TKM_Chapter_05

TKM_Chapter_05 - CHAPTER 5 TIME VALUE OF MONEY: THE BASICS...

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CHAPTER 5 TIME VALUE OF MONEY: THE BASICS Time value of money is one of the most important concepts in finance. The basic premise of time value of money problems is that time impacts the value of a dollar. That is, a dollar received today is worth more than one received in the future. The principles of time value of money are used in a variety of applications in finance, including capital budgeting, capital structure, cost of capital, and working capital management decisions. This chapter explores time value of money concepts as they apply to a lump sum or single cash flow. Future value is the value of a sum of money compounded at a given interest rate for a specific period of time. Present value is the current value of a sum of money to be received at a specified time in the future, given a stated rate of interest. People prefer to consume goods today rather than wait to consume similar goods in the future—that is, a positive time preference. The time value of money is based on the belief that people have a positive time preference for consumption. Money has a time value because a dollar in hand today is worth more than a dollar to be received in the future. The dollar in hand could be either invested to earn interest or spent today. The value of a dollar invested at a positive interest rate grows over time, and the further in the future you receive a dollar, the less it is worth today. The trade-off between spending the money today versus spending the money at some future date depends on the rate of interest you can earn by investing. The higher the interest rate, the more likely consumption will be deferred.
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Learning Objectives 5-1. Construct cash flow timelines to organize your analysis of time value of money problems 5-2. Understand compounding and calculate the future value of cash flows using mathematical formulas, a financial calculator, and an Excel spreadsheet. 5-3. Understand discounting and calculate the present value of cash flows using mathematical formulas, a financial calculator, and an Excel spreadsheet. 5-4. Understand how interest rates are quoted and know how to make them comparable. Future Value versus Present Value Financial decisions are evaluated on either a future value basis or a present value basis. Future value measures what one or more cash flows are worth at the end of a specified period, while present value measures what one or more cash flows that are to be received in the future will be worth today (at t = 0). The process of converting an amount given at the present time into a future value is called compounding . It is the process of earning interest over time. Discounting is the process of converting future cash flows to what its present value is. In other words, present value is the current value of the future cash flows that are discounted at an appropriate interest rate.
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CHAPTER ORGANIZATION 5.1 Using Timelines to Visualize Cash Flows A. A timeline identifies the timing and amount of a stream of payments, along with the interest rate
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TKM_Chapter_05 - CHAPTER 5 TIME VALUE OF MONEY: THE BASICS...

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