Chapter 3: valuation – the time value of money:

- Time Value of Money (TVM):

TVM refers to the fact that a dollar today is worth more than a dollar in the future. So, a dollar today
would grow more than a dollar later.

- Future value and Compounding:

Future value (FV): amount of money an investment will make over a certain period of time at a given
interest rate.

( 1+r )t : Future value interest factor, avec t: time.

Present Value (PV).
t
FV =PV ∗( 1+r )
INVESTING FOR A SINGLE PERIOD:

Example: suppose you invest a $100 in a savings account that pays 10% interest per year. How much will
you have in 1 year?
t 1
FV =PV∗( 1+r ) =100∗( 1+10 % ) = 110.

INVESTING FOR MORE THAN ONE PERIOD:

SIMPLE INTEREST: interest is earned each period only on the original principal.

Example: back to our $100 investment, what will you have in 2 years, assuming the rate doesn’t change?
t 2
FV =PV∗( 1+r ) =100∗( 1+10 % ) = 121.

COUMPOUND INTEREST: earning interest on interest – interest is earned on the initial principal and the
interest reinvested in prior periods.

Example: the bank has a two year investment product that generates 14%.

a) If you invest $325, how much will you have at the end of the two years?
b) How much of this is simple interest?
c) How much is compound interest?

a) Y1: FV =PV ∗( 1+r )t=$ 325∗( 1+ 14 % )1=$ 370.5

Y2: FV =PV ∗( 1+r )t=$ 370.5∗( 1+ 14 % )1 =$ 422.37 .
Total interest earned = 422.37 – 325 = $97.37.
b) Simple interest: PV ∗r =325∗0.14=$ 45.5 interest each year for a two-year total of $91 in.
c) Compound interest: 97.37 – 91 = $6.37. OR interest of 2nd year * r = 45.5 * 0.14 = $6.37.