Question

Discuss how time value of money in the context of compounding interest. please give examples. 250 words

Answer 1

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Time value of money means that the identical sum of money Available today(present point of time) is worth more than the identical sum of money Available tomorrow (Future point of time).

The factors taken into consideration by the time value of money are

1. The opportunity cost.

2. The sacrifice Of current consumption.

3. 2. The Inflation premium.

4. The general rise in prices, loss of purchasing power.

5. 3. Risk Premium:

6. Extra return or compensation required for bearing risk.

Even if we disregard the risk. They are other two factors which will be taken into consideration.

The discounting rate is determined using these factors.

Compounding meaning: It means earnings from interest on Interest i.e the interest earned on capital is reinvested to earn Interest on Interest.

Time value of money equation to calculate the compounded value of present value in the future, Formula:

FV= PV*(1+r)^n

The basic 4 variables are:

FV = future value.

PV = present value.

r= interest rate for the period.

n = number of periods.

For example:

The value of $1000 in five years compounded at the rate of 10% per annum after 5 years is:

FV = 1000*(1.10)^5

FV = $1,610.51