SG_CH05

# SG_CH05 - CHAPTER 5 The Time Value of Money Orientation: In...

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CHAPTER 5 The Time Value of Money Orientation : In this chapter, the concept of a time value of money is introduced; that is, a dollar today is worth more than a dollar received a year from now. Thus, if we are to logically compare projects and financial strategies, we must move all dollar flows either back to the present or out to some common future date. I. Compound interest results when the interest paid on the investment during the first period is added to the principal and, during the second period, the interest is earned on the original principal plus the interest earned during the first period. A. Mathematically, the future value of an investment if compounded annually at a rate of i for n years will be: FV n = PV (l + i) n where n = the number of years during which the compounding occurs, i = the annual interest (or discount) rate, PV = the present value or original amount invested at the beginning of the first year, FV n = the future value of the investment at the end of n years. 1. The future value of an investment can be increased either by increasing the number of years we let it compound or by compounding it at a higher rate. 59

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2. If the compounded period is less than one year, the future value of an investment can be determined as follows: FV n = PV mn m i 1 + where m = the number of times compounding occurs during the year. II. Determining the present value, that is, the value in today’s dollars of a sum of money to be received in the future, involves nothing other than inverse compounding. The differences in these techniques come about merely from the investor’s point of view. A. Mathematically, the present value of a sum of money to be received in the future can be determined with the following equation: PV = FV n + n i) (1 1 where n = the number of years until payment will be received, i = the annual interest (or discount) rate, PV = the present value of the future sum of money, FV n = the future value of the investment at the end of n years 1. The present value of a future sum of money is inversely related to both the number of years until the payment will be received and the opportunity rate. III. An annuity is a series of equal dollar payments for a specified number of years. Because annuities occur frequently in finance, for example, bond interest payments, we treat them specially. A. A compound annuity involves depositing or investing an equal sum of money at the end of each year for a certain number of years and allowing it to grow. 60
1. This can be done by using our compounding equation and compounding each one of the individual deposits to the future or by using the following compound annuity equation: FV n = PMT ( 29 + - = 1 n 0 t t i 1 where PMT = the annuity payment deposited or received at the end of each year, i = the annual interest (or discount) rate, n = the number of years for which the annuity will last, FV n = the future value of the annuity at the end of

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## This note was uploaded on 04/16/2008 for the course FIN 100 taught by Professor N/a during the Spring '08 term at Baylor.

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SG_CH05 - CHAPTER 5 The Time Value of Money Orientation: In...

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