Tag Archives: discounting

Time Value of Money Primer

Time value of money (TVM) is represented by the difference in value of some dollar amount of money or cash flow(s) over a period of time, assuming one can earn some sort of return on the money available.

Simple interest is calculated on the principal only while compound interest is when one also earns “interest on interest.” Compounding may be used to describe moving a value or cash flow forward in time:

Future Value=FV      

Present Value=PV

# of years=n

Cash Flow/Payment=PMT

nominal rate of interest=i

FV = PMT(1+i)^n

You have $50,000 to invest. If you think you can earn 7.5% annually, how much might you accumulate in 30 years?

Discounting is known as the process of moving a value or cash flow backward in time:

PV = PMT/(1+i)^n

If you’d like to have $50,000 in 5 years, how much might you have to invest today assuming a 5% rate of return? 

Real returns are sometimes described as the rate of return one receives net of inflation but may be more accurately calculated:

Real rate of return=r

Inflation Premium=IP

r=[(1+i)/(1+IP)]-1

One should consider the effect of taxes on earnings as well.