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TIME VALUE OF MONEY

As time progresses, inflation eats away at the value or the purchasing power of the dollar. That is to say that a dollar today is worth more than a dollar

tomorrow. Investors can determine the future value of a sum invested if they know the interest rate, the time horizon, and the compounding schedule. The future value of a sum invested today can be determined by using the following formula:

Where:

FV = future value PV = present value R = interest rate

T = the number of compounding periods for which the money will be invested

EXAMPLE FV = ?

PV = $1,000 R = 5%

T = 5 years compounded annually

FV = $1,000 (1 + .05)5 FV = $1,000 (1.276) FV = $1,276

The future value of the investment will increase as the number of compounding periods increases. Let's look at what would happen to the same investment of $1,000 for five years at 5 percent if the interest was compounded semiannually. Everything would remain the same except that T would be 10 and the interest rate for each semiannual period would be half the annual rate. In this instance, we get:

FV = $1,000 (1 + .025)10 FV = $1,000 (1.28) FV = $1,280

More compounding periods increase the investor's total return.

An investor can also determine the present value of a future payment by using the following formula:

Investors can also use the present value formula to determine how much they would have to invest today to have a given sum of money in the future. For example, let's say that an investor wants to have $10,000 saved for his child's college tuition five years from now. If the investor knows that he can receive 6 percent on his money, he can determine how much he must invest today. The present value of $10,000 five years from now at a 6 percent rate is found as follows:

The investor would have to invest $7,473 today at a 6 percent rate to have $10,000 five years from now. Investors can also use the present value and future value to determine an investment's internal rate of return through a process called iteration.

 
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