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Present and Future Value

Created @February 11, 2025 6:05 PM

Class FINANCE

Status Done

Present and Future Value

Time Value of Money

Money’s value changes over time due to consumption preferences, inflation,
and uncertainty (risk).

A dollar today is worth more than a dollar in the future;

because:

Consumption Preferences – Individuals prefer spending today rather than

waiting.

Inflation – The purchasing power of money declines over time.

Uncertainty (Risk) – Future outcomes are unpredictable, requiring

compensation for risk.

Discount Rate and Interest Rate Quoting

The discount rate is used to compare today’s value with future value and
reflects:

Real Rate – Adjusted for economic productivity and liquidity.

Nominal Rate – Adjusted for inflation.

Risk Premium – Additional compensation for investment uncertainty.

Different Interest Rate Quoting Methods

Interest rates are expressed in different ways, influencing how cash flows are
valued:

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 1. Nominal Interest Rate – The nominal interest rate is the stated interest rate
without adjusting for inflation. It represents the rate quoted by banks and
financial institutions for loans, bonds, and investments. However, it does not
reflect changes in purchasing power over time.

For example, if a bank offers a 5% annual loan rate, that 5% is the nominal
interest rate.

1. Effective Interest Annual Rate (EAR) – the actual interest rate an

investment or loan earns or costs over a year, accounting for
compounding.
EAR = [(1 + r/m)]m − 1

where:

r= Nominal annual interest rate

m= Number of compounding ( how many times) periods per year

❓ What does it mean compounding?

Compounding means earning interest on both the initial principal
and the accumulated interest from previous periods. It leads to
exponential growth over time, as each period’s interest gets added to
the principal for future calculations

For example, if you invest $1,000 at 5% annually, after one year, you earn
$50 interest. In the second year, interest is calculated on $1,050, not just
the original $1,000—this is compounding in action.

2. Annual Percentage Rate (APR) – A nominal rate calculated as:

APR = r ∗ m

A credit card charges 1.5% interest per month. The APR is:

APR=1.5%×12=18%

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 This means the lender advertises an 18% annual rate, but the actual
cost (EAR) could be different

3. Continuous Compounding Rate – is the interest rate applied infinitely

many times per period, meaning interest is constantly being added to the
principal.
where e is the mathematical constant (~2.718).

PV= 1/er t

Understanding how interest rates are quoted is essential for making informed
financial decisions in loans, investments, and valuations.

Capitalization (Compounding) and Discounting

(Actualization)
Compounding determines future value (FV) from a present investment:

Value of investment after 1 year = present value × (1 + r)

F V = P V (1 + r)t 
if we have multiple cash flows, we use the discounted cash flow (DCF)
formula :

DCF = ∑ Ct /(1 + r)t 

​

where Ct represents cash flows at different time periods t

​

Discounting is the reverse process, determining one present value (PV) of

a future cash flow:
P V = F V /(1 + r)t 
Discount factor = 1/(1 + r)t 

📖 A Discount Factor measures the present value of one dollar received

at the end of year t ( PV recieved in the future)

Compounded Interest and Discount Rates

Compounded Interest Rate accounts for interest applied to both the
principal and accumulated interest, leading to exponential growth.

Compounded Discount Rate adjusts future cash flows back to their present
value, ensuring a fair comparison of investments occurring at different

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 times.

Net Present Value (NPV) and Net Future Value (NFV)

Net Present Value (NPV): Evaluates profitability by summing discounted
future cash flows:

NPV = PV - investment (Net Value that

shareholders will recieve)
n Ct
NP V = C0 + ∑t=1 ​ ​

(1+r)t
 ​

​ C0 as initial cash flow (today) *

​

*it is usually negative→ investment== cash outflow

Net Future Value (NFV): Sums future values of cash flows at a given time:

📏 If you can find the present value of any series of cash flows,
you can always calculate its future value by multiplying by (1 + r)t:
Future value at the end of year t = PV × (1 + r)t 

NF V = P V ∗ (1 + r)t =
= (C0 + ∑nt=1
​ ​
Ct
(1+r)t
) ​

​ ∗ (1 + r)t 

Annuities and Perpetuities

Perpetuities
A perpetuity is a financial instrument that provides infinite periodic payments.

A common example of a perpetuity would be investors buying a preferred

stock with dividends.

1. Regular Perpetuity:

PV of perpetuity= Cr  ​ The perpetuity has a value of 1/r.

*the perpetuity formula tells us the value of a regular stream of payments

starting
one period from now; if we wanted to compute the value of a perpetuity
starting immediately (perpetuity due) we use the formula: = Cr ​ (1 + r)
2. Growing Perpetuity:

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 C
PV of growing perpetuity= r−g  ​

if we call the growth rate in costs g and we assume r > g

📖 A growing perpetuity is a financial instrument that pays an infinite

series of cash flows, with each payment increasing at a constant
rate (g) over time. The payments grow due to inflation, economic
growth, exc…

Annuities
An annuity provides a fixed series of payments for a predetermined period.

1. Ordinary Annuity – Payments occur at the end of each period.

2. Annuity Due – Payments occur at the beginning of each period (payment

starts immediately).

An Annuity due is worth (1+r) times the value of an ordinary annuity. *

(like perpetuities due)

Present and Future Value of an Annuity

PV = C
r
​ × (1 − 1
)
(1+r)t 
​

Future value of annuity= present value of annuity of $1 a year × (1 + r)t 

F V = C × ( 1r − ​
1
r(1+r)t
)​ × (1 + r)t 

Annuities are used in mortgages, retirement planning, and structured

settlements.

Opportunity Cost of Capital and Investment Decisions

The opportunity cost of capital represents the return an investor forgoes by
choosing one investment over another. When deciding whether to invest now or

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 in the future, this concept plays a crucial role, as funds allocated today could
generate returns elsewhere. The key trade-off is between immediate
investments that yield sooner but may be subject to greater risk and future
investments that could be more secure or offer better opportunities but delay
potential gains.

If the opportunity cost of capital is high, delaying an investment may lead to

lower overall returns.

Additionally, risk influences opportunity cost—riskier investments demand a

higher expected return to justify the uncertainty. The relationship between risk
and opportunity cost will be explored further in later sections.
For an investment to be worthwhile, it must offer a higher risk-adjusted return
than alternative options.

Riskier investments require a higher expected return to be viable.

Risk-adjusted NPV analysis ensures investments justify their risk

exposure.

Conclusion
Understanding present and future value is crucial in financial decision-making.
Compounding and discounting enable investment comparison, risk
assessment, and capital allocation. Perpetuities help estimate infinite cash
flows, while annuities structure payments over a fixed period. These principles
are essential for evaluating long-term investments and financial planning.

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