Time value of money
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The time value of money (TVM) is a way of calculating the value of a sum of money, at any time in the present or future. It allows us to calculate:
- Present Value (PV) is the present value of an amount that will be received in the future. It answers such questions as, what is the value now of a zero-coupon bond that will pay $1,000 in 10 years?
- Future Value (FV) is the future worth of a present amount. It answers such questions as, how much will be in my savings account at year end, which has $1,000 in it now, and pays 5% compounded yearly?
- Present Value of an Annuity (PVA) is the present value of a stream of future payments. It determines the value of your mortgage today, if you can afford 20 years of payments of $xxx.
- Future Value of an Annuity (FVA) is the future value of a stream of payments (annuity). If I save $2,000 per year and it earns 5% compounded yearly, what will be the total sum after 40 years?
- A Perpetuity is an annuity that lasts "forever", or at least indefinitely. Since most financial instruments have a specified end, this concept applies to investments that generate some form of (relatively) consistent cash flow; an example may be a rental property. The value of a Certificate of Deposit (CD or GIC) with a fixed term will be determined assuming it is reinvested at its maturity.
The premise of time value of money is that an investor prefers to receive money today, rather than the same amount in the future, all else being equal. As a result, the investor demands interest to compensate, which may be paid periodically or at the end of the period. The interest compensates for the time in which the money could be put to productive use, the risk of default, and the risk of inflation (as well as some other more technical factors).
CalculationsEdit
There are several basic equations that represent the equalities listed above. The variables can be input into a financial calculator, input at any suitable online calculator or extrapolated from online/printed tables of values.
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 can readily determine solutions).
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 provide a present value for 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 (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 choice of the wrong discount rate can make the results meaningless. In most cases, however, the mathematics are similar, if not identical.
For calculations of annuities, you must decide whether the payments are made at the beginning of each time period, or (as in the formulas given) at the end. The calculator you use will allow the input somehow.
FormulasEdit
Present value of a future sumEdit
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 the value of a dollar at time=0
- FV the value of a dollar at time=n in the future
- r equals the interest rate that would be compounded for each period of time
- n is the period of time you want to equate.
Future value of a present sumEdit
- The future value (FV) formula is similar and uses the same variable.
Present value of an annuityEdit
- 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.
Future value of an annuityEdit
- The future value of an annuity (FVA) formula has four variables, each of which can be solved for:
- FVA 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.
Present value of a growing annuityEdit
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.
Present value of a perpetuityEdit
The PV of a perpetuity (a perpetual annuity) formula is simple division.
Present value of a growing perpetuityEdit
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.
DerivationsEdit
Annuity derivationEdit
The formula for the future 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:
Summing over all payments from time 1 to time n, then reversing the order of terms and substituting :
Note that this is a geometric series, with the initial value being , the multiplicative factor being , with terms. Applying the formula for geometric series, we get
The present value of the annuity (PVA) is obtained by simply dividing by :
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:
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:
Initially, before any payments, the present value of the system is just the endowment principal (). At the end, the future value is the endowment principal (which is the same) plus the future value of the total annuity payments (). Plugging this back into the equation:
Perpetuity derivationEdit
Without showing the formal derivation here, the perpetuity formula is derived from the annuity formula. Specifically, the term:
can be seen to approach the value of 1 as n grows larger. At infinity, it is equal to 1, leaving as the only term remaining.
ExamplesEdit
Example 1: Present valueEdit
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:
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 amountEdit
Consider a 30 year mortgage where the principal amount P is $200,000 and the annual interest rate is 6%.
The number of monthly payments is
and the monthly interest rate is
The annuity formula for (A/P) calculates the monthly payment:
Example 3: Solving for the period needed to double moneyEdit
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:
then
The present value formula can be rearranged such that:
- (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?Edit
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:
Example 5: Calculate the value of a regular savings deposit in the future.Edit
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:
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):
These steps can be combined into a single formula:
Example 6: Price/earnings (P/E) ratio Edit
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:
And in fact, the P/E ratio is analogous to the inverse of the interest rate (or discount rate).
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:
If we wish to determine the implied rate of growth (if we are given the discount rate), we may solve for g:
Time value of money formulae with continuous compoundingEdit
Rates are sometimes converted into the continous compound interest rate equivalent because the continuous equivalent is more convenient (for example, more easily differentiated). Each of the formulae above may be restated in their continuous equivalents. For example, the present value of a future payment can be restated in the following way, where e is the base of the natural logarithm:
See below for formulaic equivalents of the time value of money formulae with continuous compounding.
Present value of an annuityEdit
Present value of a perpetuityEdit
Present value of a growing annuityEdit
Present value of a growing perpetuityEdit
See alsoEdit
- option time value
- Discounting
- Discounted cash flow
- Exponential growth
- Hyperbolic discounting
- Internal rate of return
- Perpetuity
- Real versus nominal value
- Time preference theory of interest
External linksEdit
- Time Value of Money from studyfinance.com at the University of Arizonaar:قيمة وقتية للنقود
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