Understanding Time Value of Money

The recent failure of Silicon Valley Bank (SVB) underscores the need to understand the time value of money, namely the effect of simple and compound interest on the value of an investment. A common way to assess whether a project is worthwhile is, for example, to calculate its net present value (NPV) based on the organization's required rate of return. If for example an investment will be worth $10,000 five years from now, and the organization requires a 10 percent return on its money, the NPV is roughly $6209 ($10,000 divided by 1.1 to the 5th power) which means the organization should invest no more than this to realize the gain in question. This is an extremely simple example, and more practical ones can determine the net present value of annual returns from an investment. Another possible application is a decision as to whether to buy solar panels for a house. If the current installation price of the panels is known, along with the value of electricity saved over the life of the panels, one can determine the desirability of this investment.

It is also possible to estimate the present value of a bond based on its interest rate and also the current interest rate. While the principal of a Treasury bond is always secure, one must wait until maturity to recover it—and this issue played a major role in the failure of SVB. If for example one buys a 10-year bond when the interest rate is 1 percent, and the interest rate increases to 4 percent, the bond's immediate value drops because investors can get better returns on newly issued bonds. Short-term bonds pay lower interest rates than long-term ones because the risk associated with the former is lower. If one buys a 1-year bond when the interest rate is, say, 1 percent, and the interest rate skyrockets to 6 percent the next month, one needs to wait only the remaining 11 months to get the face value of the bond. If the bond matures in 30 years, though, the drop in current value will be enormous. Join in this session to learn how to perform basic time value of money calculations and apply this to real world situations such as assessment of projects and investments.

Webinar Objectives

Attendees will learn how to perform basic time value of money calculations and apply this to real world situations such as assessment of projects and investments.

Webinar Agenda

• Learn single payment time value calculations:
  • Compound amount factor F, the future value of present investment P at future time N and interest (or rate of return) i.
  • Present worth factor P, the current value of a future amount of money given the same parameters
• Learn uniform series time value calculations. "Uniform series" means equal disbursements or receipts of A dollars in each of N time periods.
  • Sinking fund factor A/F, the annual (or other periodic) investment A required to realize a future value of F over N periods, each with an interest rate of i. If for example the total period is 10 years, the annual interest rate is 4%, and payments are made semiannually, N=20 and i=0.02.
  • The related series compound amount factor, F/A, is the future value of N payments of A with an interest rate of i.
  • The capital recovery factor A/P determines the amount (A) of the N payments needed to pay for a current investment (or loan) P, given an interest rate of i for each period.
  • The series present worth factor, P/A, is the present value of N future disbursements or receipts of A, given an interest rate of i for each.
• The net present value (NPV) is the sum of the present values of the items depicted above. If for example a new piece of equipment costs $10,000, will generate $1500 a year for 10 years, and can be sold (salvage value) for $1000 at the end of its life, its net present value can be calculated given the required rate of return. If the NPV is positive, this means the investment returns more than the required rate. If the NPV is negative, it does not.
  • The same technique can be used to calculate the current value of a bond in light of the prevailing available interest rate.

Who Should Attend

People with responsibility for financial assessment of projects and investments

Credit(s)

IRS CPE Credits: 1 Tax hour