How Do Annuities Affect Time Value of Money Problems and Investment Outcomes?

How do annuities affect time value of money problems and investment outcomes?

A basic principle of finance is the "time value of money." In other words, you have the choice of using your money in the present or the future, but if you choose to forego consuming today, then you should be rewarded for your patience. Financially, this reward comes in the form of interest and the making of money off interest is referred to as usury. Present Value: the amount required to make an investor indifferent between a sum today and another larger sum in the future.

Future Value: the amount required in the future to make the investor indifferent between that sum and a smaller sum today. Annuities are equal payments spread over time, and these can be valued in relation to lump sums today (present value) or at some future time (future value).

The most important concept about understanding any investment is the time value of money. Invested money increases in value over time because of the growth generated from the use of production factors such as machines, land and labor. Interest is the measure of value of money when in use, usually expressed as annual percentage rate, or interest rate. Discount rate is the rate used to calculate the present value of future cash flows; also called the "capitalization rate."

Present Value

Definition: Current monetary value of an asset. Sense of the current value of future economic benefits using the discounted value of aggregate future income. Definition: [crh] The amount of cash today that is equivalent in value to a payment, or to a stream of payments, to be received in the future. To determine the present value, each future Definition: cash flow is multiplied by a present value factor. For example, if the opportunity cost of funDefinition: ds is 10%, the present value of $100 to be received in one year is $100 x [1/(1 + 0.10)] = $91.

Future Values of Present Sums

Interest rates also can be used to find the future value of a present sum of money. With simple interest, the interest received is not reinvested and therefore does not generate additional income. For example, $100 yields $8 in 1 year at 8 percent. The $8 is not reinvested the second and subsequent years; only the original principal of $100 earns interest. Eight dollars is earned in the second year, and so forth.

Opportunity cost is helpful when evaluating the cost and bemefit of choices. Its usually expressed in non monetary terms, by expressing the cost of one option in terms of the foregone benefits of another, the marginal costs and benefits of the options can be compared.

Before making any investment decision, one of the key elements you face is working out the real rate of return on your investment.

Compound interest is critical to investment growth. Whether your financial portfolio consists solely of a deposit account at your local bank or a series of highly leveraged investments, your rate of return is dramatically improved by the compounding factor.

With simple interest, interest is paid just on the principal. With compound interest,