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CHAPTER 5

# CHAPTER 5 - CHAPTER 5 The Time Value of Money Orientation...

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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. 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

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