Time Value of Money PDF

` Understanding the time value of money  What is time value of money? The time value of money is based on the premise that money today is worth more than the same amount of money in the future. This is because money in the present can be invested in something and grow, while money in the fut...

` Understanding the time value of money  What is time value of money? The time value of money is based on the premise that money today is worth more than the same amount of money in the future. This is because money in the present can be invested in something and grow, while money in the future cannot because we still don’t have access to it. Time value of money is important because of its use in a variety of financial decisions, such as investment planning, retirement planning, and mortgage payments.  What is Present Value? The Present Value (PV) is a measure of how much a future cash flow, or stream of cash flows, is worth as of the current date. The Present Value (PV) of money refers to the current worth of a sum of money that is to be received or paid in the future, discounted at a specific interest rate. The concept is based on the idea that a sum of money today is worth more than the same sum in the future due to its potential earning capacity. This principle is the foundation of the time value of money (TVM).  What is Future Value? Future Value (FV) → The future value (FV) is the projected cash flow expected to be received in the future, i.e. the cash flow amount we are discounting to the present date. Discount Rate (r) → The “r” is the discount rate – the expected rate of return (interest) – which is a function of the riskiness of the cash flow (i.e. greater risk → higher discount rate). Number of Periods (n) → The final input is the number of periods (“n”), which is the duration between the date the cash flow occurs and the present date – and is equal to the number of years multiplied by the compounding frequency.  The discount rate plays a critical role in the calculation of the present value. It represents the rate of return or interest rate that could be earned on an investment, and it reflects the time value of money. In simpler terms, the discount rate shows how much less a future sum of money is worth compared to having that same amount today.  Why is the Discount Rate Important? Time Value of Money (TVM): Money today has more earning potential than money in the future due to interest. The discount rate captures this difference by “discounting” future cash flows back to their present value. Opportunity Cost: The discount rate often represents the opportunity cost of investing in one project over another. For example, if you could earn 5% by investing in an alternative, you would use that 5% as the discount rate to evaluate future cash flows. Risk Factor: The discount rate can also factor in the risk associated with future cash flows. Higher-risk investments might use a higher discount rate to reflect the uncertainty of receiving the expected future returns.  Factors Influencing the Choice of Discount Rate Interest Rates: The current interest rate in the economy, such as central bank rates or market returns, helps determine the discount rate. Inflation: If inflation is expected to be high, a higher discount rate might be used, as the purchasing power of future cash flows will be lower. Risk Premium: Riskier investments generally use a higher discount rate to reflect the possibility that the future cash flows may not be realized. Company Policy: In business settings, companies may have a standard discount rate for evaluating investments based on their cost of capital or required rate of return.  Present Value Formula: PV=FV(1+r)n PV = Present Value FV = Future Value (the amount of money in the future) r = Interest rate (expressed as a decimal) n = Number of periods (years, months, etc.) Example 1: Single Discount Rate. Let's say you want to know how much PHP 1,000, to be received in two years, is worth today, assuming a discount rate of 6%. P890.00 Let’s see how different discount rates affect the present value: With a 3% discount rate: P942.60 With a 10% discount rate: P826.45