Chapter 5 Time Value of Money

Chapter 5 Time Value of Money - Arizona State University...

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1 Arizona State University FINANCE 300 Fundamentals of Finance Chapter 2: Time Value of Money Instructor: Christian Ramirez Introduction We couldn’t conceive Finance without Time Value of Money (TVM). So far, we have only dipped our feet into the world of finance, but we are about to see what finance is all about. TVM is the most important financial concept. The TVM concepts and techniques that we will go over tonight are an integral part of the rest of the chapters we will study and until the end of the course. The remaining chapters will use most of the same concepts and techniques that we will study tonight. Therefore, it is very important that you fully understand the rationale and calculations behind TVM. It is also important that you bring a calculator to every class as we will be taking the TVM concepts to practice. This course does not require a financial calculator (use of financial calculators will not be allowed on the exams). A calculator with the exponential function “X ” will suffice. Time Value of Money How may times have you heard this phrase “Time is Money” ? 500, 1,000 times?, how about “a bird in hand is better than two in the bush”. Well, these popular sayings remind you that Time=Money in the sense that a dollar in hand today is worth more than dollar promised at some time in the future. Why? Simply because you could start earning interest on this dollar today, while the dollar promised tomorrow will not generate any value until days, months or years from today. The sooner you get money, the sooner this money will make more money for you. For example, say you win the Power ball with a 100 million jackpot. Do you think you will collect this 100 million in a lump sum right after you win? You would be right if you say No. Usually, when someone wins the lottery, the state divides the amount of the jackpot by 20 years and gives you an equal share of the jackpot every year. Now, if this is the case, Is your 100 million really worth 100 million? Not really, since this 100 million pay out is stretched over two decades and the fact that you have to wait this long to get the 100 million makes the today’s value of this prize worth about 40 million. So, Is 100 million today worth more than 100 million over 20 years? You bet, 100 million today are worth a lot more than 100 million over 20 years. TVM Timelines Most of the time, we will set up a timeline prior to solving a TVM problem. These timelines will help you visualize what is that the problem is asking and facilitate the completion of the problem by using a detailed approach. y y
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2 Sample Timeline The numbers 0-3 are periods; in this example these periods represent years. In this timeline, 0 is the beginning of the period 1, 0 also represents today. 1 marks the end of year 1 and the beginning of year 2. The intervals or years are 0 to 1, 1 to 2, and 2 to 3. Periods are usually years, but as we
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This note was uploaded on 12/16/2009 for the course FIN 300 taught by Professor Olander during the Spring '08 term at ASU.

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Chapter 5 Time Value of Money - Arizona State University...

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