The time value of money - part 2 : Beware the false profit.

Posted On Monday, 17 March 2003 02:00 Published by eProp Commercial Property News
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As stated in last week's column, when money grows in total, it is said to be accumulating. When it reduces in value, it is said to have been discounted. The principle of accumulation was then discussed. Let us now look at discounting values.

Jonathan SmithThe process of investment requires that an investor pay out a certain amount of money at the beginning of the investment period in
anticipation of receiving future financial benefits at pre-determined intervals during the investment period. This means that the investor is paying out an amount at present-day values in order to receive a future-day return, which return is quoted in nominal values. 

As stated, the real value of money declines over time. This means that the real value of an investor's return will be less than the anticipated nominal value. If the future value of the return is less in real terms than the nominal value, it is necessary to reduce the nominal value to a (real) present value to match the cash outflow required by the investment with the real values of the anticipated cash outflows. A positive variance between in- and out- flow will means that you stand to make a real profit (ie return) and a negative variance between in- and out-flows means that you will make a real loss.

 The wise investor must, however, convert the future value income stream to a present value through a process called discounting and through the use of an appropriate discount rate. Discounting is always performed with the use of compound discount rates.

Last modified on Monday, 26 May 2014 12:59

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