Question

1. Briefly explain the time value of money, its methods, and how it applies to NPV.
2. When computations are performed, it is important to justify your work by showing how the answer was determined via narrative, calculations, and formulas. Presentation is also very important and is a quality aspect in addition to utilizing a table to present data and answers.

Answer 1

The concept of time value of money states that the worth of money which is available today is more than the same amount in the future because of its potential earning capacity. As per this principle, provided that money can earn interest, it can be said that the worth of any sum of money is more the sooner it is received due to the presence of time value attached to money. It would be fair to say that a dollar was worth more yesterday than today and a dollar today is worth more than a dollar tomorrow. The time value of money is also called as net present value of money. Before proceeding further, it is important to understand the following terms-

Present value- It is the money which a person has in his hand at the present time,i.e. initial investment for the future.

Future value- This is the ending amount at a future point of time, whose worth should be more than the present value given the fact that it is earning and growing over time.

Number of periods- It means the timeline of the investment like yearly, monthly, quarterly etc.

Interest rate- It is the growth rate of money over investment lifetime.

Payment amount- They are a series of equal and evenly-spaced cash flows

Formula for calculating future value is given by-

FV = PV*(1+i/n)^(n * t), where

FV is the future value, PV is the present value, i is the interest rate, t means the number of years to be considered and n is the number of compounding periods of interest per year.