4 Responses Sep 03

Charanjeet Work:

Time Value of Money

The time value of money is the idea that money received in the present is more valuable than the same sum in the future because of its potential to be invested and earn interest. This potential opportunity to earn money over time on the amount is the opportunity cost of waiting for the money. In addition to the opportunity cost of waiting for the money, inflation gradually erodes the purchasing power of the sum of the money over time. In general, people pay attention to compounding or the future value of an investment or expense made in the present. They generally do not consider the present value of a return to be received in the future or an expense to be paid in the future (this is called discounting) (Abor, 2017).

Annuities

Annuity is a series of payments received on regular intervals - monthly, quarterly or yearly. The payments could be fixed payments or variable payments based on the type of contract between the source (e.g. an insurance company) and the beneficiary. There are 2 types of annuity -

Ordinary Annuity - In ordinary annuity, payments are made at the end of a covered term. Payments are usually made monthly, quarterly, or annually. A home mortgage, for instance, is a common type of ordinary annuity. When a homeowner makes a mortgage payment, it typically covers the month-long period leading up to the payment date. Two other common examples of ordinary annuities are interest payments from bonds and stock dividends. When a bond issuer makes interest payments, which generally happens twice a year, the interest is paid and received at the end of the period in question. Similarly, when a company pays dividends, which typically happens quarterly, it is paying at the end of the period during which it retained enough excess earnings to share its proceeds with its shareholders. Ordinary annuities are also seen in retirement accounts, where you receive a fixed or variable payment every month from an insurance company, based on the value built up in the annuity account. In a fixed annuity account, your monthly payment is based on a fixed interest rate applied to the account balance at the start of payments. Variable annuity account payments are based on the investment performance of your account (Flórez, Vera, Salazar-Torres, Huérfano, Gelvez-Almeida, Valbuena & Aranguen, 2019, November).

Annuity Due - With an annuity due, payments are made immediately, or at the beginning of a covered term rather than at the end. A rent or lease agreement, for instance, is a common example of an annuity due. When a rental or lease payment is made, it typically covers the month-long period following the payment date. Insurance premiums are another example of an annuity due, as payments are made at the beginning of a period for coverage lasting through the end of that period.

A fixed annuity’s present value is how much the future cash flows are worth in today’s time. It’s figured by reducing the value of each payment based on a discount factor and the time until the payment occurs. The discount rate is based on the opportunity cost measured from an alternate investment.

The future value of an annuity is the value of a group of recurring payments at a certain date in the future. So, Annuity due has a better present value than the ordinary annuity as payments are made at the start of the period in annuity due.

 

References

Abor, J. Y. (2017). Time Value of Money. In Entrepreneurial Finance for MSMEs (pp. 259-291). Palgrave Macmillan, Cham.

Flórez, M., Vera, M., Salazar-Torres, J., Huérfano, Y., Gelvez-Almeida, E., Valbuena, O., ... & Aranguen, M. (2019, November). Interest rates calculation in certain ordinary annuities. In Journal of Physics: Conference Series (Vol. 1414, No. 1, p. 012009). IOP Publishing.

Chandini Work:

Time Value of Money Matters to Investors

The time value of money (TVM) is an important concept to investors because a dollar on hand today is worth more than a dollar promised in the future. The dollar on hand today can be used to invest and earn interest or capital gains. A dollar promised in the future is actually worth less than a dollar today because of inflation. Provided money can earn interest, this core principle of finance holds that any amount of money is worth more the sooner it is received (Chen, 2020). At the most basic level, the time value of money demonstrates that all things being equal, it is better to have money now rather than later.

Present the value determines what a cash flow to be received in the future is worth in today's dollars. It discounts the future cash flow back to the present date, using the average rate of return and the number of periods. No matter what the present value is if you invest that present value amount at the specified rate of return and number of periods, the investment would grow into the future cash flow amount.

Present value = (future cash flow) / (1+ rate of return)^number of periods

Future the value determines what a cash flow received today is worth in the future, based on interest rates or capital gains (Chen, 2020). It calculates what a current cash flow would be worth in the future if it was invested at a specified rate of return and number of periods.

Future value = present value x {1 + (rate of return x number of periods)}

Both present value and future value take into account compounding interest or capital gains, which is another important aspect for investors to consider when looking for good investments. Time is literally money. The value of the money you have now is not the same as it will be in the future. Knowing how to determine TVM by calculating present and future value can help you distinguish between the worth of investments that offer returns at different times.

 

Ordinary annuities & annuities due

Ordinary annuities are seen in retirement accounts, where you receive a fixed or variable payment every month from an insurance company, based on the value built up in the annuity account. In a fixed annuity account, your monthly payment is based on a fixed interest rate applied to the account balance at the start of payments. Variable annuity account payments are based on the investment performance of your account. Retirement annuities send you payments at the end of each period. That’s standard when you are the recipient of annuity payments rather than the payer.

An annuity is a series of payments at a regular interval, such as weekly, monthly or yearly. Fixed annuities pay the same amount in each period, whereas the amounts can change in variable annuities (Rama- Poccia, 2018). The payments in an ordinary annuity occur at the end of each period. In contrast, an annuity due features payment occurring at the beginning of each period. The difference between an ordinary annuity and annuity due lies in when the payments occur – at the period's end for an ordinary annuity and at the period's beginning for an annuity due.

The a classic example of an annuity due is rent. When you sign a lease for an apartment, you commit to paying rent on the first of each month (Rama- Poccia, 2018). This qualifies as an annuity due because the payments occur at a regular interval (monthly) and at the beginning of each period. Insurance premium payments are another common example of an annuity due. Notice how annuity due is usually found in situations where you are paying out money. An annuity account is meant to pay you money each month for either a fixed number of years or until you die, according to your contract with the insurance company. The largest insurance carriers are likely to make all payments on time, but annuities from smaller carriers carry some risk that the insurer will default on its payments. All financial annuities carry the risk of underperforming relative to the broader stock market, especially compared to the returns available from low-cost index funds. A financial adviser can review the pros and cons of retirement annuities with you before you commit to one.

 

Reference:

Chen, J. (2020). Time Value of Money. Retrieved 21 April 2020 from https://www.investopedia.com/terms/t/timevalueofmoney.asp 

Rama- Poccia, M. (2018, December 5). What Is the Time Value of Money and Why Does It Matter? The Street, np