Understanding The Time Value Of Money

By Shauna Carther
Website; http://www.investopedia.com/articles/03/082703.asp
What Is Time Value?
If you're like most people, you would choose to receive the $10,000 now. After
all, three years is a long time to wait. Why would any rational person defer
payment into the future when he or she could have the same amount of money
now? For most of us, taking the money in the present is just plain instinctive.
So at the most basic level, the time value of money demonstrates that, all
things being equal, it is better to have money now rather than later.

But why is this? A $100 bill has the same value as a $100 bill one year from
now, doesn't it? Actually, although the bill is the same, you can do much more
with the money if you have it now because over time you can earn
more interest on your money.

Back to our example: by receiving $10,000 today, you are poised to increase
the future value of your money by investing and gaining interest over a period
of time. For Option B, you don't have time on your side, and the payment
received in three years would be your future value. To illustrate, we have
provided a timeline:


If you are choosing Option A, your future value will be $10,000 plus any interest
acquired over the three years. The future value for Option B, on the other hand,
would only be $10,000. So how can you calculate exactly how
much more Option A is worth, compared to Option B? Let's take a look.

SEE: Internal Rate Of Return: An Inside Look

Future Value Basics
If you choose Option A and invest the total amount at a simple annual rate of
4.5%, the future value of your investment at the end of the first year is
$10,450, which of course is calculated by multiplying the principal amount of
$10,000 by the interest rate of 4.5% and then adding the interest gained to the
principal amount:

Future value of investment at end of first
year:
= ($10,000 x 0.045) + $10,000
= $10,450
You can also calculate the total amount of a one-year investment with a simple
manipulation of the above equation:


Original equation: ($10,000 x 0.045) + $10,000 = $10,450
Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
Final equation: $10,000 x (0.045 + 1) = $10,450
The manipulated equation above is simply a removal of the like-variable
$10,000 (the principal amount) by dividing the entire original equation by
$10,000.

If the $10,450 left in your investment account at the end of the first year is left
untouched and you invested it at 4.5% for another year, how much would you
have? To calculate this, you would take the $10,450 and multiply it again by
1.045 (0.045 +1). At the end of two years, you would have $10,920:

Future value of investment at end of second year:
= $10,450 x (1+0.045)
= $10,920.25
The above calculation, then, is equivalent to the following equation:
Future Value = $10,000 x (1+0.045) x
(1+0.045)
Think back to math class and the rule of exponents, which states that the
multiplication of like terms is equivalent to adding their exponents. In the above
equation, the two like terms are (1+0.045), and the exponent on each is equal
to 1. Therefore, the equation can be represented as the following:



We can see that the exponent is equal to the number of years for which the
money is earning interest in an investment. So, the equation for calculating the
three-year future value of the investment would look like this:


This calculation shows us that we don't need to calculate the future value after
the first year, then the second year, then the third year, and so on. If you know
how many years you would like to hold a present amount of money in an
investment, the future value of that amount is calculated by the following
equation:



SEE:Accelerating Returns With Continuous Compounding

Present Value Basics
If you received $10,000 today, the present value would of course be $10,000
because present value is what your investment gives you now if you were to
spend it today. If $10,000 were to be received in a year, the present value of
the amount would not be $10,000 because you do not have it in your hand now,
in the present. To find the present value of the $10,000 you will receive in the
future, you need to pretend that the $10,000 is the total future value of an
amount that you invested today. In other words, to find the present value of the
future $10,000, we need to find out how much we would have to invest today in
order to receive that $10,000 in the future.

To calculate present value, or the amount that we would have to invest today,
you must subtract the (hypothetical) accumulated interest from the $10,000. To
achieve this, we can discount the future payment amount ($10,000) by the
interest rate for the period. In essence, all you are doing is rearranging the
future value equation above so that you may solve for P. The above future
value equation can be rewritten by replacing the P variable with present
value (PV) and manipulated as follows:


Let's walk backwards from the $10,000 offered in Option B. Remember, the
$10,000 to be received in three years is really the same as the future value of
an investment. If today we were at the two-year mark, we would discount the
payment back one year. At the two-year mark, the present value of the
$10,000 to be received in one year is represented as the following:

Present value of future payment of $10,000 at end
of year two:

Note that if today we were at the one-year mark, the above $9,569.38 would be
considered the future value of our investment one year from now.

Continuing on, at the end of the first year we would be expecting to receive the
payment of $10,000 in two years. At an interest rate of 4.5%, the calculation
for the present value of a $10,000 payment expected in two years would be the
following:

Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the
future value of the investment every year counting back from the $10,000
investment at the third year. We could put the equation more concisely and use
the $10,000 as FV. So, here is how you can calculate today's present value of
the $10,000 expected from a three-year investment earning 4.5%:


So the present value of a future payment of $10,000 is worth $8,762.97 today
if interest rates are 4.5% per year. In other words, choosing Option B is like
taking $8,762.97 now and then investing it for three years. The equations
above illustrate that Option A is better not only because it offers you money
right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in
cash! Furthermore, if you invest the $10,000 that you receive from Option A,
your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000)
greater than the future value of Option B.

SEE: Economics And The Time Value Of Money

Present Value of a Future Payment
Let's add a little spice to our investment knowledge. What if the payment in
three years is more than the amount you'd receive today? Say you could
receive either $15,000 today or $18,000 in four years. Which would you
choose? The decision is now more difficult. If you choose to receive $15,000
today and invest the entire amount, you may actually end up with an amount of
cash in four years that is less than $18,000. You could find the future value of
$15,000, but since we are always living in the present, let's find the present
value of $18,000 if interest rates are currently 4%. Remember that the
equation for present value is the following:


In the equation above, all we are doing is discounting the future value of an
investment. Using the numbers above, the present value of an $18,000
payment in four years would be calculated as the following:

Present Value

From the above calculation we now know our choice is between receiving
$15,000 or $15,386.48 today. Of course we should choose to postpone
payment for four years!

The Bottom Line
These calculations demonstrate that time literally is money - the value of the
money you have now is not the same as it will be in the future and vice versa.
So, it is important to know how to calculate the time value of money so that you
can distinguish between the worth of investments that offer you returns at
different times.

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