Time Value of Money and Discounted Cash Flow Valuation

The future value of money refers to the fact that the value of money in the present is
worth more than in the future. There are factors that can affect the value of money. For
example, the money you earn today can be worth more in the future if you invest it and
earn interest while waiting. Future value is the value of a current asset at a future date
based on the interest rate. Compounding is the process through which earnings from an
asset, such as interest or capital gains, are reinvested to produce more earnings over
time. Compounding the interest means earning interest on interest. The investment will
produce earnings from both its initial principal and the accumulated earnings from prior
periods, which are calculated using exponential functions.
It is important to know the future value of money as it enables investors to make sound
decisions and allows them to predict, with varying degrees of accuracy, the amount of
profit that can be generated by different investments based on their expectations and
needs. But there are also factors that can affect the future value of the asset, such as
inflation, market volatility, and uncertainty about future investment conditions. The
opposite of future value is present value, which calculates what something at a future
date is worth today. The percentage of the principal that the lender charges for the use
of its funds is known as the interest rate.
Simple interest only increases depending on the principal, which is the cash you deposit
or invest. Compound interest is interest that is calculated using both the principal and
any prior interest. The present value of an investment is the current value of a future
sum of money. It represents the value of that sum at the current point in time vs. its
expected value in the future. The present value helps compare money received today to
money received in the future. Present value is the current value of a future sum of
money or stream of cash flows given a specified rate of return.
Calculating present value involves assuming that a rate of return could be earned on
the funds over the period. Finding the present value of a payment that will be received
in the future is the process of discounting. The discount rate refers to the rate of interest
that is applied to future cash flows of an investment to calculate its present value.
Discounted cash flow refers to a valuation method that estimates the value of an
investment using its expected future cash flows. It can aid those who are trying to
decide whether to purchase securities or a firm. Business owners and managers can
use discounted cash flow analysis to help them make decisions about operational and
capital budgets. It is a type of financial model that determines whether an investment is
worthwhile based on future cash flows.
A discounted cash flow valuation is used to determine if an investment is worthwhile in
the long run. The process of discounting a future amount back to the present is the
opposite of compounding or calculating the future value. There are two ways to
calculate future values for multiple cash flows: (1) compound the accumulated balance
forward one year at a time or (2) calculate the future value of each cash flow first and
add these up. Future value of a series of cash flow is used to determine the total worth
of continuous cash flow of some years at a usual rate of interest. In other words, it is the
total return to be obtained after the maturity of a continuous deposit scheme in the
money was invested at regular intervals.
Present Value with Multiple Cash Flows can be calculated by either discount back one
period at a time, or we can calculate the present values individually and add them up. In
working present and future value problems, cash flow timing is critically important
because timing is everything when it comes to managing cash in a business, we need
to be sure about the dates when major payments into the business are expected. In
almost calculations, it is essentially assumed that the cash flows occur at the end of
each period.
The present value of an annuity is the current value of future payments from an
annuity, given a specified rate of return, or discount rate. The higher the discount rate,
the lower the present value of the annuity. The present value of an annuity refers to
how much money would be needed today to fund a series of future annuity payments.
An annuity is an insurance contract or series of payment made at equal intervals that
exchanges present contributions for future income payments. The future value of
an annuity is the value of a group of recurring payments at a certain date in the future,
assuming a particular rate of return, or discount rate. To calculate the future value of an
annuity: first, define the periodic payment you will do (P), the return rate per period (r),
and the number of periods you are going to contribute (n). Second, calculate: (1 +
r)ⁿ minus one and divide by r. Third, multiply the result by P, and you will have the future
value of an annuity.
Annuity due is an annuity for which the cash flows occur at the beginning of the period.
A perpetuity is a security that pays for an infinite amount of time. In finance, perpetuity is
a constant stream of identical cash flows with no end. The present value of a perpetuity
is: Perpetuity PV = C/r. Effective annual rate is the rate actually earned on investment or
paid on the loan after compounding over a given period of time and is used to compare
financial products with different compounding periods.
The effective annual interest rate is the rate of interest that an investor can earn (or pay)
in a year after taking into consideration compounding. Effective Annual Rate Formula. i
= (1 + r m) m − 1 i = (1 + r m) m − 1. Where r = R/100 and i = I/100; r and i are
interest rates in decimal form. m is the number of compounding periods per year. The
effective annual rate is the actual interest rate for a year. Annual percentage rate is the
interest rate charged per period multiplied by the number of periods per year. It can be
calculated as Annual Percentage Rate (APR) = (Periodic Interest Rate x 365 Days) x
100. Where: Periodic Interest Rate = [ (Interest Expense + Total Fees) / Loan
Principal] / Number of Days in Loan Term. The Annual Percentage Rate, or, in its more
common form, APR, is a particular type of interest rate often published by banks or
financial institutions.

There are three basic types of loans which are the following; pure discount loans,
interest-only loans, and amortized loans. The pure discount loan is the simplest form of
loan. With such a loan, the borrower receives money today and repays a single lump
sum at some time in the future. A second type of loan has a repayment plan that calls
for the borrower to pay interest each period and to repay the entire principal (the original
loan amount) at some point in the future. Such loans are called interest-only loans. With
a pure discount or interest-only loan, the principal is repaid all at once. An alternative is
an amortized loan, with which the lender may require the borrower to repay parts of the
loan amount over time.

Jerrie May B. Jambangan