02_Time_Value_of_Money-Day_2-2011.02.01v2

# 02_Time_Value_of_Money-Day_2-2011.02.01v2 - Time Value of...

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Time Value of Money Thomas Hogan FNAN 301 February 1, 2011

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Agenda Basics of time value of money Risk & uncertainty
Time Value of Money (TVM) TVM: A dollar (or other payment) can have different values depending on when the payment is received. Everyone has an innate understanding of TVM. Interest rates represent the amount of change in value over time.

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Ex. 1: 3 Piggy Banks What’s the most you would pay today for the pink piggy bank if it had \$100 in it and you could get into it today? What’s the most you would pay today for the purple piggy bank if it had \$100 in it and you could not get into it for one year? What’s the most you would pay today for the yellow piggy bank if it had \$100 in it and you could not get into it for five years?
Ex. 2: 1 Piggy Bank What’s the most you would pay today for the pink piggy bank if it had \$100 in it and you could open it in exactly 1 year? The piggy bank is indestructible for now but can be broken in 1 year at no cost. Your bank account pays you 10% per year.

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Ex. 3: The Check What’s the most you would pay today for a check written for \$110, but you could not cash it for 1 year? The market interest rate is 10%. The check was written by a major bank. Other banks are willing to purchase the check for its market value. file:/ C:/Users/thogan1/Documents/Fin_301_Spring_2010/slides/wip/img/check_for_1 0_in_1_year_v3.bmp
Assumptions on TVM Our goal is to make money. There are many buyers and sellers. There are no transaction costs. The "market interest rate" represents the collective preferences of traders. The yield curve is flat. Unless told otherwise, the same interest rate applies regardless of the time of the investment.

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Understanding TVM TVM tells us that: 1) If we invest money today, we will be repaid more money in the future. 2) If we expect to receive some payment in the future, we can trade it for a smaller payment today. Rule of thumb: "A dollar today is worth more than a dollar tomorrow." Or, conversely: A dollar today, can be traded for more than one dollar tomorrow. The important question is, " How much more?"
Simple Interest Interest rate and dollar amount of interest payments are constant over time. Ex: You invest money in a savings account, and it pays out the same amount every year. Interest accrues on the principal invested but not on past interest earned. Simple interest formula: FV = PV × (1 + r × t)

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Variable Definitions Present value (PV) = cash flow at beginning of investment period (not always today). Future value (FV) = cash flow at end of
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02_Time_Value_of_Money-Day_2-2011.02.01v2 - Time Value of...

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