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What are some real life scenarios where you can apply the time value of money

Online Training on Investment Banking 1 — Future Value of A Single Amount The first one in time value of money concept that we discuss is to calculate future value of a single amount.

If one allows the interest income to be reinvested, the investment shall grow as follows: It can also be utilized with the help of a calculator or an excel spread sheet as well. The below snapshot is an instance of how the rate is computed for different interest rates and at different time intervals. Login details for this Free course will be emailed to you 2 — Time Value of Money: Investors are generally keen to know by when their investment can double up at a given Interest.

This scenario states the Present Value of a sum of money which is expected to be received after a given time period. The process of discounting used for computation of the present value is simply the inverse of compounding.

#2 – Time Value of Money: Doubling Period

The PV formula can be readily obtained by using the below formula: An annuity is a stream of constant cash flows receipts or payments occurring at regular time interval. The premium payments of a life insurance policy, for instance, are an annuity.

  • Fine Wines While I can safely say I am not a regular at fancy wine auctions, there are certain wines that improve with age, which may be worth a whole lot more in the future;
  • The money to be saved between years 11 and 30 is the third inflow;
  • Professional Athlete Pay Many professional athletes have pay packages that give them a promised amount over a set number of seasons;
  • Once the children are finished with college, she will have extra disposable income, but is worried about just how much of an increase it will take to meet her ultimate retirement goals.

When the cash flows occur at the end of each period, the annuity is called an Ordinary annuity or deferred annuity. When this flow occurs at the beginning of each period, it is called as Annuity due.

Time Value Of Money Applications

Our focus will be more on the deferred annuity. This concept is a reversal of the future value of annuity just instead of FV the focus will be on PV. Perpetuity is an annuity of an indefinite duration. Although the total face value of the perpetuity is infinite and undeterminable, its Present value is not. The formula for computing the Present value of the perpetuity is: If we assume that the increase will continue indefinitely, the rental system will be termed as a growing perpetuity.

Do You Understand The Time Value of Money?

The deposit amount will grow as follows: However, this situation is a bit theoretical, as investors normally invest in stocks for dividends as well as capital appreciation. Let us take an example of Dividend Discount Model here.

This problem can be solved in 3 steps — Step 1 — Find the present value of Dividends for Year 1 and Year 2. Step 2 — Find the Present value of future selling price after two years.

Why the Time Value of Money Matters, and 10 Ways It Affects You

Repayments are to be made at the end of each month. The loan must be fully repaid by the end of the term. It requires Principal, Interest and term as inputs.

  • Fine Wines While I can safely say I am not a regular at fancy wine auctions, there are certain wines that improve with age, which may be worth a whole lot more in the future;
  • Professional Athlete Pay Many professional athletes have pay packages that give them a promised amount over a set number of seasons;
  • These are essentially choices you give up to do something else;
  • Thus, whoever gave Wimpy that burger should get his money in hand today because Wimpy was probably defaulting later;
  • Wimpy was in love with hamburgers, but never could pay for them;
  • The Delicious Cupcakes in My Fridge We are somewhat obsessed with cupcakes in our house, and rationing hasn't worked.

Since money tends to lose value over time, there is inflation which reduces the buying power of money. However, the cost of receiving money in the future rather than now shall be greater than just the loss in its real value on account of inflation.

#6 – Present Value of Perpetuity

The opportunity cost of not having the money right now also includes the loss of additional income which could be earned by simply having possession of cash earlier. Moreover, receiving money in the future rather than now may involve some risk and uncertainty regarding its recovery.

For these reasons, future cash flows are worth less than the present cash flows.

Time Value of Money | Top Real Life Examples | Formula

Time Value of Money concept attempts to incorporate the above considerations into financial decisions by facilitating an objective evaluation of cash flows from different time periods by converting them into present value or future value equivalents. This will only attempt to neutralise the present and future value of money and arrive at smooth financial decisions.