You are on page 1of 12

# Time Value Of Money: Determining Your Future

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.

## Time Value of Money

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,

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.

## Illustrating the Net Present Value

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.

## Specific variations of time value of money calculations are:

• 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.

## Five Factors to a TVM Calculation.

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

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
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

## What Does Present Value - PV Mean?

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.

## Investopedia explains Present Value - PV

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.

## The calculation of discounted or present value is extremely important in many financial

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

## What Does Future Value - FV Mean?

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:

## 1) For an asset with simple annual interest: = Original Investment x (1+(interest

rate*number of years))

## 2) For an asset with interest compounded annually: = Original Investment x ((1+interest

rate)^number of years)

## Investopedia explains Future Value - FV

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.

## Calculating The Present And Future Value Of

Annuities
by Shauna Carther (Contact Author | Biography)

Email Article

Print

Feedback

Reprints

Share
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.)

## What Are Annuities?

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.

## Calculating the Future Value of an Ordinary Annuity

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:

## C = Cash flow per period

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.)

## Calculating the Present Value of an Ordinary Annuity

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.

## C = Cash flow per period

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

## What Does Nominal Interest Rate Mean?

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.

## Investopedia explains Nominal Interest 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.

## What Does Effective Annual Interest Rate Mean?

An investment's annual rate of interest when compounding occurs more often than once
a year. Calculated as the following:

## Investopedia explains Effective Annual Interest Rate

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