Page 35 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 2.6 Summary

 The compensation for waiting is the time value of money, called interest. Interest is a fee
that is paid for having the use of money.

 The future value varies with the interest rate, the compounding frequency and the number
of periods.

 The general formula for the future value of 1, with n representing the number of
n
compounding period is fv = (1 + i) .
 Finding the present value of future receipts involves discounting the future value to the
present. Discounting is the opposite of compounding.
n
 The general formula for the present value of 1 is pv = 1/(1+i) .
 An annuity is a series of equal payments made at equal time intervals, with compounding
or discounting taking place at the time of each payment. Each annuity payment is called a
rent.
 The future value of an annuity or amount of annuity is the sum accumulated in the future
from all the rents paid and the interest earned by the rents.
 The present value of an annuity is the sum that must be invested today at compound
interest in order to obtain periodic rents over some future time.
 An annuity that goes on for ever is called a perpetuity. The present value of a perpetuity
of C amount is given by the simple formula: C/i where i is the rate of interest.
 Compound growth rate can be calculated with the following formula:
gr = V (1 + r) = V
n
o n
2.7 Keywords

Annuity: It is a stream of equal annual cash flows.
Cash Flow: It is the movement of cash into or out of a business, a project, or a financial product.
It is usually measured during a specified, finite period of time.

Compound Interest: When interest is added to the principal, so that from that moment on, the
interest that has been added also itself earns interest.
Compound Value: The interest earned on the initial principal becomes a part of the principal at
the end of a compounding period.
Interest: It is a fee paid on borrowed assets. It is the price paid for the use of borrowed money.
Present Value: In case of present value concept, we estimate the present worth of a future
payment/instalment or series of payment adjusted for the time value of money.
Time Value of Money: Time value of money is that the value of money changes over a period of
time.

2.8 Review Questions

1. "Cash flows of two years in absolute terms are uncomparable" Give reasons in support of
your answer.

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