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Unformatted text preview: Chapter 2 Chapter 2 Time Value of Money (TVOM) Terminology Cash Flow Actual Cash Flow an actual amount of money that changes hands from one person/entity to another Estimated Cash Flow an estimated amount of money that is expected to change hands from one person/entity to another; a forecasted amount Terminology Cash Flow Diagram A simple graphical model which depicts cash flows with respect to time A cash flow will be represented with net cash amounts (Revenue minus Expenses or Costs) unless noted otherwise Revenues are money inflow and expenses (costs) are money outflow End of Period Convention (for cash flow modeling) The assumption that a cash flow occurs at the end of a given period of time We will assume End of Period convention unless noted otherwise Terminology Financial Risk a term associated with the chance or probability that a sum of money that was entrusted to someone (another entity) will not be fully returned or recovered (usually with interest) Terminology Cash Flow Diagrams A Cash Flow Diagram is a graphical representation of a Cash Flow Profile. The Cash Flow Diagram consists of the following characteristics: Vertical arrows represent a net cash amount either + (up arrow) or (down arrow) The horizontal bar represents the time magnitude or planning horizon associated with the cash flow; time ascends from left to right (can be expressed in any time period terms such as weeks, months, years, etc.) Cash Flow Diagrams End of Period Revenues Expenses Net Amount $0 $5,000$5,000 1 $3,000 $1,500 $1,500 2 $2,000 $3,000$1,000 3 $4,000 $2,000 $2,000 4 $1,000 $500 $500 Cash Flow Profile Cash Flow Diagram $1,500 $2,000 $500 1 2 3 4 $5,000 $1,000 Initial Investment Initial Investment Dont forget that these are negative net values at time 0 and time period 2 Cash Flow Profiles for Two Investment Alternatives (EOY) Alt A Alt B (BA)$100,000$100,000 $0 1 $10,000 $50,000 $40,000 2 $20,000 $40,000 $20,000 3 $30,000 $30,000 $0 4 $40,000 $20,000$20,000 5 $50,000 $10,000$40,000 End of Year Although the two investment alternatives have the same initial investment, there are obvious differences. Example 2.1 ( + ) 1 2 3 4 5 End of Year (  ) $50,000 $40,000 $30,000 $20,000 $10,000 $100,000 ( + ) 1 2 3 4 5 End of Year (  ) $50,000 $40,000 $30,000 $20,000 $10,000 $100,000 Alt A Alt B Which would you prefer, A or B? Why? Example 2.2 1 2 3 4 5 6 7 1 2 3 4 5 6 7 (+) () Alternative C (+) () Alternative D $6,000 $6,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 Which would you choose? Interest Rate At this point we have determined that there is a connection between time and the value of money In considering the time value of money, it is convenient to represent mathematically the relationship between the current or 'Present Value' of a single sum of money and its 'Future Value'....
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This note was uploaded on 09/26/2011 for the course IEM 3503 taught by Professor Deyong during the Spring '07 term at Oklahoma State.
 Spring '07
 Deyong

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