the amount earned is reinvested. which can also be referred to as initial cash flow or present value. and n would be 12 (months). we would have: After solving. Putting this into the formula. the idea is that it is better to receive this amount today. As on e example. the interest earned is $ 126. the ending balance after 12 months would be $1061. The additional earnings plus simple inter est would equal the total amount earned from compound interest. an investment will earn money based on the effect of compounding. As the months continue along. See example at the bottom of the page. For example. if one wa s offered $100 today or $100 five years from now.5% pe r month is not the same as earning 6% per year. Example of Future Value Formula An individual would like to determine their ending balance after one year on an account that earns . Compounding is the concept that any amount earned on an investment can be reinve sted to create additional earnings that would not be realized based on the origi nal principal. For this example. assuming that the monthly earnin gs are reinvested. Example of Compound Interest Formula Suppose an account with an original balance of $1000 is earning 12% per year and is compounded monthly. the future value formula is incorporated into other formulas. the next month will earn interest on the o riginal balance plus the $40 from the previous month. if an account is compounded monthly. Earning . The interest on the original balance alone would be called simple interest. . Use of Future Value The future value formula is used in essentially all areas of finance.83. the next month's earnings will make additional monies on the earnings from the prior months. the original balance.005(. By multiplying the o riginal principal by the second portion of the formula. In many ci rcumstances. The opportunity cost for not having this amount in an investment or savings is quantified using the future value formula.68 earned in t his example is due to compounding. The additional $1. For example. then one day would be one period and the rate and number of periods would accommodate this. Banking. alone. investments.68. or original balance. For example. r would b e .

Instead of using this alternative formula. no amount was earned on the interest that wa s earned in prior years. An exam ple of a simple interest calculation would be a 3 year saving account at a 10% r ate with an original balance of $1000. the result would be $1300. Compound Interest Using the prior example.683%. Using compound interest. the effect ive rate would be 12.30. The compound interest earned could be determined by m ultiplying the principal balance by the effective rate.83. it is important that rate and time are appropriat ely measured in relation to one another. If the time is in months. this formula would return an ending balance of $1126. Still using the prior exa mple. Alternative Compound Interest Formula The ending balance of an account with compound interest can be calculated based on the following formula: As with the other formula. the simple interest would be calculated as principal ti mes rate times time. essentially leading to an infinite amou nt of compounding periods. Compound ing is the effect of earning interest on the interest that was previously earned . Continuous Compounding The continuous compounding formula is used to determine the interest earned on a n account that is constantly compounded. the amount earned would be $126. based on the effect of compounding. As with any financial formula. By adding $300 to the original amount of $1000. The additional $6. after 3 years the ba lance would be $1300. Ending Balance with Simple Interest Formula The ending balance. one can earn at an exponential rate. or at times payi ng interest on a debt. Simple interest is money earned or paid that does not have compounding. Using the prior example. By inputting these variables into the for mula. Given this. The simple interest formula is fair ly simple to compute and to remember as principal times rate times time. This can be determined by multiplying the $1000 original b alance times [1+(10%)(3)]. Simple Interest The simple interest formula is used to calculate the interest accrued on a loan or savings account that has simple interest.8 3 earned would be due to the effect of compounding. the amount earned would be higher. By earning interest on prior interest. or times 1. the amount earned could be simply add ed to the original balance to find the ending balance. The effect of compounding is earning interest on an investment. $1000 times 10% times 3 years would be $300. that is reinvested to earn additional monies that would n ot have been gained based on the principal balance alone. If the account was compounde d daily. . or future value.Simple Interest vs. the calculation of the formula that is on the top of the page showed $300 of interest. the interest earned would be $1000 times 1 year times 12%. the simple interest earned would be $120. of an account with simple interest can be c alculated using the following formula: Using the prior example of a $1000 account with a 10% rate. After using this formula. Compound Interest Formula in Relation to APY The compound interest formula contains the annual percentage yield formula of This is due to the annual percentage yield calculating the effective rate on an account.83 . As shown in the previous example. the rate per period and number of periods must match how often the account is compounded. then the rate would need to be the monthly rate and not the annual rate. Using the prior example.

t is time. This alternative formula to the rule of 72 can be shown as If we take a look at the prior example of Rule of 72.net/Continuous_Compounding. the rule of 72 can be applied to estimate the rate needed to doub le an investment within a specific time period.Continuous Compounding FV of Annuity . If a company or i ndividual has large sums involved.2) which will return a balance of $1221. the estimate becomes less accurate. the equation would be This can be shown as $1000 times e(.Continuous Compounding FV . If an individual wants to estimate the rate needed to double their money within 12 years. Breakdowns of Rule of 72 The rule of 72 is generally used for quick estimates in situations where the rat e is in the several percent range. continuous compounding will effectively reinvest gains perpetually. is infinite the formula can be rewrit ten as The limit section in the middle of the formula can be shown as er. As the rate gets too low or too high below an d above approximately 8%. In order for this estim ation to be remotely accurate.40 a fter the two years. we must assume that there will be no withdrawals nor deposits into this account. Doubling Time . one is more likely to r emember the rule of 72 than the exact formula for doubling time or may not have access to a calculator that allows logarithms. we can apply the same exam ple to an individual wanting to estimate what their rate needs to be in order to double their money within a specific period of time. Alternative Formula for Rule of 72 Alternatively. How the Continuous Compounding Formula is derived The continuous compounding formula can be found by first looking at the compound interest formula where n is the number of times compounded. Example of Rule of 72 An individual is earning 6% on their money market account would like to estimate how long it would take to double their current balance. Example of Continuous Compounding Formula A simple example of the continuous compounding formula would be an account with an initial balance of $1000 and an annual rate of 10%. and r is the rate. but the company or individual may choose to use the actual doubli . Instead of compounding interest on an monthly. To calculate the ending b alance after 2 years with continuous compounding. or annual b asis. We can estimate that it will take approximately 12 years to double the current balance after dividing 72 by 6.The continuous compounding formula takes this effect of compounding to the furth est limit. When n. Although the concept of infinit e seems that it would return a very large amount. For comparison. or the number of times compounded. Another issue with the rule of 72 is with large sums of money.Continuous Compounding PV . an account that is compounded monthly will r eturn a balance of $1220. which leads t o the formula at the top of the page. The rule of 72 is primarily used in off the cuff situat ions where an individual needs to make a quick calculation instead of working ou t the exact time it takes to double an investment. the effect of each compound be comes smaller each time. Also.Continuous Compounding http://www. this can be esti mated as 6% from dividing 72 by 12 years.39 after the two years.html Rule of 72 The Rule of 72 is a simple formula used to estimate the length of time required to double an investment.financeformulas. quarterly. this doesn't necessarily affect the outcome o f the formula.

Therefore. The weighted average would be 2. Putting these variables into the formula would be which would return a total weighted average of 3. all weights should be equal to 100%.Future Value • Annuity . and 50% in investment C. the incorr ect return on investment calculated would have been 4.C A ________________________________________ • Annual Percentage Yield (APY) • Annuity .(FV) Solve for n • Annuity . and 2% for investment C. Weighted Average The weighted average formula is used to calculate the average value of a particu lar set of numbers with different levels of relevance. However. and 3 would be the sum of 1 + 2 + 3 divi ded by 3. perhaps due to producing a seasonal product. The weights should be represented as a percentage of t he total relevancy. Use of Weighted Average Formula The concept of weighted average is used in various financial formulas. Example of Weighted Average Formula A basic example of the weighted average formula would be an investor who would l ike to determine his rate of return on three investments. An example would be the average of 1.(PV) Solve for n • Annuity . The weighted average formula is a general mathematical formula. 25% in investment B.Future Value w/ Continuous Compounding • Annuity .35. A .Payment Factor (PV) • Annuity .75% on the total amount investe d. the weighted average formula looks at h ow relevant each number is. The rate of return is 5% for investment A. Another example of using the weighted average formula is when a company has a wi de fluctuation in sales. 6% for investment B .Payment (PV) • Annuity . the company could use the weighted average formula with sales as the weight to gain a better understanding of their expenses compared to how much they produce or se ll. This considerable dif ference between the calculations shows how important it is to use the appropriat e formula to have an accurate analysis on how profitable a company is or how wel l an investment is doing.Payment (FV) • Annuity . This formula adds all of the numbers and divides by the amount of numbers.ng time formula as each decision could affect their profitability on a larger sc ale. If the investor had made the mistake of using the arithmetic mean.PV Factor • Annuity Due . Say that 1 only happens 10% of the time while 2 and 3 each happen 45% of the time. or 1. but the followin g information will focus on how it applies to finance. Weighted average cost of capital (WACC) and weighted average beta are two examples that u se this formula. The relevance of each num ber is called its weight. which would return 2.33%.Future Value • Annuity Due Payment (PV) • Annuity Due Payment (FV) • Asset to Sales Ratio .Present Value • Annuity Due .2. Assume the investments are proportioned accordingly: 25% in investment A. The percentages in this example would be the weig hts.Present Value • Annuity . The most common formula used to determine an average is the arithmetic mean form ula. If the com pany would like to calculate the average of one of their variable expenses.

Stock • Dividends Per Share • Doubling Time • Doubling Time . Compounding E ________________________________________ • Earnings Per Share • Equity Multiplier • Equivalent Annual Annuity • Estimated Earnings F ________________________________________ • Future Value • FV .Payments • Bid Ask Spread • Bond Equivalent Yield • Book Value per Share C ________________________________________ • Capital Asset Pricing Model • Capital Gains Yield • Compound Interest • Continuous Compounding • Contribution Margin • Current Ratio • Current Yield D .Payment (FV) • Growing Annuity .Cont.• Asset Turnover Ratio • Avg Collection Period B ________________________________________ • Balloon Loan .Payment (PV) • Growing Annuity .Continuous Compounding • Future Value Factor G .Future Value • Growing Annuity .I G ________________________________________ • Geometric Mean Return • Growing Annuity .Present Value • Growing Perpetuity .Present Value H ________________________________________ • Holding Period Return I ________________________________________ • Interest Coverage Ratio • Inventory Turnover Ratio .F D ________________________________________ • Days in Inventory • Debt Coverage Ratio • Debt Ratio • Debt to Equity Ratio • Debt to Income Ratio (D/I) • Dividend Payout Ratio • Dividend Yield .

Balloon Balance • Loan .PV & FV O ________________________________________ P ________________________________________ • Payback Period • Perpetuity • Preferred Stock • Present Value • PV .Continuous Compounding • Present Value Factor • Price to Book Value • Price to Earnings (P/E Ratio) • Price to Sales (P/S Ratio) Q .PV with Constant Growth • Stock .J .PV with Zero Growth .P M ________________________________________ N ________________________________________ • Net Asset Value • Net Present Value • Net Profit Margin • Net Working Capital • Number of Periods .L J ________________________________________ K ________________________________________ L ________________________________________ • Loan .Payment • Loan .Remaining Balance • Loan to Deposit Ratio • Loan to Value (LTV) M .S Q ________________________________________ • Quick Ratio R ________________________________________ • Rate of Inflation • Real Rate of Return • Receivables Turnover Ratio • Retention Ratio • Return on Assets (ROA) • Return on Equity (ROE) • Return on Investment • Risk Premium • Rule of 72 S ________________________________________ • Simple Interest • Stock .

can be found on a company's income statement. For return on assets.html . Both of these variables can be found on a company's balance sheet. Use of ROE Formula The return on equity can be used internally by a company or can be used by an in vestor to evaluate how well the company is turning a profit relative to its stoc kholder's equity. Stockholder's equity is also referred to as net assets.T . the denominator is average total assets and for the return on equity formula. Return on Assets Formula The difference between return on equity and return on assets can be found in the denominators of each formula. The numerator of the retu rn on equity formula. See Return on Equity DuPont for further explanati on. sometimes abbreviated as ROE. is a company's n et income divided by its average stockholder's equity. the stockhold er's equity should be averaged based on the time being evaluated. net income. Average Stockholder's Equity in the ROE Formula The denominator of the return on equity formula.net/Return-on-Equity. When calculating the return on equity. i f an investor is calculating the return on equity for 2012. average stockholder's equity. Alternative ROE Formula The return on equity can also be calculated by multiplying Profit Margin x Asset Turnover x Equity Multiplier. ROE Formula vs. http://www. c an be found on a company's balance sheet. the denominator is average st ockholder's equity. Assets shown on a balance sheet is stockholder's equity plus liabilities. Stockholder's equity is a company's as sets minus its liabilities. the return on equity formula is the same as return on assets except that it does not include liabilities.financeformulas. For example. then the beginning a nd ending stockholder's equity should be used.Z W ________________________________________ • Weighted Average X ________________________________________ Y ________________________________________ • Yield to Maturity Z ________________________________________ • Zero Coupon Bond Value • Zero Coupon Bond Yield • Return on Equity (ROE) The formula for return on equity.V T ________________________________________ • Tax Equivalent Yield • Total Stock Return U ________________________________________ V W . Theref ore.

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