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Understanding Time Value of Money: Future and Present Value Concepts

Learn the basics of time value of money, including future and present value, compounding interest, and how to calculate them. Understand the Rule of 72 for estimating doubling money time.

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Understanding Time Value of Money: Future and Present Value Concepts

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  1. Time Value of Money – Part One (Ch. 2) 04/10/06

  2. Basic intuition • Because of the ability of investors to earn interest on funds available today, the time value of money posits that a dollar today is worth more than a dollar tomorrow.

  3. Future value • Future value – the value of a present or future, single cash flow or stream of cash flows at a specific future date. • Principal – amount deposited today • Interest rate – the rate at which your money is growing. This can also be considered to be a growth rate and can also represent an opportunity cost. • Compounding of interest (interest on interest) – interest earned on accumulated interest

  4. Future value • The future value at time n of a single cash flow today compounded (or growing) at an interest rate r can be calculated as: • The term (1+r)n is also referred to as the Future Value Interest Factor (FVIF)

  5. Methods of calculation • Equation • Financial calculator • Spreadsheet

  6. Present value • Present value – the value of a future, single cash flow or stream of future cash flows today. • Discount rate – the interest rate that allows us to convertfuture cash flows into cash flows in present dollars.

  7. Present value • The present value of a single cash flow at time n today discounted at an interest rate r can be calculated as: • The term 1/(1+r)n is also referred to as the Present Value Interest Factor (PVIF)

  8. Four variables -- one equation • With a single future cash flow and a cash flow today, we can also solve for • n: • r:

  9. Doubling your money: The rule of 72s • Before calculators and spreadsheets a quick estimate of the time needed to double your money was found by using the rule of 72s: • Time estimate = 72 / interest rate • The rule is also good to find the interest rate needed to double your money in a given period • Interest rate estimate = 72 / n

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