How is time value of money computed?

The time value of money may be computed in the following circumstances:

1.  Future value of a single cash flow
2.  Future value of an annuity
3.  Present value of a single cash flow
4.  Present value of an annuity

(1)   Future Value of a Single Cash Flow

For a given present value (PV) of money, future value of money (FV) after a period ‘t’ for which compounding is done at an  interest rate of ‘r’,  is given

by the equation
FV  = PV (1+r)t

This assumes that compounding is done at discrete intervals.  However, in case of continuous compounding, the future value is determined using the formula
FV = PV * ert

Where ‘e’ is a mathematical function called ‘exponential’ the value of exponential (e) = 2.7183. The compounding factor is calculated by taking natural logarithm (log to the base of 2.7183).

Example 1: Calculate the value of a deposit of Rs.2,000 made today, 3  years hence if the interest rate is 10%.

By discrete compounding:
FV = 2,000 * (1+0.10)3 = 2,000 * (1.1)3 = 2,000 * 1.331 = Rs. 2,662
By continuous compounding: 

 

 

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