In: Accounting
Discuss the importance of the various time value of money concepts such as compounding (future value), discounting (present value) and annuities. Is there anything that amazes you about the power of these concepts?
Solution
COMPOUNDING - Compounding, also called compound interest, is the process of generating earnings on an asset’s reinvested earnings. It has two main components: reinvestment of earnings and time. With compounding, interest is computed on the accumulated interest as well as the original principal. Investments such as savings accounts, certificates of deposit and reinvested dividends from equities generally employ the benefits of compounding. So let’s go through a simple example. Let’s begin with $1,000 invested at 5% interest with a compounding frequency of one year. At the end of year 1, you will have $1,050. Straight forward enough. Let’s move to the end of year 2. If you’ve chosen to “set it and forget it,” and you’ve left the interest in the account, you now have $1,102.5. And at the end of year 3 - $1,157.63. Each year, the interest gets added to the balance from the prior year and earns 5%, also. Your interest is earning interest.
DISCOUNTING - Discounting is the process of determining the present value of a payment or a stream of payments that is to be received in the future. Given the time value of money, a dollar is worth more today than it would be worth tomorrow. Discounting is the primary factor used in pricing a stream of tomorrow's cash flows.
When a car is on sale for 10% off, it represents a discount to the price of the car. The same concept of discounting is used to value and price financial assets. For example, the discounted, or present value, is the value of the bond today. The future value is the value of the bond at some time in the future. The difference in value between the future and the present is created by discounting the future back to the present using a discount factor, which is a function of time and interest rates.
For example, a bond can have a par value of $1,000 and be priced at a 20% discount, which is $800. In other words, the investor can purchase the bond today for a discount and receive the full face value of the bond at maturity. The difference is the investor's return. A larger discount results in a greater return, which is a function of risk.
ANNUITIES - It is a very important concept. An annuity is a series of payments made at equal intervals. Examples of annuities are regular deposits to a savings account, monthly home mortgage payments, monthly insurance payments and pension payments. Annuities can be classified by the frequency of payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other regular interval of time.
An annuity is a series of payments made at equal intervals. Examples of annuities are regular deposits to a savings account, monthly home mortgage payments, monthly insurance payments and pension payments. Annuities can be classified by the frequency of payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other regular interval of time. An annuity which provides for payments for the remainder of a person's lifetime is a life annuity.
All these Concepts are very importanct and a part of Corporate
finance. Whenever a financial proposal is being made these concepts
are looked in and analysed to check whether that proposal is viable
or not.