Chapter 5: Introduction to Valuation: The Time
Value of Money
Future Value and Compounding

Future Value (FV)
 amount an investment is worth after one or more periods
Investing for a Single Period

If you invest for one period at an interest rate of
r
, your investment will grow to ( 1 +
r
)
per dollar invested
Investing for More Than One Period

Have 4 parts:
o
Original Principal
o
Interest in 1
st
year
o
Interest in 2
nd
year
o
Interest earned in 2
nd
year on interest paid in first year

Compounding
 process of accumulating interest on an investment over time to earn more
interest
o
Interest on Interest
 interest earned on the reinvestment of previous interest payments
o
Called compound interest

Simple Interest
 interest is not reinvested, so interest is earned each period only on the
original principle

Example 5.1

Future value of $1 invested for
t
periods at a rate of
r
per period is:
o
FV = $1 x ( 1 +
r
)
t
o
Future Value Interest Factor = ( 1 +
r
)
t
o
Table 5.1
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Figure 5.1

Future values depend critically on the assumed interest rate, particularly for longlived
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