Question

1. Explain how calculating the future value of cash flows is different from calculating the present value of cash flows.

2. Explain the annuity transformation method. Provide an example.

Answer 1

Ans 1) In future value of cash flows we want to know future value of the funds at the end of specific period. If we are investing every year for n number of years at r rate so we will be receiving interest every month and that will be reinvested and compounded. So future value is availability of funds to us at the end of n number of years

However in present value of the funds we wish to know after discounting all the future inflows with the interest rate how much money I have today.

In both we try to incorporate the impact of inflation and wish to beat that using the rate of interest.

Future Value - Money value in future to use

Present Value - Money value today to use

Ans 2) Annuity transformation is a relation between an ordinary annuity and an annuity due. In ordinary annuity cash flow occurs at the end of period but in annuity due it occur at the beginning of the period. So with switching the annuity period one can take advantage of tax applied on the annuity.  

Annuity transformation used to convert an ordinary annuity to an annuity due. We pay rent at the beginning of the month which is Annuity due and we pay loan EMI at the end of month which is ordinary annuity .