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Worth

If you were offered $100 today or $100 a year from now, which would you choose?

Would you rather have $100,000 today or $1,000 a month for the rest of your life?

Net present value (NPV) provides a simple way to answer these types of financial

questions. This calculation compares the money received in the future to an amount of

money received today, while accounting for time and interest. It's based on the principle

of time value of money (TVM), which explains how time affects monetary value. (For

background reading, see Understanding The Time Value Of Money.)

The TVM calculation may look complicated, but with some understanding of NPV and

how the calculation works, along with its basic variations: present value and future

value, we can start putting this formula to use in common application.

If you were offered $100 today or $100 a year from now, which would be the better

option and why?

This question is the classic method in which the TVM concept is taught in virtually every

business school in America. The majority of people asked this question choose to take

the money today. But why? What are the advantages and, more importantly,

disadvantages of this decision?

There are three basic reasons to support the TVM theory. First, a dollar can be invested

and earn interest over time, giving it potential earning power. Also, money is subject to

inflation, eating away at the spending power of the currency over time, making it worth

less in the future. Finally, there is always the risk of not actually receiving the dollar in

the future - if you hold the dollar now, there is no risk of this happening. Getting an

accurate estimate of this last risk isn't easy and, therefore, it's harder to use in a precise

manner.

Would you rather have $100,000 today or $1,000 a month for the rest of your life?

Most people have some vague idea of which they'd take, but a net present value

calculation can tell you precisely which is better, from a financial standpoint, assuming

you know how long you will live and what rate of interest you'd earn if you took the

$100,000.

• Net Present Value (lets you value a stream of future payments into one lump

sum today, as you see in many lottery payouts)

• Present Value (tells you the current worth of a future sum of money)

• Future Value (gives you the future value of cash that you have now)

Determining the Time Value of Your Money

Which would you prefer: $100,000 today or $120,000 a year from now?

The $100,000 is the "present value" and the $120,000 is the "future value" of your

money. In this case, if the interest rate used in the calculation is 20%, there is no

difference between the two.

1. Number of time periods involved (months, years)

2. Annual interest rate (or discount rate, depending on the calculation)

3. Present value (what do you have right now in your pocket)

4. Payments (if any exist. If not, payments equal zero)

5. Future value (the dollar amount you will receive in the future. A standard mortgage

will have a zero future value, because it is paid off at the end of the term)

Many people use financial calculators to quickly solve these TVM questions. By

knowing how to use one, you could easily calculate a present sum of money into a

future one, or vice versa. The same goes for determining the payment on a mortgage,

or how much interest is being charged on that short-term Christmas expenses loan.

With four of the five components in-hand, the financial calculator can easily determine

the missing factor. To calculate this by hand, the formula would look like this:

FV = PV (1+i)N

Or conversely

PV = FV

(1+i)N

Net present value calculations can also help you discover answers to other

questions. Retirement planning needs can be determined on an overall, monthly or

annual basis, as can the amount to contribute for college funds. By using a net present

value calculation, you can find out how much you need to invest each month to achieve

your goal. For example, in order to save $1 million dollars to retire in 20 years,

assuming an annual return of 12.2%, you must save $984 per month. Try the

calculation and test it for yourself. (To learn more about how compounding contributes

to retirement savings, see Young Investors: What Are You Waiting For? and Why is

retirement easier to afford if you start early?)

Below is a list of the most common areas in which people use net present value

calculations to help them make decisions and solve their financial problems.

• Mortgage payments

• Student loans

• Savings

• Home, auto or other major purchases

• Credit cards

• Money management

• Retirement planning

• Investments

• Financial planning (both business and personal)

Conclusion

The net present value calculation and its variations are quick and easy ways to measure

the effects of time and interest on a given sum of money, whether it is received now or

in the future. The calculation is perfect for short- and- long-term planning, budgeting or

reference. When plotting out your financial future, keep this formula in mind.

Present Value - PV

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.

This sounds a bit confusing, but it really isn't. The basis is that receiving $1,000 now is

worth more than $1,000 five years from now, because if you got the money now, you

could invest it and receive an additional return over the five years.

calculations. For example, net present value, bond yields, spot rates, and pension

obligations all rely on the principle of discounted or present value. Learning how to use

a financial calculator to make present value calculations can help you decide whether

you should accept a cash rebate, 0% financing on the purchase of a car or to pay points

on a mortgage

Future Value - FV

The value of an asset or cash at a specified date in the future that is equivalent in value

to a specified sum today. There are two ways to calculate FV:

rate*number of years))

rate)^number of years)

Consider the following examples:

1) $1000 invested for 5 years with simple annual interest of 10% would have a future

value of $1,500.00.

2) $1000 invested for 5 years at 10%, compounded annually has a future value of

$1,610.51.

Annuities

by Shauna Carther (Contact Author | Biography)

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Filed Under: Formulas, Personal Finance, Retirement, Savings

At some point in your life you may have had to make a series of fixed payments over a

period of time - such as rent or car payments - or have received a series of payments

over a period of time, such as bond coupons. These are called annuities. If you

understand the time value of money and have an understanding of future and present

value you're ready to learn about annuities and how their present and future values are

calculated. (To read more on this subject, see Understanding The Time Value Of

Money and Continuously Compound Interest.)

Annuities are essentially series of fixed payments required from you or paid to you at a

specified frequency over the course of a fixed period of time. The most common

payment frequencies are yearly (once a year), semi-annually (twice a year), quarterly

(four times a year) and monthly (once a month). There are two basic types of annuities:

ordinary annuities and annuities due.

• Ordinary Annuity: Payments are required at the end of each period. For example,

straight bonds usually pay coupon payments at the end of every six months until

the bond's maturity date.

• Annuity Due: Payments are required at the beginning of each period. Rent is an

example of annuity due. You are usually required to pay rent when you first move

in at the beginning of the month, and then on the first of each month thereafter.

Since the present and future value calculations for ordinary annuities and annuities due

are slightly different, we will first discuss the present and future value calculation for

ordinary annuities.

If you know how much you can invest per period for a certain time period, the future

value of an ordinary annuity formula is useful for finding out how much you would have

in the future by investing at your given interest rate. If you are making payments on a

loan, the future value is useful for determining the total cost of the loan.

Let's now run through Example 1. Consider the following annuity cash flow schedule:

In order to calculate the future value of the annuity, we have to calculate the future

value of each cash flow. Let's assume that you are receiving $1,000 every year for the

next five years, and you invested each payment at 5%. The following diagram shows

how much you would have at the end of the five-year period:

Since we have to add the future value of each payment, you may have noticed that, if

you have an ordinary annuity with many cash flows, it would take a long time to

calculate all the future values and then add them together. Fortunately, mathematics

provides a formula that serves as a short cut for finding the accumulated value of all

cash flows received from an ordinary annuity:

i = interest rate

n = number of payments

If we were to use the above formula for Example 1 above, this is the result:

= $1000*[5.53]

= $5525.63

Note that the one cent difference between $5,525.64 and $5,525.63 is due to a

rounding error in the first calculation. Each of the values of the first calculation must be

rounded to the nearest penny - the more you have to round numbers in a calculation the

more likely rounding errors will occur. So, the above formula not only provides a short-

cut to finding FV of an ordinary annuity but also gives a more accurate result. (Now that

you know how to do these on your own, check out our Future Value of an Annuity

Calculator for the easy method.)

If you would like to determine today's value of a series of future payments, you need to

use the formula that calculates the present value of an ordinary annuity. This is the

formula you would use as part of a bond pricing calculation. The PV of ordinary annuity

calculates the present value of the coupon payments that you will receive in the future.

For Example 2, we'll use the same annuity cash flow schedule as we did in Example 1.

To obtain the total discounted value, we need to take the present value of each future

payment and, as we did in Example 1, add the cash flows together.

Again, calculating and adding all these values will take a considerable amount of time,

especially if we expect many future payments. As such, there is a mathematical shortcut

we can use for PV of ordinary annuity.

i = interest rate

n = number of payments

The formula provides us with the PV in a few easy steps. Here is the calculation of the

annuity represented in the diagram for Example 2:

= $1000*[4.33]

= $4329.48

Not that you'd want to use it now that you know the long way to get present value of an

annuity, but just in case, you can check out our Present Value of an Annuity Calculator.

Calculating the Future Value of an Annuity Due

When you are receiving or paying cash flows for an annuity due, your cash flow

schedule would appear as follows:

Since each payment in the series is made one period sooner, we need to discount the

formula one period back. A slight modification to the FV-of-an-ordinary-annuity formula

accounts for payments occurring at the beginning of each period. In Example 3, let's

illustrate why this modification is needed when each $1,000 payment is made at the

beginning of the period rather than the end (interest rate is still 5%):

Notice that when payments are made at the beginning of the period, each amount is

held for longer at the end of the period. For example, if the $1,000 was invested on

January 1st rather than December 31st of each year, the last payment before we value

our investment at the end of five years (on December 31st) would have been made a

year prior (January 1st) rather than the same day on which it is valued. The future value

of annuity formula would then read:

Therefore,

= $1000*5.53*1.05

= $5801.91

Check out our Future Value Annuity Due Calculator to save some time.

Calculating the Present Value of an Annuity Due

For the present value of an annuity due formula, we need to discount the formula one

period forward as the payments are held for a lesser amount of time. When calculating

the present value, we assume that the first payment was made today.

We could use this formula for calculating the present value of your future rent payments

as specified in a lease you sign with your landlord. Let's say for Example 4 that you

make your first rent payment at the beginning of the month and are evaluating the

present value of your five-month lease on that same day. Your present value calculation

would work as follows:

Of course, we can use a formula shortcut to calculate the present value of an annuity

due:

Therefore,

= $1000*4.33*1.05

= $4545.95

Recall that the present value of an ordinary annuity returned a value of $4,329.48. The

present value of an ordinary annuity is less than that of an annuity due because the

further back we discount a future payment, the lower its present value: each payment or

cash flow in ordinary annuity occurs one period further into future.

Check out our Present Value Annuity Due Calculator.

Conclusion

Now you can see how annuity affects how you calculate the present and future value of

any amount of money. Remember that the payment frequencies, or number of

payments, and the time at which these payments are made (whether at the beginning or

end of each payment period) are all variables you need to account for in your

calculations.

Nominal Interest Rate

Nominal interest rates refer to referes to the rate of interest prior to taking inflation into

account. Depending on its application, an inflation and risk premium must be added to

the real interest rate in order to obtain the nominal rate.

Nominal Interest Rate = Real Interest Rate + Inflation Premium + Risk Premium

In practice, the inflation premium is often assumed to be the expected inflation rate and

the risk premium is ignored. Unless the economy is experiencing a deflationary period,

the nominal rate will be higher than the real rate.

An investment's annual rate of interest when compounding occurs more often than once

a year. Calculated as the following:

Consider a stated annual rate of 10%. Compounded yearly, this rate will turn $1000 into

$1100. However, if compounding occurs monthly, $1000 would grow to $1104.70 by the

end of the year, rendering an effective annual interest rate of 10.47%. Basically the

effective annual rate is the annual rate of interest that accounts for the effect of

compounding

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