The Techniques Used for Solving Time Value Problems

The Techniques Used for Solving Time Value Problems
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The time value of money is a finance concept used to value cash flows over different time periods. Receiving money in the present is more valuable than receiving money in the future because you can invest money received today and receive interest. With time value techniques, you can determine the correct value of various investments.

Future Value

The simplest time value technique is the future value calculation. The future value calculation determines what a current investment grows to in the future using a given interest rate and time period. This calculation is known as compounding because the investment grows each year by the annual interest rate. The formula for a future value calculation is: future value = present value x (1+ interest rate)^ number of years. If you invest $1,000 for five years at five percent, the future value equals $1,000 x (1+0.05)^5 = $1,276.28.

Present Value

The present value calculation is the opposite of the future value calculation. This technique determines the value of a future cash flow in today's dollars. This technique is called discounting because the future value is reduced each year by the annual interest rate. To calculate the present value, you need a fixed interest rate, a fixed number of years and a future value. The formula for present value is: present value equals future value/(1+ interest rate)^number of years. For example, if you earn a future value of $1,276.28 in five years with an interest rate of five percent, the present value is 1,276.28/(1+0.05)^5 = $1,000.

Length of Time

Another time value technique is the calculation of the length of time of an investment. This calculation is used when you want to calculate how long it would take to grow a current investment to a future value using a fixed interest rate. For this this technique, it is best to use a financial calculator. On your calculator, input the interest rate as I/YR, the present value as PV and the future value as FV. Press "compute N" and the calculator determines the total number of years needed to solve your problem.

Interest Rate

The final time value technique is the calculation of an unknown interest rate. This technique calculates the necessary rate of return to grow a present value into a future value over a fixed period of years. This technique is also calculated using a financial calculator. Input your present value as PV, your desired future value as FV and the years of your investment period as N on your financial calculator. Press "compute I/YR" and the calculator determines the interest return needed to grow your current investment into your desired future value.