Time value of money

Summary

In this lecture, the concept of the Time Value of Money (TVM) is explored, emphasizing how the value of money decreases over time due to inflation. The discussion covers key financial principles like Present Value (PV), Future Value (FV), and how compounding interest impacts investments. Examples illustrate the effect of inflation and the benefits of investing money to grow its value. The lecture also explains the significance of discounting future cash flows, Net Present Value (NPV) for business decisions, and how annuities are assessed for profitability. Ultimately, understanding TVM is essential for making informed investment choices and business evaluations.

Takeaways

• 😀 Inflation decreases the purchasing power of money over time, meaning the value of money decreases as time passes.
• 😀 The Time Value of Money (TVM) suggests that money today is worth more than the same amount in the future due to its potential to earn interest or returns.
• 😀 Compounding refers to the process where interest is added to both the principal and the accumulated interest, increasing the future value of an investment.
• 😀 The more frequently interest is compounded (e.g., daily or monthly), the higher the future value of an investment.
• 😀 Discounting is the reverse of compounding, used to determine the present value of future sums of money.
• 😀 The **Net Present Value (NPV)** method helps assess the profitability of a project by comparing the present value of future cash flows to the initial investment.
• 😀 To evaluate the profitability of annuities, you need to calculate the present value of the series of future payments and compare it to the initial investment.
• 😀 In business decisions, a positive NPV suggests a profitable investment, while a negative NPV indicates a loss.
• 😀 The formula for Future Value (FV) helps calculate the value of an investment in the future, considering interest rate, compounding periods, and time.
• 😀 Understanding compounding periods (e.g., annual, monthly, daily) is essential as higher compounding periods result in greater future value.
• 😀 Present Value (PV) calculations allow you to determine how much money needs to be invested now to achieve a desired future amount, considering the discount rate.

Q & A

What is the Time Value of Money (TVM)?

The Time Value of Money (TVM) is a financial concept that suggests money today is worth more than the same amount in the future due to its potential earning capacity over time. It takes into account factors like inflation and interest rates.

How does inflation affect the value of money over time?

Inflation reduces the purchasing power of money over time. As prices of goods and services increase, the value of money decreases, meaning that the same amount of money will buy fewer goods or services in the future.

What is the difference between Present Value (PV) and Future Value (FV)?

Present Value (PV) refers to the current value of money, while Future Value (FV) is the amount of money a sum will grow to at a specified time in the future, based on a certain interest rate.

What role does compounding play in the Time Value of Money?

Compounding refers to the process where the interest earned on an investment is added to the principal, so that future interest is calculated on the new, larger amount. The more frequently interest is compounded, the greater the future value of the investment.

How does the frequency of compounding affect the future value of an investment?

The more frequently interest is compounded (e.g., daily, monthly, or quarterly), the higher the future value of an investment, as interest is added to the principal more often, resulting in more significant growth over time.

What is discounting in the context of Time Value of Money?

Discounting is the reverse of compounding. It involves calculating the present value of a future sum of money by applying a discount rate. This helps determine how much money needs to be invested today to achieve a desired future amount.

What is Net Present Value (NPV) and how is it used in business decisions?

Net Present Value (NPV) is a method used to evaluate the profitability of a project by comparing the present value of future cash flows to the initial investment. A positive NPV indicates a profitable investment, while a negative NPV suggests a loss.

How do compounding periods affect the final return on an investment?

The frequency of compounding periods affects the final return on an investment. The more frequent the compounding (e.g., daily instead of annually), the higher the future value, as interest is added more frequently, leading to greater growth.

What is an annuity and how is its profitability assessed?

An annuity is a series of equal payments made at regular intervals over time. To assess the profitability of an annuity, its present value is calculated by discounting each future payment back to the present. If the present value is higher than the initial investment, the annuity is profitable.

Why is it important to calculate the present value of future cash flows when making investment decisions?

Calculating the present value of future cash flows helps determine whether an investment is worthwhile. It enables investors to understand how much they need to invest today to achieve a future financial goal, factoring in interest rates and time.