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4-1McGraw-Hill/IrwinCopyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.Time value of moneyA dollar today is worth more than a dollar tomorrowWhy?Default riskInflationOpportunity costDiscount rates help us value future cash flows today4-3Basic DefinitionsPresent Value (PV)The current value of future cash flows discounted at the appropriate discount rateValue at t=0 on a time lineFuture Value (FV)The amount an investment is worth after one or more periods.Later money on a time line4-4Basic DefinitionsInterest rate(r)Discount rateCost of capitalOpportunity cost of capitalRequired returnTerminology depends on usage4-5Time Line of Cash FlowsCF3CFCF1CF2123r%Tick marksat ends of periodsTime 0 is today; Time 1 is the endof Period 1+CF = Cash INFLOW -CF = Cash OUTFLOW PMT = Constant CF4-6Time Line for a $100 Lump Sum due at the End of Year 2.10012 Yearr%4-7Future Values: General FormulaFV = PV(1 + r)tFV = future valuePV = present valuer = period interest rate, expressed as a decimalt = number of periodsFuture value interest factor = (1 + r)tNote: yx key on your calculator4-8Future Values Example 1Suppose you invest $100 for one year at 10% per year. What is the future value in one year?Interest = 100(.10) = 10Value in one year = Principal + interest = 100 + 10 = 110Future Value (FV) = 100(1 + .10) = 1104-9Future Values Example 1Suppose you leave the money in for another year. How much will you have two years from now?FV = 100(1.10)(1.10) = 100(1.10)2= 121.004-10Effects of CompoundingSimple interest Interest earned only on the original principalCompound interestInterest earned on principal and on interest receivedInterest on interest interest earned on reinvestment of previous interest payments4-11Effects of CompoundingConsider the previous exampleFV w/simple interest = 100 + 10 + 10 = 120FV w/compound interest =100(1.10)2= 121.00 = 121.... View Full Document

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