Time value of money

Time value of money means that the value of a unit of money is different in different time periods. The value of a sum of money received today is more valuable than the money received after sometime.

Present value:The current value of a future amount of money or a series of payments or cash flows, evaluated at a given interest rate.

The present value of a single amount is calculated as PV= FV/ (1+i)n

PV= FV x PVIF i,n

Where i = interest rate per year n= number of years.

The present value of a series of payments is calculated as PV= FV x PVIFA i,n

Example of Present value:

Simple interestSimple interest is interest paid (earned) on only the original amount, or principal, borrowed.

Compound interestCompound interest is interest paid (earned) on any previous interest earned, as well as on the principal borrowed.

Amortization1. The paying off of debt in regular installments over a period of time.

2. The deduction of capital expenses over a specific period of time (usually over the asset's life). More specifically, this method measures the consumption of the value of intangible assets, such as a patent or a copyright.

PerpetuityA constant stream of identical cash flows with no end.

Future value:The value, at some future time, of a present amount of money or a series of payments or cash flows, evaluated at a given interest rate.

The future value of a single amount is calculated as FV=PV X (1+i)n

FV= PV x FVIF i,n

Where i = interest rate per year n = number of years.

The future value of a series of payments is calculated as FV= PV x FVIFA i,n

Example of Future value:

AnnuityAn annuity is a series of equal payments or receipts occurring over a specified number of periods.

Ordinary AnnuityWhen a series of equal cash flows occur at the end of each period, is known as Ordinary Annuity.

PV and FV of ordinary annuity are calculated as

Present value of an ordinary annuity – cash flows occur at the end of each period, and present value is calculated as of one period before the first cash flow.

Future value of an ordinary annuity – cash flows occur at the end of each period, and future value is calculated as of the last cash flow.

Annuity DueWhen a series of equal cash flows occur at the beginning of each period, is known as Annuity Due.

PV and FV of annuity due are calculated as

Present value of an annuity due – cash flows occur at the beginning of each period, and present value is calculated as of the first cash flow.

Future value of an annuity due – cash flows occur at the beginning of each period, and future value is calculated as of one period after the last cash flow.