Team Members : Partha Pattanayak Baishali Shaw

Importance of the time value of money. Difference between simple interest and compound interest. Present value, future value, time or rate

Money received today can be invested to earn a rate of return Thus $1 today is worth more than $1 to be received at some future date

The interest rate or discount rate is the variable that equates a present value today with a future value at some later date

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Time Value of Money

Simple interest is interest paid or received on only the initial investment (or principal). At the end of the investment period, the principal plus interest is received.

0
I1

1
I2

2
I3

In+P

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PROBLEM: Invest $1,000 today for a five-year term and receive 8 percent annual simple interest. How much will you accumulate by the end of five years?

Year 1 1 1 1 1

Beginning Amount $1111 , 11 1 , 1 11 1 , 1 11 1 , 1 11 1 , 1

Ending Amount $1111 , 11 1 , 1 11 1 , 1 11 1 , 1 $1111 ,

Value (time n) = P + (n P k) Value1 = $1 1 + (1 $1 1 .1) ,11 ,11 1 = $1 1 + (1 $1) ,11 1 = $1 1 + $11 ,11 1 = $1 1 ,11

CHAPTER 5 Time Value of Money

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Time Value of Money

Compound interest is interest that is earned on the principal amount invested and on any accrued interest.

PROBLEM:
Invest $1,000 today for a five-year term and receive 8 percent annual compound interest.

The Interest-earned-on-Interest Effect:

Interest (year 1) = $1,000 .08 = $80 Interest (year 2 ) =($1,000 + $80).08 = $86.40 Interest (year 3) = ($1,000+$80+$86.40) .08 = $93.31
Year 1 1 1 1 1 Beginning Amount $11111 , .1 11 11 , 1. 1 11 11 , 1. 1 11 11 , 1. 1 11 11 , 1. 1 Ending Amount $11111 , .1 11 11 , 1. 1 11 11 , 1. 1 11 11 , 1. 1 11 11 , 1. 1 Interest earned in the year $11 .11 $11 .11 $11 .11 $1111 .1 $1111 .1

CHAPTER 5 Time Value of Money

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5-1 FIGURE
8,000 7,000 6,000 5,000 4,000

S RALL OD

3,000 2,000 1,000 0

10

11 12

13

14

15

16

17

18 19

20

EY A SR

Simple

Compound

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CHAPTER 5 Time Value of Money

FV n = PV 1 1 k) ( +

( 1 k)n is known as the compound interest factor = CVIF +

Where: FV= future value P = principal invested n = number of years k = interest rate

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CHAPTER 5 Time Value of Money

Tables of Compound Value Interest Factors can be created:

CVIFk =1 n =1 years = (1 .1)1 + 11 %, 1 = 1 11 .11

1 % 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 1 % 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 1 % 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 1 % 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 1 % 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11

Period 1 1 1 1 1 1 1 1 1 1 1

1 % 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11

1 % 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11 11 1 . 11

CHAPTER 5 Time Value of Money

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Present value calculations determine what the value of a cash flow received in the future would be worth today (time 0) The process of finding a present value is called discounting (hint: it gets smaller) The interest rate used to discount cash flows is generally called the discount rate

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1.

How much would $100 received five years from now be worth today if the current interest rate is 10%? Draw a timeline

? 0 1

i = 10% 2 3 4

$100 5

The arrow represents the flow of money and the numbers under the timeline represent the time period. Note that time period zero is today.
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You can think of future value as the opposite of present value Future value determines the amount that a sum of money invested today will grow to in a given period of time The process of finding a future value is called compounding (hint: it gets larger)

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1.

How much money will you have in 5 years if you invest $100 today at a 10% rate of return? Draw a timeline

$100 0
2.

i = 10% 1 2 3 4

? 5

Write out the formula using symbols: FVt = CF0 * (1+r)t

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Common formulas that are used in TVM calculations:* Present value of a lump sum: PV = FVt / (1+r)t Future value of a lump sum: FVt = PV * (1+r)t

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Time Value of Money, or TVM, is a concept that is used in all aspects of finance including:
Bond valuation Stock valuation Accept/reject decisions for project management Financial analysis of firms And many others!

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conclusion
The concept of time value of money can be applied to a particular amount ,or a series of amount i.e the Annuity amount. It can be used to find out the rate of interest, or number of period of cash inflows/outflows. Thus time value plays an important role in the consideration of any financial decision.

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