effective time_value_of_money in finance

Content type

User Generated

Type

Study Guide

Uploaded By

Znhyvx

Pages

Rating

Time Value of Money

Introduction

Time Value of Money (TVM) is an important concept in financial management. It can be used to

compare investment alternatives and to solve problems involving loans, mortgages, leases,

savings, and annuities.

TVM is based on the concept that a dollar that you have today is worth more than the promise or

expectation that you will receive a dollar in the future. Money that you hold today is worth more

because you can invest it and earn interest. After all, you should receive some compensation for

foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest

rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar

is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the

$1.06 you expect to receive in one year is only $1.

A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced

payments or receipts promised in the future can be converted to an equivalent value

today. Conversely, you can determine the value to which a single sum or a series of future

payments will grow to at some future date.

You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods,

Payments, Present Value, and Future Value. Each of these factors is very briefly defined in the

right-hand column below. The left column has references to more detailed explanations,

formulas, and examples.

Interest

 Simple

 Compound

Interest is a charge for borrowing money, usually stated as a

percentage of the amount borrowed over a specific period of

time. Simple interest is computed only on the original amount

borrowed. It is the return on that principal for one time period. In

contrast, compound interest is calculated each period on the original

amount borrowed plus all unpaid interest accumulated to

date. Compound interest is always assumed in TVM problems.

Number of Periods

Periods are evenly-spaced intervals of time. They are intentionally

not stated in years since each interval must correspond to a

compounding period for a single amount or a payment period for an

annuity.

Payments

Payments are a series of equal, evenly-spaced cash flows. In TVM

applications, payments must represent all outflows (negative amount)

or all inflows (positive amount).

Present Value

 Single Amount

 Annuity

Present Value is an amount today that is equivalent to a future

payment, or series of payments, that has been discounted by an

appropriate interest rate. The future amount can be a single sum that

will be received at the end of the last period, as a series of equally-

spaced payments (an annuity), or both. Since money has time value,

the present value of a promised future amount is worth less the longer

you have to wait to receive it.

Future Value

 Single Amount

 Annuity

Future Value is the amount of money that an investment with a

fixed, compounded interest rate will grow to by some future date. The

investment can be a single sum deposited at the beginning of the first

period, a series of equally-spaced payments (an annuity), or

both. Since money has time value, we naturally expect the future

value to be greater than the present value. The difference between the

two depends on the number of compounding periods involved and the

going interest rate.

Loan Amortization

A method for repaying a loan in equal installments. Part of each

payment goes toward interest and any remainder is used to reduce the

principal. As the balance of the loan is gradually reduced, a

progressively larger portion of each payment goes toward reducing

principal.

Cash Flow

Diagram

A cash flow diagram is a picture of a financial problem that shows all

cash inflows and outflows along a time line. It can help you to

visualize a problem and to determine if it can be solved by TVM

methods.

%, fixed-rate mortgage, a person must pay $898.83 each month for 180 months (with a small

adjustment at the end to account for rounding). $583.33 of the first payment goes toward interest

and $315.50 is used to reduce principal. But by payment 179, only $10.40 is needed for interest

and $888.43 is used to reduce principal.

End of Preview - Want to read all 24 pages?

Access Now

Unformatted Attachment Preview

Time Value of Money Introduction Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the $1.06 you expect to receive in one year is only $1. A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value. Each of these factors is very briefly defined in the right-hand column below. The left column has references to more detailed explanations, formulas, and examples. ...
Purchase document to see full attachment