Course notes RSM332 - Class 3

Course notes RSM332 - Class 3 - The Time Value of Money...

Info iconThis preview shows pages 1–2. Sign up to view the full content.

View Full Document Right Arrow Icon
The Time Value of Money Suppose market interest rates are 10%/year. That means, if you invest 1000 today, in 1 year, you will have 1000(1.10) = 1,100 = 1,000 (your original principal) + 100 interest. We could also ask, what is the present value (PV) (the value NOW) of 1,100 to be received in 1 year, if market interest rates are 10%/year? Answer: PV = X such that X(1.10) = 1100 => X = 1100/1.10 = 1000. What is the PV of 1000 in 1 year, if the interest rate is 10%? Answer: X such that X(1.10) = 1000 => X = 1000/1.10 = 909.09 What would you rather have, 909.09 now or 1000 in 1 year? Example: If interest rates are 12%/year, what does 1500 grow to in 5 years? In 1 year, 1500 => 1500(1.12) = 1680 = 1500 + 180 of interest. In the second year, 1680 => 1680(1.12) = 1881.60. Note: 1881.60 –1500 = 381.60 and 180 x 2 = 360 and 381.60 – 360 = 21.60. 21.60 is the interest earned in the second year, on the interest earned in the first year. Benjamin Franklin: “Money makes money, and the money that money makes, makes more money.” In 5 years, 1500 => 1500(1.12)^5 = 1500(1.7623) = 2643.51. We say, 2643.51 is the future value (FV) of 1500 in 5 years if interest rates are 12% annually with annual compounding. In general: FV = C 0 (1+r) T where C 0 is the amount invested, r = the annual rate and T = the number of years it is invested for. Similarly, What is the PV of 2643.51 in 5 years if r = 12%? PV = X such that X(1.12) 5 = 2643.51 => X = 2643.51/(1.12) 5 = 1500. PV of an amount C 1 in 1 year: PV = C 1 /(1+r) PV of an amount C T in T years is PV = C T /(1+r) T Suppose we invest C 0 now in return for: C 1 in 1 year C 2 in 2 years C T in T years First note: If r is the appropriate annual interest rate, the PV of the future payments is given by: PV= C 1 /(1+r) + C 2 /(1+r) 2 + … + C T /(1+r) T And the Net Present Value (NPV) = -C 0 + C 1 /(1+r) + C 2 /(1+r) 2 + … + C T /(1+r) T
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 2
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 01/10/2011 for the course RSM RSM332 taught by Professor Booth during the Spring '10 term at University of Toronto- Toronto.

Page1 / 5

Course notes RSM332 - Class 3 - The Time Value of Money...

This preview shows document pages 1 - 2. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online