Present values and future values can be compared
by measuring them at either the end of the investment
or at time zero. In our example, we can compute
the future value of investing $10,000 for 5 years
and compare it to the future value of investing
each of the cash flows for 4, 3, 2 and 1 years.
Or we can compute the present value of $10,000
at time zero (that is, $10,000) and compare it
to the present values of the cash flows.
- To compute future value, use compounding
to find the future value of each cash flow at
a future time -- and then sum all these future
values.
- To compute present value, use discounting
to find the present value of each cash flow
at time zero -- and then sum all these present
values.
Although present value and future value techniques
produce the same decisions, financial planners
(who live and work at time zero) tend to rely
on present value techniques.
|
A time line depicts cash flows of
an investment. Consider an investment of $10,000
that produces returns over 5 years:
End of year |
Amount |
0 |
-10,000 |
1 |
+2,000 |
2 |
+3,000 |
3 |
+4,000 |
4 |
+2,000 |
5 |
+1,000 |
Money has time value. In our example, receiving
$2,000 after one year has more value than receiving
the same amount after four years. The earlier
money may be consumed or reinvested before the
later money. We value it more highly.
|
1.1 Introduction-Time value of money