Chapter 5
The Time Value of Money
Slide 5  1
Question to be Asked
Suppose you are promised to be given $100 in year 0,
$200 in year 1, $300 in year 2, and $400 in year 3. How
about you receive $1,000 right now? Are you better off
from receiving $1,000 right now? Why?
This chapter discusses the time value of money, from
which we determine the equivalent payment right now to
receiving the money in three years.
Slide 5  2
The Time Value of Money
±
Time value of money
A dollar today is better than a dollar in the future.
Then, how can we compare money flows if they are at
different time points?
±
Two approaches
●
Compounding:
convert money flows to their future value
●
Discounting:
convert money flows to their present value
Slide 5  3
±
Concept
Present value (PV): Earlier money on a time line
Future value (FV): Later money on a time line
●
Interest rate:
“exchange rate” between earlier money and
later money
¾
Discount rate
¾
Opportunity cost of capital
¾
Required return
Basic Definitions
t=0
1
……
t1
t
Present Value
Future Value
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View Full DocumentSlide 5  4
Future Values
±
Suppose you invest $1,000 for one year at 5% per year.
What is the future value in one year?
Interest = 1,000(.05) = 50
Value in one year = Principal + Interest = 1,000 + 50 = 1,050
Future value (FV) = 1,000(1 +.05) = 1,050
±
Suppose you leave the money for another year.
How much
will you have two years from now?
FV = 1,000(1.05)(1.05) = 1,000(1.05)
2
= 1,102.50
Future value is the amount to which an investment will grow after
earning interest.
Slide 5  5
Future Values
±
The General Formula
FV = PV (1 + r)
t
Where, FV = Future value
PV = Present value
r = Period interest rate, expressed as a decimal
t = Number of periods
Future Value Interest Factor (FVIF):
FVIF = (1+ r)
t
⇒
FV = PV
×
FVIF
Slide 5  6
±
Simple Interest
Simple interest assumes that the interest earned is withdrawn or
spent eliminating compounding: No interest on interest.
$100+(100x.05)=$105
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 Fall '11
 Lin
 Time Value Of Money

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