Time Value of Money
There are three basic reasons to support the TVM theory. First, a dollar can be invested and earn interest over time, giving it potential earning power. Also, money is subject to inflation, eating away at the spending power of the currency over time, making it worth less in the future. Finally, there is always the risk of not actually receiving the dollar in the future – if you hold the dollar now, there is no risk of this happening. Getting an accurate estimate of this last risk isn’t easy and, therefore, it’s harder to use in a precise manner.
Specific variations of time value of money calculations are:
- Net Present Value (lets you value a stream of future payments into one lump sum today, as you see in many lottery payouts)
- Present Value (tells you the current worth of a future sum of money)
- Future Value (gives you the future value of cash that you have now)
Techniques of Time Value of Money
- Compounding technique-
How much a sum of money becomes at a future date?
- Discounting or present value technique-
What the value is today of some future sum of money?
An annuity requires that:
- the periodic payments or receipts (rents) always be of the same amount,
- the interval between such payments or receipts be the same, and
Types of Annuities
Annuities may be broadly classified as:
- Ordinary or deferred annuities: where cash flows occur at the end of the period.
- Annuities due: where cash flows occur at the beginning of the period.