 | This article includes a list ofgeneral references, butit lacks sufficient correspondinginline citations. Please help toimprove this article byintroducing more precise citations.(December 2019) (Learn how and when to remove this message) |
Thetime value of money refers to the fact that there is normally a greater benefit to receiving a sum ofmoney now rather than an identical sum later. It may be seen as an implication of the later-developed concept oftime preference.
The time value of money refers to the observation that it is better to receive money sooner than later. Money you have today can be invested to earn a positive rate of return, producing more money tomorrow. Therefore, a dollar today is worth more than a dollar in the future.[1]
Thetime value of money is among the factors considered when weighing theopportunity costs of spending rather thansaving orinvesting money. As such, it is among the reasons whyinterest is paid or earned: interest, whether it is on abank deposit ordebt, compensates the depositor or lender for the loss of their use of their money. Investors are willing to forgo spending their money now only if they expect a favorable netreturn on their investment in the future, such that the increasedvalue to be available later is sufficiently high to offset both the preference to spending money now and inflation (if present); seerequired rate of return.
TheTalmud (~500 CE) recognizes the time value of money. In TractateMakkos page 3a the Talmud discusses a case where witnesses falsely claimed that the term of a loan was 30 days when it was actually 10 years. The false witnesses must pay the difference of the value of the loan "in a situation where he would be required to give the money back (within) thirty days..., and that same sum in a situation where he would be required to give the money back (within) 10 years...The difference is the sum that the testimony of the (false) witnesses sought to have the borrower lose; therefore, it is the sum that they must pay."[2]
The notion was later described byMartín de Azpilcueta (1491–1586) of theSchool of Salamanca.
Time value of money problems involve the net value of cash flows at different points in time.
In a typical case, the variables might be: a balance (the real or nominal value of a debt or a financial asset in terms of monetary units), a periodic rate of interest, the number of periods, and a series of cash flows. (In the case of a debt, cash flows are payments against principal and interest; in the case of a financial asset, these are contributions to or withdrawals from the balance.) More generally, the cash flows may not be periodic but may be specified individually. Any of these variables may be the independent variable (the sought-for answer) in a given problem. For example, one may know that: the interest is 0.5% per period (per month, say); the number of periods is 60 (months); the initial balance (of the debt, in this case) is 25,000 units; and the final balance is 0 units. The unknown variable may be the monthly payment that the borrower must pay.
For example, £100 invested for one year, earning 5% interest, will be worth £105 after one year; therefore, £100 paid nowand £105 paid exactly one year laterboth have the same value to a recipient who expects 5% interest assuming that inflation would be zero percent. That is, £100 invested for one year at 5% interest has afuture value of £105 under the assumption that inflation would be zero percent.[3]
This principle allows for the valuation of a likely stream of income in the future, in such a way that annual incomes arediscounted and then added together, thus providing a lump-sum "present value" of the entire income stream; all of the standard calculations for time value of money derive from the most basic algebraic expression for thepresent value of a future sum, "discounted" to the present by an amount equal to the time value of money. For example, the future value sum to be received in one year is discounted at the rate of interest to give the present value sum:
Some standard calculations based on the time value of money are:
There are several basic equations that represent the equalities listed above. The solutions may be found using (in most cases) the formulas, a financial calculator, or aspreadsheet. The formulas are programmed into most financial calculators and several spreadsheet functions (such as PV, FV, RATE, NPER, and PMT).[7]
For any of the equations below, the formula may also be rearranged to determine one of the other unknowns. In the case of the standard annuity formula, there is no closed-form algebraic solution for the interest rate (although financial calculators and spreadsheet programs can readily determine solutions through rapid trial and error algorithms).
These equations are frequently combined for particular uses. For example,bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sumreturn of capital at the end of the bond'smaturity—that is, a future payment. The two formulas can be combined to determine the present value of the bond.
An important note is that the interest ratei is the interest rate for the relevant period. For an annuity that makes one payment per year,i will be the annual interest rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate. For example, a monthly rate for a mortgage with monthly payments requires that the interest rate be divided by 12 (see the example below). Seecompound interest for details on converting between different periodic interest rates.
The rate of return in the calculations can be either the variable solved for, or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is critical to the exercise, and the use of an incorrect discount rate will make the results meaningless.
For calculations involving annuities, it must be decided whether the payments are made at the end of each period (known as an ordinary annuity), or at the beginning of each period (known as an annuity due). When using a financial calculator or aspreadsheet, it can usually be set for either calculation. The following formulas are for an ordinary annuity. For the answer to the present value of an annuity due, the PV of an ordinary annuity can be multiplied by (1 +i).
The following formula use these common variables:
Thefuture value (FV) formula is similar and uses the same variables.
The present value formula is the core formula for the time value of money; each of the other formulas is derived from this formula. For example, the annuity formula is the sum of a series of present value calculations.
Thepresent value (PV) formula has four variables, each of which can be solved for bynumerical methods:
The cumulative present value of future cash flows can be calculated by summing the contributions ofFVt, the value of cash flow at timet:
Note that this series can be summed for a given value ofn, or whenn is ∞.[8] This is a very general formula, which leads to several important special cases given below.
In this case the cash flow values remain the same throughout then periods. The present value of anannuity (PVA) formula has four variables, each of which can be solved for by numerical methods:
To get the PV of anannuity due, multiply the above equation by (1 +i).
In this case, each cash flow grows by a factor of (1 +g). Similar to the formula for an annuity, the present value of a growing annuity (PVGA) uses the same variables with the addition ofg as the rate of growth of the annuity (A is the annuity payment in the first period). This is a calculation that is rarely provided for on financial calculators.
Wherei ≠g :
Wherei =g :
To get the PV of a growingannuity due, multiply the above equation by (1 +i).
Aperpetuity is payments of a set amount of money that occur on a routine basis and continue forever. Whenn → ∞, thePV of a perpetuity (a perpetual annuity) formula becomes a simple division.
When the perpetual annuity payment grows at a fixed rate (g, withg <i) the value is determined according to the following formula, obtained by settingn to infinity in the earlier formula for a growing perpetuity:
In practice, there are few securities with precise characteristics, and the application of this valuation approach is subject to various qualifications and modifications. Most importantly, it is rare to find a growing perpetual annuity with fixed rates of growth and true perpetual cash flow generation. Despite these qualifications, the general approach may be used in valuations of real estate, equities, and other assets.
This is the well knownGordon growth model used forstock valuation.
The future value (aftern periods) of an annuity (FVA) formula has four variables, each of which can be solved for by numerical methods:
To get the FV of an annuity due, multiply the above equation by (1 +i).
The future value (aftern periods) of a growing annuity (FVA) formula has five variables, each of which can be solved for by numerical methods:
Where i ≠ g :
Where i = g :
The following table summarizes the different formulas commonly used in calculating the time value of money.[9] These values are often displayed in tables where the interest rate and time are specified.
| Find | Given | Formula |
|---|---|---|
| Future value (F) | Present value (P) | |
| Present value (P) | Future value (F) | |
| Repeating payment (A) | Future value (F) | |
| Repeating payment (A) | Present value (P) | |
| Future value (F) | Repeating payment (A) | |
| Present value (P) | Repeating payment (A) | |
| Future value (F) | Initial gradient payment (G) | |
| Present value (P) | Initial gradient payment (G) | |
| Fixed payment (A) | Initial gradient payment (G) | |
| Future value (F) | Initial exponentially increasing payment (D) Increasing percentage (g) | (fori ≠g) (fori =g) |
| Present value (P) | Initial exponentially increasing payment (D) Increasing percentage (g) | (fori ≠g) (fori =g) |
Notes:
The formula for the present value of a regular stream of future payments (an annuity) is derived from a sum of the formula for future value of a single future payment, as below, whereC is the payment amount andn the period.
A single paymentC at future timem has the following future value at future timen:
Summing over all payments from time 1 to timen, then reversing the order of terms and substitutingk =n −m:
Note that this is ageometric series, with the initial value beinga =C, the multiplicative factor being 1 +i, withn terms. Applying the formula for geometric series, we get:
The present value of the annuity (PVA) is obtained by simply dividing by:
Another simple and intuitive way to derive the future value of an annuity is to consider an endowment, whose interest is paid as the annuity, and whose principal remains constant. The principal of this hypothetical endowment can be computed as that whose interest equals the annuity payment amount:
Note that no money enters or leaves the combined system of endowment principal + accumulated annuity payments, and thus the future value of this system can be computed simply via the future value formula:
Initially, before any payments, the present value of the system is just the endowment principal,. At the end, the future value is the endowment principal (which is the same) plus the future value of the total annuity payments (). Plugging this back into the equation:
Without showing the formal derivation here, the perpetuity formula is derived from the annuity formula. Specifically, the term:
can be seen to approach the value of 1 asn grows larger. At infinity, it is equal to 1, leaving as the only term remaining.
Rates are sometimes converted into thecontinuous compound interest rate equivalent because the continuous equivalent is more convenient (for example, more easily differentiated). Each of the formulas above may be restated in their continuous equivalents. For example, the present value at time 0 of a future payment at timet can be restated in the following way, wheree is the base of thenatural logarithm andr is the continuously compounded rate:
This can be generalized to discount rates that vary over time: instead of a constant discount rater, one uses a function of timer(t). In that case, the discount factor, and thus the present value, of a cash flow at timeT is given by theintegral of the continuously compounded rater(t):
Indeed, a key reason for using continuous compounding is to simplify the analysis of varying discount rates and to allow one to use the tools of calculus. Further, for interest accrued and capitalized overnight (hence compounded daily), continuous compounding is a close approximation for the actual daily compounding. More sophisticated analysis includes the use ofdifferential equations, as detailed below.
Using continuous compounding yields the following formulas for various instruments:
These formulas assume that payment A is made in the first payment period and annuity ends at timet.[10]
Ordinary andpartialdifferential equations (ODEs and PDEs)—equations involving derivatives and one (respectively, multiple) variables—are ubiquitous in more advanced treatments offinancial mathematics. While time value of money can be understood without using the framework of differential equations, the added sophistication sheds additional light on time value, and provides a simple introduction before considering more complicated and less familiar situations. This exposition follows (Carr & Flesaker 2006, pp. 6–7).
The fundamental change that the differential equation perspective brings is that, rather than computing anumber (the present valuenow), one computes afunction (the present value now or at any point infuture). This function may then be analyzed(how does its value change over time?) or compared with other functions.
Formally, the statement that "value decreases over time" is given by defining thelinear differential operator as:
This states that value decreases (−) over time (∂t) at the discount rate (r(t)). Applied to a function, it yields:
For an instrument whose payment stream is described byf(t), the valueV(t) satisfies theinhomogeneousfirst-order ODE ("inhomogeneous" is because one hasf rather than 0, and "first-order" is because one has first derivatives but no higher derivatives)—this encodes the fact that when any cash flow occurs, the value of the instrument changes by the value of the cash flow (if one receives a £10 coupon, the remaining value decreases by exactly £10).
The standard technique tool in the analysis of ODEs isGreen's functions, from which other solutions can be built. In terms of time value of money, the Green's function (for the time value ODE) is the value of a bond paying £1 at a single point in timeu; the value of any other stream of cash flows can then be obtained by taking combinations of this basic cash flow. In mathematical terms, this instantaneous cash flow is modeled as aDirac delta function
The Green's function for the value at timet of a £1 cash flow at timeu is
whereH is theHeaviside step function. The notation "" is to emphasize thatu is aparameter (fixed in any instance—the time when the cash flow will occur), whilet is avariable (time). In other words, future cash flows are exponentially discounted (exp) by the sum (integral,) of the future discount rates ( for future,r(v) for discount rates), while past cash flows are worth 0 (), because they have already occurred. Note that the valueat the moment of a cash flow is not well-defined—there is a discontinuity at that point, and one can use a convention (assume cash flows have already occurred, or not already occurred), or simply not define the value at that point.
In case the discount rate is constant, this simplifies to
where is "time remaining until cash flow".
Thus for a stream of cash flowsf(u) ending by timeT (which can be set to for no time horizon) the value at timet, is given by combining the values of these individual cash flows:
This formalizes time value of money to future values of cash flows with varying discount rates, and is the basis of many formulas in financial mathematics, such as theBlack–Scholes formula withvarying interest rates.
{{citation}}:External link in|postscript=| Key concepts | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| Measurement andstandards |
| ||||||||
| Philosophy of time | |||||||||
| Human experience anduse of time | |||||||||
| Time inscience |
| ||||||||
| Related | |||||||||
