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Fin 101 Time Value of Money

# Fin 101 Time Value of Money - Fin 101 Time Value of MONEY...

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Fin 101 – Time Value of MONEY In this chapter of the Finance Review packet, the basic concepts of time value of money will be reviewed. Examples of computing the present and future values of single cash flows, cash flow series and annuities will be presented. At the end of the chapter review problems and their answers will be provided. Please note that formulas will be applied to find present and future values. Students who want to solve time value of money problems with financial calculators should refer to their individual calculator manuals if needed. If you need additional information, please refer to Chapter 4 in the Brigham and Besley textbook. Outline of chapter • What is meant by Time Value of Money? o The worth of \$1 varies across time 1 \$1 invested today (a current dollar) for one year can earn interest 2 \$1 that will be paid in one year (a future dollar) cannot earn interest, investors also lose the opportunity to spend it; therefore the future dollar’s worth today is less than \$1 3 n Why Does Money Have a Time Value? 4 n Opportunity Cost 5 Investors that give up the opportunity to invest \$1 today or spend \$1 today must be compensated for the lost opportunity. 6 n The Opportunity Cost Equals: 7 Risk-free interest rate (US government borrowing rate) PLUS A Risk Premium that depends upon the future cash flow’s range (more specifically, the expected cash flow’s variance) n How is Time Value of Money Used? n To compare the value of a future cash flows to a current price n To determine what an investment made today will be worth in 10 years n Examples 8 You’ve just won the lottery! You must determine whether you would like to receive your winnings in a single lump sum or in a series of payments paid over 20 years.

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If you find the present value of the payment series, you can compare it to the lump sum and determine whether you’d prefer the lump sum or the series (you’d prefer whichever is largest) n An investor would like to know what price s/he should pay for a bond. 1 The investor will find the present value of the bond’s cash flows. The present value represents the maximum price s/he should be willing to pay. 2 n A parent would like to save for his/her child’s college tuition. If s/he invests \$10,000 a year for each of the next 10 years and earns 4% interest a year, how much money will be saved at the end of 10 years? Finding the Future value will let you determine the amount An investor with \$1000 has the opportunity to put \$1000 in a bank account that will pay 5% interest one year from now. The investment’s timeline is: Investment Payoff Principal Principal + Interest 1000 1000+ .05*(1000) = \$1000 +\$50 1 1 Assume that at the end of the first year, the investor can decide to reinvest the \$1050 payoff for one more year, earning an additional 5% interest.
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