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# ch05 - Chapter 5 The Time Value of Money Learning...

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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 the terms principal, simple interest, and compound interest, and use the future value formula to make business decisions. 3. Explain the concept of present value, how it relates to future value, and use the present value formula to make business decisions. 4. Discuss why the concept of compounding is not restricted to money, and 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 . 1

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A. 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, 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 the likelihood of consumption being deferred. B. Time Lines as Aids to Problem Solving Timelines are an easy way to visualize the cash flows associated with investment decisions. A timeline is a horizontal line that starts at time zero (today) and shows cash flows as they occur over time. See Exhibit 5.1 . It is conventional to show that all cash outflows are given a negative value; then all cash inflows must have a positive value. 2
5.2 Future Value and Compounding A. Single-Period Investment We can determine the value of an investment at the end of one period (whether it is a month, quarter or year) if we know the interest rate to be earned by the investment. If you invest for one period at an interest rate of i , your investment, or principal, will grow by (1 + i ) per dollar invested.

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ch05 - Chapter 5 The Time Value of Money Learning...

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