Introduction
This paper intends to discuss the concept of time value of money. The goal is to show that current cash flow is valued highly compared with future cash flows hence the need to compare cash flows in terms of present value and future value. Time value of money is the most important tool in investment and personal finance because it values future cash flows. It recognizes uncertainty of future cash flows and risk that accompanies such finances.
Movement of cash from one period to the other entails interest and risk (Time value of money overview, n.d). Interest serves the purpose of compensating for opportunity cost and uncertainty in payment of money borrowed (Drake & Fabozzi, 2009). In order to find the future value of money, compounding comes into the equation.
Conversely, future value of money is discounted to obtain the present value. Using illustrations, McCracken (n.d) discussed extensively the process of obtaining future values and present values. The following calculations further shade light on calculating future value and present value of cash flows.
Present value of lump sums
Future value of lump sums
Present value of ordinary annuities
Future value of ordinary annuities
Present values of perpetuities
Summary table
From the summarized results tabulated on the table, future lump sum of $100,000 and $200,000 was discounted to arrive at present values of $78,352.62 and $77,108.66 respectively. The present values of lump sum can be compared to a case of ordinary annuities. It is clear from the table that annuities give higher present values compared with lump sum payments. Similarly, the table shows present values of $100,000 and $200,000 compounded to give future values of $127,628.16 and $518,748.49 respectively.
These values, however, are lower than the computed future values of annuities. Finally, the case of perpetuity confirms that interest rate is critical in valuing an investment. According to JohnFinance (2014), cash flow is divided by interest rate in order to arrive at present values. Applying the formulae, the perpetuities of $100,000 and $200,000 yielded the same present value of $2,000,000.
Conclusion
This paper has established that value of lump sum payment and annuities depends on time and interest rate. The calculations confirmed that annuities have higher present values and future values compared with lump sum payments evaluated over same period and interest rate. Finally, perpetuities were investigated. It emerged that perpetuity of $100,000 with an interest rate of 5% yields a present value of $2,000,000. If the perpetuity and the interest rates were doubled, the resultant present value would be $2,000,000.
References
Drake, P., & Fabozzi, F. (2009). Foundations and Applications of the Time Value of Money. Hoboken: John Wiley & Sons.
JohnFinance. (2014). Present Value of a Perpetuity. Web.
McCracken, M. (n.d.). The time value of money. Web.
Time value of money overview. (n.d). Web.