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There are numerous concepts that revolve around the time value of money, including present value, future value, amortization and opportunity costs. These concepts are extremely important in the analysis and management of investment opportunities. By using various time value of money concepts, a person can effectively compare various investment opportunities. The premise of these concepts is to determine whether a series of payments for an extended period of time in the future is more valuable than a lump sum payment today.
Present value is one of the more popular time value of money concepts. In analyzing an income stream, calculating the present value allows a person to determine what a future payment would be worth today. Many factors have to be considered when calculating present value, including the interest rate and the length of time before the future payment is completed.
In addition to calculating the present value of money, there are time value of money concepts that are designed to calculate the future value of money. This concept is often used to determine what the value of a series of payments will be worth in the future. Generally, future values are calculated on investments that offer fixed interest rates over an extended period of time.
Calculating the internal rate of return (IRR) of an investment is another formula that is based on time value of money concepts. This calculation is made to determine the compounded average annual rate of return on a particular investment. Analyzing internal rates of returns can help investors determine whether certain investments will produce returns that are greater than the cost of the capital used to make the investments.
Amortization is another concept that is used to create payment installments for a loan. These payments generally encompass interest and principle payments as the loan is gradually reduced over time. Payments that are amortized generally are applied to the interest accrued on the loan, and the remainder is applied to the principle. Over time, the bulk of the payment will begin to be applied to the principle, with less going toward interest payments.
Opportunity costs also are considered to be one of the time value of money concepts. The premise behind this concept is that every investment opportunity must be measured against the performance of a foregone opportunity upon which the investor did not act. The difference in the amount that was generated by the missed opportunity in comparison with the opportunity that was acted upon is the opportunity cost.
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