833 words - 3 pages

The time value of money (TVM), also known as discounted present value, is one of the main concepts of finance. The time value of money is based on the idea that one will prefer to receive a certain amount of money today than the same amount in the future, all else equal. As a result, when one deposits money into a bank account, one demands interest. Money received today is more valuable than money received in the future by the amount of interest we can earn. If $90 today will accumulate to $100 a year from now, then the present value of $100 to be received one year from now is $90.Interest Rates and CompoundingInterest is the 'rent' paid to borrow money. The lender receives a compensation for deferring their own consumption. The original amount lent is called the 'principal', and the percentage of the principal is the "interest rate." Compound interest is interest which is added to the original principal. New interest is then calculated, not only on the principal, but also on the interest that has been added. The more frequently interest is compounded, the faster the principal grows. Yearly compounded interest is considered the norm unless it is specified to be otherwise.Present ValueThe present value of a future cash flow is the amount of money to change hands at some future date, discounted to account for the time value of money. A given amount of money is always more valuable sooner than later since this enables one to take advantage of investment opportunities. Because of this present values are smaller than corresponding future values. The simplest model of the time value of money is compound interest, which is in fact much simpler than simple interest. To someone who has the opportunity to invest an amount of money C for t years at a rate of interest of i% compounded annually, the present value of the receipt of C, t years in the future, is:The expression (1 + i/100)−t enters almost all calculations of present value. It represents the present value of 1. Many equations are expressed more concisely by making the substitution v = (1 + i/100)−1. Something worth 1 at time = t (years in the future) is worth vt at time = 0 (the present). If the interest rate is expected to change during the payback period it is common to use these different interest rate estimates for the future time periods. An investment over a two year period would then have PV(Present Value) ofFuture ValueFuture Value is the...

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