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Chapter 5: Introduction to the Valuation - The Time Value of Money

Time value of money: the fact that a dollar in hand today is worth more than a dollar promised at some time in the future.

Future Value and Compounding

Future Value (FV): the amount of money an investment will grow to over some period of time at some given interest rate. o The case value of an investment at some time in the future. o The future value of $1 invested for t periods at a rate of r per period is: FV = PV x (1 + r)t Single Period Investment if you invest for one period at an interest rate r, your investment will grow to (1+r) per dollar invested. More than one period investment: o Compounding: the process of accumulating interest on an investment over time to earn more interest. Reinvesting the interest. Interest on interest: interest earned on the reinvestment of previous interest payments. Compound interest: interest earned on both the initial principal and the interest reinvested from prior periods. Simple interest: interest earned only on the original principal amount invested. The effect of compounding is not great over short time periods

Present Value and Discounting

Present Value (PV): the current value of future cash flows discounted at the appropriate discount rate. o General Formula: Single Period PV = $1 x [1/(1 + r)] = $1/(1 + r) Multiple Period PV = $1 x [1/(1 + r)t] = $1/(1 + r)t o The quantity in brackets = discount factor. Discount: calculate the present value of some future amount. o Discount rate: the rate used to calculate the present value of future cash flows. o Discounted cash flow (DCF) valuation: calculating the present flow to determine its value today.

As the length of time until payment grows, present value declines. For a given length of time, the higher the discount rate is, the lower is the present value. o Present value and discount rates inversely related.

More about Present and Future Values

Future value factor = (1 + r)t Present value factor = 1/(1 + r)t o PV = FVt/(1 + r)t = FVt x [1/(1 + r)t] basic present value equation Determining the Discount Rate: o PV = FVt/(1 + r)t Four Parts of this equation: Present value (PV) Future value (FV) Discount rate (r) Life of the investment (t) o The discount rate is often called the rate of return on an investment. For reasonable rates of return, the time it takes to double your money is given approximately by 72/r% = years. US EE Savings Bonds: o Purchase them for half of their face value. o Receive no interest in between, and the interest rate is adjusted every six months. The length of time until your purchase price grows to maturity depends on future interest rates. o The bonds are guaranteed to be worth mature amount at the end of 17 years.