Question

There are five time value of money components – FV, PV, N, I, and PMT. Briefly describe each and create a hypothetical and realistic calculation word problem to find one of the components

Answer 1

Solution:-

The five time value of money components can be described as follows.

1) FV:- This stands for future value. This is the amount to be received in future at the specific date. The higher the future value the higher will be the present value , other 4 components remaining constant.

2) Present value(PV) :- This is the value calculated by discounting the future values at the required rate of return .

3) N:-It stands for number of periods. Number of periods have inverse relation with the PV, while direct relation with FV. Meaning thereby, when number of periods increases , PV decreases and FV increases if all other factors remain constant.

4) I:- It is the rate of interest at which the cash flows are discounted to calculate PV. Interest rate has inverse relation with PV and direct relation with FV.

5) PMT:- It stands for the equal periodic cash flows.

Let us assume, the following example.

Maturity value of bond (FV) =$1000

Yearly interest (PMT) = $100

Time to mature (n)= 6 years

Required rate of return (i)=5%

Present value of bond= ?

The present value of bond can be calculated as follows:-

Present value= PMT*PVIFA(i,n)+FV*PVIF(i,n)

substituting the values, we get

Present value(PV)=100*PVIFA(5%,6)+1000*PVIF(5%,6)

                                    =100*5.0756920+1000*0746215

                                    =505.57+746.22

                                    =$1251.79