Discount Flow Techniques and Value of Money

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TIME VALUE OF MONEY

Interest rates, compounding and future value

(Book IM Pandey)
Before making any investment decision, one of the key elements you face is working out the real rate of return on your investment.

Simple interest is interest on the principle amount while compound interest is when your principle and any earned interest earned interest. The interest rate is applied to the original principle and any accumulated interest.

Compound interest is critical to investment growth. With simple interest, interest is paid just on the principal. With compound interest, the return that you receive on your initial investment is automatically reinvested. In other words, you receive interest on the interest.

Future Value = Present Value (1+r)^n
r= interest rate
n= time period

Thus, there is a time preference for money. Time preference for money is an individual's preference for possession of a given amount of money now, rather than the same amount at some future time.

Three reasons may be attributed to the individual's time preference for money:
- risk
- preference for consumption
- investment opportunities

Future value of today's Rs 100 @10% per annum after one year will be Rs. 110/-

Thus, compounding technique is used to find the future value of the investment.

Future value of Annuity

We can also use the compounding technique to find out the future value of annuity in the following manner:

Example:
What's the future value in 10 years of $1,000 payments received at the beginning of each year for the next 10 years? A 5.625% interest rate is assumed.

Here we have to find out the compounded value of annuity
F=A*((1+r)^n-1)/r
F=Future value, A= Annuity r= rate of interest n=duration

A= 1000, r= 5.625%, n=10 =$12950.96

PRESENT VALUE

Present value is the future value being discounted by an appropriated capitalization rate. The value of sum of money received today is more than its value received after some time.

In other words present worth of rupee received after some time will be less than the rupee received today. This is because of time value of money. The investor has time preference of money because he has reinvestment opportunities for funds, which are received early.

The present value of a future cash flow is the nominal amount of money to change hands at some future date, ...