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# QABE_Notes - QABE Lecture 3 Evaluating Time-Money Choices...

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QABE Lecture 3 Evaluating Time-Money Choices School of Economics, UNSW 2011 Contents 1 Introduction 1 2 Equations of value 2 2.1 Simple Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2.2 Compound Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3 Net Present Value 3 3.1 The Scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3.2 Working it out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 3.3 The Importance of the Interest Rate . . . . . . . . . . . . . . . . . . . . . 5 4 Internal Rate of Return 5 4.1 Working it out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 5 Summary 7 1 Introduction We spend a little more time looking at how the value of money is actually dependent on the time at which it is in our hand. That is, as before, we note that there exists a time value of money ; would you prefer \$100 in your hand today, or \$101 tomorrow? There are various explanations for this fact. As you might have reﬂected above – ‘I’d prefer the money today, since I’m not sure what will happen tomorrow,’ – that is the uncertainty of our lives kicking in. Just one of the factors that contribute to the apparent value of money changing through time. We then move on to applying some of our new-found skills in time-value-of-money to one of the most common problems faced in the commercial world, namely, the problem of deciding whether or not to go ahead with a project, or if there is choice between projects, deciding which of the projects to fund. The reason it is so common (if not already obvious) is that in practically every business situation, one has to ‘spend money, to make money’ – that is, make an initial investment (called capital ) and after time, begin to yield some kind of income stream from the business. The big competition that then ensues is between that money invested in your project, versus that money invested in the bank at some going rate – who gives the best return will decided how you will proceed. However, the question of whether one project is actually worth it on its own, or in comparison to another is not always 1

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ECON 1202/ECON 2291: QABE c School of Economics, UNSW immediately obvious. Not to worry – by applying what we have learnt up till now, we have the tools to become experts on these issues! The methods we will develop are two of the most common – the net present value of the project on the one hand, and the internal rate of return on the other. The two methods are very connected, but their interpretation requires some care.
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QABE_Notes - QABE Lecture 3 Evaluating Time-Money Choices...

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