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# Time value of money The time value of money is the value of money figuring in a given amount of interest earned

or inflation accrued over a given amount of time. The ultimate principle suggests that a certain amount of money today has different buying power than the same amount of money in the future. This notion exists both because there is an opportunity to earn interest on the money and because inflation will drive prices up, thus changing the "value" of the money. For example, \$100 of today's money invested for one year and earning 5% interest will be worth \$105 after one year. Therefore, \$100 paid now or \$105 paid exactly one year from now both have the same value to the recipient who assumes 5% interest; using time value of money terminology, Some standard calculations based on the time value of money are: 1. Present value The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations. 2. Present value of an annuity An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due. 3. Present value of perpetuity is an infinite and constant stream of identical cash flows. 4. Future value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. 5. Future value of an annuity (FVA) is the future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.

Formula
Present 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. For example, the annuity formula is the sum of a series of present value calculations. The present value (PV) formula has four variables, each of which can be solved for:

1. PV is the value at time=0

2. multiply the above equation by (1 + i). FV is the value at time=n 3. Present value of an annuity for n payment periods In this case the cash flow values remain the same throughout the n periods. the value of cash flow at time t Note that this series can be summed for a given value of n. multiply the above equation by (1 + i). each of which can be solved for: 1. Present value of a growing annuity In this case each cash flow grows by a factor of (1+g). the present value of a growing annuity (PVGA) uses the same variables with the addition of g as the rate of growth of the annuity (A is the annuity payment in the first period). The present value of an annuity (PVA) formula has four variables. or when n is ∞. 2. PV(A) is the value of the annuity at time=0 A is the value of the individual payments in each compounding period i equals the interest rate that would be compounded for each period of time n is the number of payment periods. n is the number of periods (not necessarily an integer) The cumulative present value of future cash flows can be calculated by summing the contributions of FVt. Similar to the formula for an annuity. Where i = g : .This is a very general formula. Where i ≠ g : To get the PV of a growing annuity due. To get the PV of an annuity due. 3. or the interest rate at which the amount will be compounded each period 4. This is a calculation that is rarely provided for on financial calculators. which leads to several important special cases given below. 4. i is the discount rate.

2. FV(A) is the value of the annuity at time = n A is the value of the individual payments in each compounding period i is the interest rate that would be compounded for each period of time n is the number of payment periods To get the FV of an annuity due. In practice. 4. and the application of this valuation approach is subject to various qualifications and modifications.069/4)^(5 yrs*4 qtrs in a year ) = 1000*(1+0. there are few securities with precise characteristics. equities. This is the well known Gordon Growth model used for stock valuation. each of which can be solved for: 1. Present Value of Int Factor Annuity A=P(1+r/n)^nt Investment = 1000 Int 6.Present value of a perpetuity When n → ∞. the PV of a perpetuity (a perpetual annuity) formula becomes simple division. Despite these qualifications. Future value of a growing annuity The future value of a growing annuity (FVA) formula has five variables. and other assets. each of which can be solved for: Where i ≠ g : . Future value of a present sum The future value (FV) formula is similar and uses the same variables. Future value of an annuity The future value of an annuity (FVA) formula has four variables.069/4)^20 = 1407. 3. the general approach may be used in valuations of real estate.90% Compounded Utterly (4 Times in Year) Tenure Yrs 5 = 1000*(1+. multiply the above equation by (1 + i). Most importantly. it is rare to find a growing perpetual annuity with fixed rates of growth and true perpetual cash flow generation.842172 Present value of a growing perpetuity When the perpetual annuity payment grows at a fixed rate (g) the value is theoretically determined according to the following formula.

3.Where i = g : 1. 4. 5. 2. FV(A) is the value of the annuity at time = n A is the value of initial payment paid at time 1 i is the interest rate that would be compounded for each period of time g is the growing rate that would be compounded for each period of time n is the number of payment periods .

In this case. When rates are the same but the periods are different a direct comparison is inaccurate because of the time value of money. or on that portion of the principal amount that remains unpaid. 1.Interest: is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. imagine that a credit card holder has an outstanding balance of \$2500 and that the simple interest rate is 12.  Corporate bond where the first \$3 are due after six months. Paying \$3 every six months costs more than \$6 paid at year end so. For example. the 6% bond cannot be 'equated' to the 6% GIC.  Certificate of deposit (GIC) where \$6 is paid at the year's end: 6/100 = 6%/year. B0 the initial balance and mt the number of time periods elapsed. The amount of simple interest is calculated according to the following formula: Where r is the period interest rate (I/m).99% per annum. And they would have to pay \$2581. There are two complications involved when comparing different simple interest bearing offers. and the second \$3 are due at the year's end: (3+3)/100 = 6%/year. For example. the amount of interest paid would be.[1] or money earned by deposited funds Types of interest Simple interest Simple interest is calculated only on the principal amount.19 to pay off the balance at this point. To calculate the period interest rate r. given a \$100 principal:  Credit card debt where \$1/day is charged: 1/100 = 1%/day = 7%/week = 365%/year. The interest added at the end of 3 months would be. . Their balance at the end of 3 months would still be \$2500. one divides the interest rate I by the number of period’s mt. The steady payments have an additional cost that needs to be considered when comparing loans. If instead they make interest-only payments for each of those 3 months at the period rate r. the time value of money is not factored in. It is most commonly the price paid for the use of borrowed money.

since withdrawing money and immediately depositing it again would be advantageous.. a government is more likely to pay than a private citizen. among other factors. both the value of inflation and the real price of money are changed to their expected values resulting in the following equation: Here. therefore.). the interest rate charged to a private citizen is larger than the rate charged to the government. However. In this particular case. is the nominal interest at the time of the loan. Therefore. One reason behind the difference between the interest that yields a treasury bond and the interest that yields a mortgage loan is the risk that the lender takes from lending money to an economic agent.2. Composition of interest rates In economics. First. Second that the lenders know the inflation for the period of time that they are going to lend the money. does it remain 'interest payable'. A bank account that offers only simple interest. is the real interest expected over the period of the loan. which refers to the price before adjustment to inflation. etc. that money can freely be withdrawn from is unlikely. if this statement were true. To take into account the information asymmetry aforementioned. but compound interest. Nominal interest is composed of the real interest rate plus inflation. . When interest is due. it is also subject to distortions due to inflation. that all interest rates within an area that shares the same inflation (that is. it would imply at least two misconceptions. but not paid. interest is considered the price of credit.e. This formula attempts to measure the value of the interest in units of stable purchasing power. The nominal interest rate. r is the real interest and is inflation. is the one visible to the consumer (i. the interest tagged in a loan contract. credit card statement. A simple formula for the nominal interest is: Where i is the nominal interest. will it be added to the balance due? In the latter case it is no longer simple interest. like the bond's \$3 payment after six months or. is the inflation expected over the period of the loan and is the representative value for the risk engaged in the operation. the same country) should be the same.

This type of interest is basically the opposite of the compound interest rate. Not knowing what type of interest to ask for or what type of interest that you already have can keep you in debts for many. It is important to know and understand what type of interest you have and how you are being charged. After the introductory rate the rates go up and you will be shocked to see how much you now owe on top of your balance in interest rate fees. This type of interest rate keeps going and going. Fixed interest rates If you have a fixed interest rate it is an interest rate that is basically locked in for the duration of the agreement. Introductory interest rates This is an interest rate that is given in the beginning of the offer for the time stated on the agreement. If at all possible steer clear of this type of interest rate. but make sure that the agreement is read thoroughly. . Most creditors offer this type of interest for obvious reasons. This type of rate is given a guideline from the creditor. Fixed interest rates can be beneficial. Below are the different types of interest and how they work. The problem with this interest is that it is extremely hard when trying to find out how to pay off debt because most of the consumer’s minimum payments go towards the interest rates each month and not the principal balance. Partially fixed interest rate This is an interest rate that allows the consumer to pay partial interest on one part of the loan and variable interest on the other.Interest Rates and What They Mean For You Interest rates can become very tricky when trying to understand them and how they work. There are many different types of interest rates with the different ways that they are charged. It is very important not to get sucked into an agreement because the initial sign up looks great. Compound interest rates Compound interest is interest that is charged on a daily basis. Simple interest rates Simple interest is only calculated towards the principal amount that is unpaid. Some of these agreements may state that after a few months the rates will increase. many years. This is the type of interest rate that most consumers are on. it is not charged on a daily basis and the debt can be paid in a most effective manner.

Variable interest rate A variable interest rate is just as it sounds. These interest rates basically flip flop at any given time due to the providers guidelines. it varies depending on the changes in cash rate of other changes made by your provider. .