theory of finance - ECON*2560- Theory of Finance CHAPTER 4-...

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ECON*2560- Theory of Finance CHAPTER 4- THE TIME VALUE OF MONEY - Companies invest in hopes to receive even more than they invested - Companies pay for their investments by raising money – and in the process assume liabilities - All financial decisions ( of assuming liabilities) require comparisons of cash payments at different dates - The time value of money describes the relationship between the value of the dollar today and the value of the same dollar in the future o How much do you need to invest today to produce a specified sum of money in the future ? o How does inflation affect these financial decisions ? 4.1 FUTURE VALUES AND COMPOUND INTEREST Interest= interest rate x initial investment - In general, for any interest rate (r ) the value of the investment at the end of the period will become (1+r) times the amount invested at the end of an investing period Future value (FV): amount to which and investment will grow after earning interest Compound interest: interest earned on interest. Simple interest: interest earned only on the original investment; no interest is earned on interest. - The higher the rate of interest, the faster your savings will grow - The future value of any investment can be calculated with the future value formula FV of $investment = I x ( 1 + r) t Future value interest factor: future value of a current cash flow of $1 Future value factor , FVIF(r,t)= (1+r) t - The future value of an investment can be calculated by multiplying in invested amount ( principle) by the future value factor of $1 investment for the same period and interest rate FV= Ix future value factor = I x FVIF (r,t) = I x (1+r) t - Can also look up values in the FV table Compound growth means that value increases each period by the factor (1+growth rate ) . the value after t periods will equal the initial value times (1 + growth rate ) t . when money is invested at compound interest, the growth rate is the interest rate. 4.2 PRESENT VALUES ‘ a dollar today is worth more than a dollar tomorrow’ o this statement is true such that money can be invested to earn interest ex. If offered $100,000 now and $100,000 later, the clear choice would be to accept the money now and earn a year’s interest - we have examined how to grow a future value, BUT how much do we need to invest now in order to produce a certain amount? This phenomenon is called, present value Present value( PV): value today of a future cash flow Preset value = future value after t periods (1+r) t
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- How much is this money worth today, on the basis that we will gain interest of a certain amount over a specific time period On the basis that we can invest this money at a specific rate; how much more is this dollar worth today- as to tomorrow? -
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This note was uploaded on 02/13/2012 for the course ECON 2560 taught by Professor Bower during the Spring '11 term at University of Guelph.

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theory of finance - ECON*2560- Theory of Finance CHAPTER 4-...

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