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Unknown

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Part 2

Valuation

3
The Time Value of Money
Contents
n n n

Objectives
After studying Chapter 3, you should be able to: n The Interest Rate Simple Interest Compound Interest
Single Amounts • Annuities • Mixed Flows

Understand what is meant by “the time value of money.” Understand the relationship between present and future value. Describe how the interest rate can be used to adjust the value of cash flows – both forward and backward – to a single point in time. Calculate both the future and present value of: (a) an amount invested today; (b) a stream of equal cash flows (an annuity); and (c) a stream of mixed cash flows. Distinguish between an “ordinary annuity” and an “annuity due.” Use interest factor tables and understand how they provide a shortcut to calculating present and future values. Use interest factor tables to find an unknown interest rate or growth rate when the number of time periods and future and present values are known. Build an “amortization schedule” for an installment-style loan.

n

n

Compounding More Than Once a Year
Semiannual and Other Compounding Periods • Continuous Compounding • Effective Annual Interest Rate n n n

Amortizing a Loan Summary Table of Key Compound Interest Formulas Summary Questions Self-Correction Problems Problems Solutions to Self-Correction Problems Selected References

n

n n n n n n

n

n

n

n

39

Part 2 Valuation

The chief value of money lies in the fact that one lives in a world in which it is overestimated.
—H. L. MENCKEN A Mencken Chrestomathy

The Interest Rate
Which would you prefer – $1,000 today or $1,000 ten years from today? Common sense tells us to take the $1,000 today because we recognize that there is a time value to money. The immediate receipt of $1,000 provides us with the opportunity to put our money to work and earn interest. In a world in

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