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Chapter 5
The Time Value of Money
Learning Objectives
1.
Explain what the time value of money is and why it is so important in the field of
finance.
2.
Explain the concept of future value, including the meaning of
principal amount,
simple interest,
and
compound interest,
and be able to use the future value formula to
make business decisions.
3.
Explain the concept of present value and how it relates to future value, and be able
use the present value formula to make business decisions.
4.
Discuss why the concept of compounding is not restricted to money, and be able to
use the future value formula to calculate growth rates.
I.
Chapter Outline
5.1
The Time Value of Money
•
A basic problem faced by managers in financial decision making is to determine the
value of a series of future cash flows, whether paying for an asset or evaluating a
project.
•
The question that is being raised is: What is the value of the stream of future cash
flows today?
•
We refer to this value as the
time value of money
.
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Consuming Today or Tomorrow
•
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,

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