Time Value of Money – Part One (Ch. 2) 04/10/06

Basic intuition Because of the ability of investors to earn interest on funds available today, the time value of money posits that a dollar today is worth more than a dollar tomorrow.

Future value Future value – the value of a present or future, single cash flow or stream of cash flows at a specific future date. Principal – amount deposited today Interest rate – the rate at which your money is growing. This can also be considered to be a growth rate and can also represent an opportunity cost. Compounding of interest (interest on interest) – interest earned on accumulated interest

Future value The future value at time n of a single cash flow today compounded (or growing) at an interest rate r can be calculated as: The term (1+r)n is also referred to as the Future Value Interest Factor (FVIF)

Methods of calculation Equation Financial calculator Spreadsheet

Present value Present value – the value of a future, single cash flow or stream of future cash flows today. Discount rate – the interest rate that allows us to convert future cash flows into cash flows in present dollars.

Present value The present value of a single cash flow at time n today discounted at an interest rate r can be calculated as: The term 1/(1+r)n is also referred to as the Present Value Interest Factor (PVIF)

Four variables -- one equation With a single future cash flow and a cash flow today, we can also solve for n: r:

Doubling your money: The rule of 72s Before calculators and spreadsheets a quick estimate of the time needed to double your money was found by using the rule of 72s: Time estimate = 72 / interest rate The rule is also good to find the interest rate needed to double your money in a given period Interest rate estimate = 72 / n