Question

What is the role of time value of money in finance? Explain.
Differentiate between FV & PV of single amounts, annuities, & uneven cash flow patterns.
Identify the steps involved in determining rate of return or interest rate between PV & FV.

Answer 1

The time value of money measures the future value of a present cash flow given an interest rate. Alternatively it can also be used to find the present value of a future cash flow given the interest rate. The concept of "time value" of money was formulated since value of money depreciates over time due to inflation in the economy and hence to negate the effects of inflation, interest rates are given.

FV - FV is the future value of today's cash flow or an annuity starting today.

PV- PV is the present value of a cash flow that occurs at a future point of time or an annuity starting a future point of time.

FV of single amount = PV*(1+r)^n

FV of an annuity = P*((1+r)^n-1)/r where P is the first annuity

PV of single amount = FV/(1+r)^n

PV of annuity =P*(1-(1+r)^-n)/r where P is the first annuity

In all formula's, n= number of years and r is the interest rate.

In order to determine the interest rate, we need to plug in all the other value in any of the formulas mentioned and calculate the value of "r", the interest rate.