Finance Lecture 2

Time value of money:

 TVM: the difference in value between a dollar in hand today and a dollar promised in
the future
 Time line: identifies the rate of interest, magnitude and timing of cash flows


Because money has time value, it is meaningless to combine or compare amounts at

different points in time. We need to know how to state each amount at a common
point in time, to combine or compare
 $5000 in a year’s time is not worth $5000 today
Definitions:

 Future value (FV): accumulated value; the value of an investment after it earns
interest for one or more periods

 Present value (PV): the equivalent value at an earlier date (e.g. today) of a future
sum(s) of money

 Simple interest:
interest earned on the original principle only
 Compound interest: interest earned on the original principal and on the interest
earned (simple interest + interest-on-interest)
 Compounding: process by which interest earned on an investment is reinvested, so
in future periods interest is earned on the interest as well as the principal
 Discounting: process by which the present value of future cash flows is obtained i.e.
it’s the reverse (opposite) to compounding
Future value:


Simple interest formula:

Compound interest formula:

Future value and compounding:

 The greater the interest rate, the greater the future value (accumulated value)
 The longer the time-period, the greater the effect of compounding due to interest-
on-interest
 The greater the interest rate and time-period, the less is the present value of some
future amount
 Because of compounding, the growth over time is not linear (straight line on graph),
but exponential (curved line)
Example:
Compounding frequency:

 An amount can be compounded once a year (annually), for example, $1000 with
10% per annum compounded
- $1000 x (1+0.10) = $1100
 Or the same amount can be compounded at 10% per annum, twice a year (semi-
annually)
- This means the interest is paid twice a year at 10%/2 = 5%
- $1000 x (1+0.05) = $1050 after six months
- $1050 x (1+0.05) = $1102.50 at end of year
 The FV at end of year is greater with semi-annual compounding than with annual
compounding
 The effective annual rate (EAR) is the rate of interest compounding once a year that’s
equivalent to the rate of interest that compounds more often than once a year
- In the above example, the EAR is 10.25% which is equivalent to 10%
compounded semi-annually
Present value:

 Example:

- Always draw a timeline – helps to answer question

Finding the rate of interest and the number of periods: