Time Value of Money-PART 1 Chapter 3 Time Value of Money-PART 1

Time value of money-most important concepts in Finance. Money that the firm has in its possession today is more valuable than money in the future because the money it now has can be invested and earn positive returns.

Time value of money is based on the belief that an Omani Riyal today is worth more than an Omani Riyal that will be received at some future date.

The Role of Time Value in Finance Most financial decisions involve costs & benefits that are spread out over time. Time value of money allows comparison of cash flows from different periods. There are two views on Time value-Future Value and Present Value. Time lines are used to illustrate these relationships.

TIME LINE A horizontal line on which time zero appears at the leftmost end and future periods are marked from left to right; can be used to depict investment cash flows. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Future Value is cash you will receive at a given future date. Present Value is just like cash in hand today.

Computational Tools How to calculate future value and present value? Using different tools(techniques) 1. Use the Equations 2. Use the Financial Tables 3. Use Financial Calculators 4. Use Electronic Spreadsheets

Basic Patterns of Cash Flow The cash inflows and outflows of a firm can be described by its general pattern. The three basic patterns include a single amount, an annuity, or a mixed stream. Single Amount - A lump sum amount either currently held or expected at some future date. Examples: OMR 500 today in hand or OMR 400 to be received after 3 years Annuity- A level periodic stream of cash flow. Examples: Paying or receiving OMR 200 at the end of each of the next 5 years

Mixed Stream- A stream of cash flow that is not an annuity; a stream of unequal periodic cash flows that reflect no particular pattern.

Mixed Stream Note that neither cash flow stream has equal, periodic cash flows and that A is a 6-year Mixed stream and B is a 4-year mixed stream. .

Future Value of a Single Amount Future value is cash you will receive at a given future date. Future value is the value at a given future date of a present amount placed on deposit today and earning interest at a specified rate. Example: If you deposit OMR 100 today into a bank account that pays 8% interest compounded, how much would you have in the account at the end of two years? You will get OMR 116.64.This is called the future value.

The Concept of Future Value The Future Value of present amount is found by applying compound interest over a specified period of time. (Interest means charge for the borrowed money).

Simple Interest With simple interest, you don’t earn interest on interest. Year 1: 5% of $100 = $5 + $100 = $105 Year 2: 5% of $100 = $5 + $105 = $110 Year 3: 5% of $100 = $5 + $110 = $115 Year 4: 5% of $100 = $5 + $115 = $120 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Compound Interest With compound interest, a depositor earns interest on interest! Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00 Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25 Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76 Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

The future value technique uses compounding to find the future value of each cash flow at the end of an investment’s life . Compound Interest- Interest that is earned on a given deposit and has become part of the principal at the end of a specified period. Principal-Amount of money on which interest is paid.

Formulae to calculate future value at the end of period n is FVn =PV x ( 1 + i )n FVn = future value at the end of period n. PV = initial principle or present value i = annual rate of interest n = number of periods(years )

If you deposit OMR 100 today into a bank account that pays 8% interest compounded, how much would you have in the account at the end of two years? FVn =PV x ( 1 + i )n PV=100 , i=8 %=8/100=.08, n=2 =100 x ( 1 + .08 )2 =100 x 1.08 x 1.08=116.64