TIME VALUE OF MONEY

The 'time value of money' is the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal.
In other words, the present value of a certain amount ''a'' of money is greater than the present value of the right to receive the same amount of money at time ''t'' in the future. This is because the amount ''a'' could be deposited in an interest-bearing bank account (or otherwise invested) from now to time ''t'' and yield interest. (Consequently, lenders acting at arm's length demand interest payments for use of their financial capital. Additional motivations for demanding interest are to compensate for the risk of borrower default and the risk of inflation, as well as other, more technical considerations.)
All of the standard calculations are based on the most basic formula, the present value of a future sum, "discounted" to a present value. For example, a sum of ''FV'' to be received in one year is discounted (at the appropriate rate of ''r'') to give a sum of ''PV'' at present.
Some standard calculations based on the time value of money are:
:'Present Value' (PV) of an amount that will be received in the future.
:'Future Value' (FV) of an amount invested (such as in a deposit account) now at a given rate of interest.
:'Present Value of an Annuity' (PVA) is the present value of a stream of (equally-sized) future payments, such as a mortgage.
:'Future Value of an Annuity' (FVA) is the future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.
:'Present Value of a Perpetuity' is the value of a regular stream of payments that lasts "forever", or at least indefinitely.

Calculations

There are several basic equations that represent the equalities listed above. The solutions may be found using (in most cases) the formulas, a financial calculator or a spreadsheet program such as Microsoft Office Excel or OpenOffice.org Calc. The formulas are programmed into most financial calculators and several spreadsheat functions (such as PV, FV, RATE, NPER, and PMT).
For any of the equations below, the formulae may also be rearranged to determine one of the other unknowns. In the case of the standard annuity formula, however, there is no closed-form algebraic solution for the interest rate (although financial calculators and spreadsheet programs can readily determine solutions through rapid trial and error algorithms).
These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sum return of capital at the end of the bond's maturity - that is, a future payment. The two formulas can be combined to determine the present value of the bond.
An important note is that the interest rate ''r'' is the interest rate for the relevant period. For an annuity that makes one payment per year, r will be the annual interest rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate, For example, a monthly rate for a mortgage with monthly payments requires that the interest rate be divided by 12 (see the example below). See compound interest for details on converting between different periodic interest rates.
The rate of return in the calculations can be either the variable solved for, or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is critical to the exercise, and the use of an incorrect discount rate will make the results meaningless.
For calculations involving annuities, you must decide whether the payments are made at the end of each time period (known as an ordinary annuity), or at the beginning of each time period (known as an annuity due). If you are using a financial calculator or a spreadsheet, you can usually set it for either calculation. The following formulas are for an ordinary annuity. If you want the answer for the Present Value of an annuity due simply multiply the PV of an ordinary annuity by (1+r).

Formulas

Present value of a future sum

The present value formula is the core formula for the time value of money; each of the other formulae is derived from this formula. For example, the annuity formula is the sum of a series of present value calculations.

★ The present value (PV) formula has four variables, each of which can be solved for:

★ # PV is the value at time=0

★ # FV is the value at time=n

★ # i is the rate at which the amount will be compounded each period

★ # n is the number of periods
:

PV  =  rac{FV}{(1+i)^n}

Future value of a present sum

★ The future value (FV) formula is similar and uses the same variables.
:

FV    =   PV cdot (1+i)^n

Present value of an annuity

★ The present value of an annuity (PVA) formula has four variables, each of which can be solved for:

★ # PVA the value of the annuity at time=0

★ # A the value of the individual payments in each compounding period

★ # r equals the interest rate that would be compounded for each period of time

★ # n is the number of payment periods.

★ #:

PV(A) ,=,Acdotrac{1-rac{1}{left(1+r
ight)^n}}{r}

Future value of an annuity

★ The future value of an annuity (FVA) formula has four variables, each of which can be solved for:

★ # FV(A) the value of the annuity at time=n

★ # A the value of the individual payments in each compounding period

★ # r equals the interest rate that would be compounded for each period of time

★ # n is the number of payment periods.

★ #:

FV(A) ,=,Acdotrac{left(1+r
ight)^n-1}{r}

Present value of a growing annuity

Similar to the formula for an annuity, the present value of a growing annuity (PVGA) uses the same variables with the addition of ''G'' as the rate of growth of the annuity (A is the annuity payment in the first period). This is a calculation that is rarely provided for on financial calculators.
:

PV,=,{A over (r-g)}left[ 1- left({1+g over 1+r}
ight)^n 
ight]

Present value of a perpetuity

The PV of a perpetuity (a perpetual annuity) formula is simple division.
:

PV(P)  =  { A over r }

Present value of a growing perpetuity

When the perpetual annuity payment grows at a fixed rate (g) the value is theoretically determined according to the following formula. In practice, there are few securities with precisely these characteristics, and the application of this valuation approach is subject to various qualifications and modifications. Most importantly, it is rare to find a growing perpetual annuity with fixed rates of growth and true perpetual cash flow generation. Despite these qualifications, the general approach may be used in valuations of real estate, equities, and other assets. True.
:

PVGP   =  { A over (r-g) }

Derivations

Annuity derivation

The formula for the present value of a regular stream of future payments (an annuity) is derived from a sum of the formula for future value of a single future payment, as below, where C is the payment amount and n the time period.
A single payment C at future time i has the following future value at future time n:
:

FV  = C(1+r)^{n-i}

Summing over all payments from time 1 to time n, then reversing the order of terms and substituting

k = n-i

:
:

FVA  = sum_{i=1}^n C(1+r)^{n-i}  = sum_{k=0}^{n-1} C(1+r)^k

Note that this is a geometric series, with the initial value being

a = C

, the multiplicative factor being

1+r

, with

n

terms. Applying the formula for geometric series, we get
:

FVA  = rac{ C ( 1 - (1+r)^n )}{1 - (1+r)}  = rac{ C ( (1+r)^n - 1 )}{r}

The present value of the annuity (PVA) is obtained by simply dividing by

(1+r)^n

:
:

PVA  = rac{FVA}{(1+r)^n} = rac{C}{r} left( 1 - rac{1}{(1+r)^n} 
ight)

----
Another simple and intuitive way to derive the future value of an annuity is to consider an endowment, whose interest is paid as the annuity, and whose principal remains constant. The principal of this hypothetical endowment can be computed as that whose interest equals the annuity payment amount:
:

ext{Principal} 	imes r = C

ext{Principal} = C / r

Note that no money enters or leaves the combined system of endowment principal + accumulated annuity payments, and thus the future value of this system can be computed simply via the future value formula:
:

FV = PV(1+r)^n

Initially, before any payments, the present value of the system is just the endowment principal (

PV = C/r

). At the end, the future value is the endowment principal (which is the same) plus the future value of the total annuity payments (

FV = C/r + FVA

). Plugging this back into the equation:
:

rac{C}{r} + FVA = rac{C}{r} (1+r)^n

FVA = rac{C}{r} ((1+r)^n - 1)

Perpetuity derivation

Without showing the formal derivation here, the perpetuity formula is derived from the annuity formula. Specifically, the term:
:

left({1 - {1 over { (1+r)^n } }}
ight)

can be seen to approach the value of 1 as n grows larger. At infinity, it is equal to 1, leaving

{C over r}

as the only term remaining.

Examples

Example 1: Present value

One hundred euros to be paid 1 year from now, where the expected rate of return is 5% per year, is worth in today's money:
:

P   =     F 	imes (P/F)   = F 	imes  { 1 over (1+r)^n }   =  rac{ 100}{1.05}  =   95.23

So the present value of €100 one year from now at 5% is €95.23.

Example 2: Present value of an Annuity - solving for the payment amount

Consider a 10 year mortgage where the principal amount ''P'' is $200,000 and the annual interest rate is 6%.
The number of monthly payments is
:

n = 10 {
m  years} 	imes 12 {
m  months  per  year} = 120 {
m  months}

and the monthly interest rate is
:

r = { 6 {
m %  per  year} over 12 {
m  months  per  year} } =  0.5 {
m %  per  month}

The annuity formula for (''A''/''P'') calculates the monthly payment:
:

A  =  P 	imes left( A / P  
ight)  =  P 	imes {  r (1+r)^n over (1+r)^n - 1   }  
 =  $200,000 	imes { 0.005(1.005)^{120}  over (1.005)^{120} - 1 }

=  $200,000 	imes 0.01110205  =  $2,220.41 {
m  per  month}

Example 3: Solving for the period needed to double money

Consider a deposit of $100 placed at 10% (annual). How many years are needed for the value of the deposit to double to $200?
Using the algrebraic identity that if:
:

x  =  b^y

then
:

y  =  {ln (x) over ln(b)}

The present value formula can be rearranged such that:
:

y  =  {ln ({FV over PV}) over ln(1+r)}  =   {ln ({200 over 100}) over ln(1.10)}  = {0.693 over 0.0953}  = 7.27

''(years)''
This same method can be used to determine the length of time needed to increase a deposit to any particular sum, as long as the interest rate is known. For the period of time needed to double an investment, the Rule of 72 is a useful shortcut that gives a reasonable approximation of the time period needed.

Example 4: What return is needed to double money?

Similarly, the present value formula can be rearranged to determine what rate of return is needed to accumulate a given amount from an investment. For example, $100 is invested today and $200 return is expected in five years; what rate of return (interest rate) does this represent?
The present value formula restated in terms of the interest rate is:
:

r  =  left({FV over PV}
ight)^{1 over n} - 1  =  left({200 over 100}
ight)^{1 over 5} - 1  =  2^{0.20} - 1  =  0.15  =  15%

Example 5: Calculate the value of a regular savings deposit in the future.

To calculate the future value of a stream of savings deposit in the future requires two steps, or, alternatively, combining the two steps into one large formula. First, calculate the present value of a stream of deposits of $1,000 every year for 20 years earning 7% interest:
:

PVA ,=,Acdotrac{1-rac{1}{left(1+r
ight)^n}}{r}  =  1000cdotrac{1-rac{1}{left(1+.07
ight)^{20}}}{.07}  =  1000cdot {1- 0.258 over .07}  =  1000 ★  10.594  =  $10,594

This does not sound like very much, but remember - this is ''future money'' discounted back to its value ''today''; it is understandably lower. To calculate the future value (at the end of the twenty-year period):
:

FV    =   PV  (1+r)^n  =  $10,594 ★  (1+.07)^{20}  =  $10,594 ★  3.87  =  $40,995

These steps can be combined into a single formula:
:

FV ,=,Acdotrac{1-rac{1}{left(1+r
ight)^n}}{r} cdot (1+r)^n ,=,Acdotrac{left(1+r
ight)^n-1}{r}

Example 6: Price/earnings (P/E) ratio

It is often mentioned that perpetuities, or securities with an indefinitely long maturity, are rare or unrealistic, and particularly those with a growing payment. In fact, many types of assets have characteristics that are similar to perpetuities. Examples might include income-oriented real estate, preferred shares, and even most forms of publicly-traded stocks. Frequently, the terminology may be slightly different, but are based on the fundamentals of time value of money calculations. The application of this methodology is subject to various qualifications or modifications, such as the Gordon growth model.
For example, stocks are commonly noted as trading at a certain price/earnings ratio. The P/E ratio is easily recognized as a variation on the perpetuity or growing perpetuity formulae - save that the P/E ratio is usually cited as the ''inverse'' of the "rate" in the perpetuity formula.
If we substitute for the time being: the ''price'' of the stock for the present value; the earnings per share of the stock for the cash annuity; and, the discount rate of the stock for the interest rate, we can see that:
:

{P over E}   =  {1 over r}  =  {PV over A }

And in fact, the P/E ratio is analogous to the inverse of the interest rate (or discount rate).
:

{ 1 over P/E }  =  r

Of course, stocks may have increasing earnings. The formulation above does not allow for growth in earnings, but to incorporate growth, the formula can be restated as follows:
:

{ P over E }  =  {1 over (r-g)}

If we wish to determine the implied rate of growth (if we are given the discount rate), we may solve for ''g'':
:

g  =  r - {E over P}