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Time value of money


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Time value of money, Compounding, Discounting and Annuity

Published in: Economy & Finance
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Time value of money

  2. 2. Money has a time, a fixed value associated with it. It is this we call time value of money. Value of money decreases with time. Today Re.1 is some value less than Re.1 in forthcoming year and greater than Re.1 in previous year. This degradation is because of the practicality of the concept of interest is basically two forms: simple interest and compound interest.
  3. 3. Compounding can be defined as keeping a particular amount at a particular rate of interest for a particular time period. It can be simply stated as “Interest on Interest”. It will always give incremented value of the invested money subject to constraints as recession and inflation
  4. 4. The future value of money can be easily calculated by the formula:- FV = PV(I+R/T)^(N*T) Where FV = future value of the given amount PV = present value of amount R = rate of interest at which present amount set to N = time for which amount is kept under interest T = type of compounding (annually, semiannually, quarterly, daily)
  5. 5. One can calculate after how many years money will be doubled if one keeps at a certain rate of interest and vice-versa T = 72/R Where T = time duration in number of years R = rate of interest
  6. 6.  Compounding requires two things – the re- investment of earnings and time  An investment with interest compounded monthly will grow faster than an interest compounded annually  While compounding is beneficial if one is receiving the interest, if he/she is the one paying compound interest on a loan or credit card, then it’s costing him/her a lot of money, as interest is charged on interest
  7. 7. Discounting is used to calculate present value from the estimated future value. As per degradation, discounting will be less than compounding.
  8. 8. Discounting can be easily calculated by the formula:- PV = FV____________- (1+R/T)^(N*T) Where PV = present value to be calculated FV = future value estimated R = rate of interest N = time period of present value being converted to future value T = type of interest imposed
  9. 9.  For the purposes of investors, interest rates, impatience and risk necessitate that future costs and benefits are converted into present value in order to make them comparable with each other.  Economists assume that today’s investments and technical change will produce economic growth.  High discount rates imply giving low values to future damages, and thus, betting against the environment and future generations.  An important consideration when discounting future costs and benefits to present value is the discount rate applied.
  10. 10. An annuity is an insurance product that pays out income, and can be used as part of a retirement strategy. Annuities are a popular choice for investors who want to receive a steady income stream in retirement.
  11. 11.  There are two basic types of annuities: Deferred and Immediate.  With a Deferred annuity, money is invested for a period of time until one is ready to begin taking withdrawals, typically in retirement.  If one opt for an Immediate annuity he/she begin to receive payments soon after he/she make initial investment.  The Deferred annuity accumulates money while the Immediate annuity pays out.  Deferred annuities can also be converted into Immediate annuities when the owner wants to start collecting payments.