Time Value of Money

The time value of money serves as the foundation for all other notions in finance. It impacts
business finance, consumer finance, and government finance. Time value of money results from
the concept of interest.

This overview covers an introduction to simple interest and compound interest, illustrates the use
of time value of money tables, shows a matrix approach to solving time value of money
problems, and introduces the concepts of intrayear compounding, annuities due, and perpetuities.
A simple introduction to working time value of money problems on a financial calculator is
included as well as additional resources to help understand time value of money.

Time Value of Money

The time value of money serves as the foundation for all other notions in finance. It impacts
business finance, consumer finance, and government finance. Time value of money results from
the concept of interest.

This overview covers an introduction to simple interest and compound interest, illustrates the use
of time value of money tables, shows a matrix approach to solving time value of money
problems, and introduces the concepts of intrayear compounding, annuities due, and perpetuities.
A simple introduction to working time value of money problems on a financial calculator is
included as well as additional resources to help understand time value of money.

Explanation of of the Concept of Time Value of Money

Investments commonly involve returns that extend over fairly long period of time.

Therefore, in approaching capital budgeting decisions, it is necessary to employ techniques

that recognize the time value of money.

"A dollar today is worth more than a dollar a year from now"

The same concept applies in choosing between investment projects. Those projects that
promise earlier returns are preferable to those that promise later retunes. The capital
budgeting techniques that recognize the above two characteristics of business
investments most fully are those that involve discounted cash flow. Two approaches to
making capital budgeting decisions use discounted cash flows. One is the net present
value method and other is internal rate of return method
Annuities

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Using Tables to Solve Future Value of Annuity Problems

An annuity is an equal, annual series of cash flows. Annuities may be equal annual deposits,
equal annual withdrawals, equal annual payments, or equal annual receipts. The key is equal,
annual cash flows.

When cash flows occur at the end of the year, this makes them an ordinary annuity. If the cash
flows were at the beginning of the year, they would be an annuity due. Annuities due will be
covered a later.

Annuities work as follows:

 Annuity = Equal Annual Series of Cash Flows

 Assume annual deposits of $100 deposited at end of year earning 5% interest for three years

Year 1: $100 deposited at end of year = $100.00

Year 2: $100 × .05 = $5.00 + $100 + $100 = $205.00

Year 3: $205 × .05 = $10.25 + $205 + $100 = $315.25

Again, there are tables for working with annuities. TVM Table 2: Future Value of Annuity
Factors is the table to be used in calculating annuities due. Basically, this table works the same
way as the previous table. Look up the appropriate number of periods, locate the appropriate
interest, take the factor found and multiply it by the amount of the annuity.

For instance, on the three-year, 5% interest annuity of $100 per year. Going down three years,
out to 5%, the factor of 3.152 is found. Multiply that by the annuity of $100 yields a future value
of $315.20.

Present Value

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Using Tables to Solve Present Value Problems

Present value is simply the reciprocal of compound interest. Another way to think of present
value is to adopt a stance out on the time line in the future and look back toward time 0 to see
what was the beginning amount.

Present Value

Present Value = P0 = Pn / (1+I)n

TVM Table 3 shows Present Value Factors. Notice that they are all less than one. Therefore,
when multiplying a future value by these factors, the future value is discounted down to present
value.

The table is used in much the same way as the previously discussed time value of money tables.
To find the present value of a future amount, locate the appropriate number of years and the
appropriate interest rate, take the resulting factor and multiply it times the future value.

Definition of 'Net Present Value - NPV'

The difference between the present value of cash inflows and the present value of cash outflows.
NPV is used in capital budgeting to analyze the profitability of an investment or project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project
will yield.

Formula:
In addition to the formula, net present value can often be calculated using tables, and
spreadsheets such as Microsoft Excel.

Books

 M Y Khan and P K Jain : Financial Management (TMH)

 Prasanna Chandra, Financial Management. TMH