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PP Lesson 4 Time Value of Money - TIME VALUE OF MONEY Topic...

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TIME VALUE OF MONEY Topic 4
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TIME VALUE OF MONEY Introduction: Concept of TVM Compound Interest Present Value Annuities Perpetuities Capital Budgeting
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Introduction It is very crucial for a businessman who decides to make an investment, to understand the concept of time value of money. Understanding the concept helps us to invest in profitable investments. In finance, RM1 on hand today, is worth more than RM1 promised some time in the future The money that we can have today is worth more than the money promised some time in the future, because the money we can have now can be invested in projects or deposited in banks to earn interest .
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The Importance of TVM A successful business is one that creates value for its owners wealth is created when the benefits are greater than costs the investment decision rule is - accept only those investments that raise the wealth of shareholders One problem is that benefits and costs occur at different times and over a number of years this leads us to consider the time value of money
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Introduction: Concept of TVM Why should this be? There are 4 reasons: 1. Interest forgone 2. Inflation 3. Risk 4. Personal consumption *We will concentrate on the first reason only
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Time Value of Money How much is $100 investment worth in 10 years, with 10% interest compounded annually? Time Line: 0 1 2 3 4 5 6 7 8 9 10
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Interest Interest Interest - - A fee for borrowing money A fee for borrowing money Borrow Borrow - - interest rate charges >> interest rate charges >> significant cost to firm/individual significant cost to firm/individual Lend/save Lend/save - - interest rate earned >> interest rate earned >> revenue to firm/individuals revenue to firm/individuals
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Interest 2 basic types of interest commonly used: 1. 1. Simple interest Simple interest - interest paid only on - interest paid only on the principal the principal 2. 2. Compound interest Compound interest - interest paid on - interest paid on both principal and interest previously both principal and interest previously earned. earned.
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Interest 2 basic types of interest commonly used: 1. 1. Simple interest Simple interest - interest paid only on the principal - interest paid only on the principal I = PRT I = PRT example: Ali deposited RM1000 in Bank Bumiputera Commerce with interest rate 10% for two years. I = 1000 x .1 x 2 =200 2. 2. Compound interest Compound interest - interest paid on both - interest paid on both principal and interest previously earned principal and interest previously earned . . Year 1 = 1000 x .1 x 1 = 100 x 1 = 100 Year 2 = 1100 x .1 x 1 = 110 Compound Interest = 210 Year 2 = 1100 x .1 x 1 = 110 Compound Interest = 210
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Compound interest occurs when interest paid (earned) on the investment during the first year is added to the principal, then during the second year, interest is earned on this new investment Several methods can be used to calculate compound interest: Future Value Formula FVIF Table Financial Calculator Compound Interest
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Future Value Formula FV n = PV(1 + i) n Definition: PV:Present Value, or initial amount/principal amount i: Interest rate the bank pays for each period.
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