Time Value of Money
The time value of money refers to the value of money existing in a given amount of interest which is earned during a specific time period. The time value of money can be explained as the central concept in finance theory. Moreover, the concept of time value of money also helps in evaluating a likely stream of income in the future in a manner that the annual incomes are discounted and added thereafter, thereby providing a lump-sum present value of the complete income stream.
Almost all the standard calculations related to time value of money are derived from the most crucial expression for the present value of any future value which is discounted to the present value by an amount equivalent to the time value of money.
Some of the standard calculations based on the time value of money include:
- Present value
The concept of time value of money is helpful in estimating the current worth of a future sum of money or a cash flow stream at a specific rate of interest. The future cash flows are discounted at the discount rate. A higher discount rate indicates a lower present value of the future cash flows.
- Present value of a perpetuity
The present value of a perpetuity refers to an infinite and continuous stream of identical cash flows.
- Present value of an annuity
In addition to the present value, the concept also assists in calculating the present value of an annuity. an annuity refers to a series of equal payments or receipts occurring at uniform time intervals. Some good examples include leases and rental payments. For an ordinary annuity, these receipts or payments occur at the end of every time period while for an annuity due, these occur at the start of each time period.
- Future value of an annuity
The future value refers to the value of cash or an asset on a particular date in the future which features a value equivalent to a specified sum in the present date. The future value of an annuity, on the other hand, refers to the future value of a stream of payments, presuming that the payments are invested at a specific interest rate.