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## PowerPoint Slideshow about ' Chapter 27' - melinda-oliver

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### Chapter 27

Time Value of Money

- A dollar received in the future does not have the same purchasing power as a dollar today
- Why? Inflation
- Interest helps dollars grow to maintain their purchasing power

Simple Interest

- Principle x Rate x Time
- Principle is an amount borrowed or invested
- Rate is the annual rate of interest paid or earned
- Time is a function of one year

- If you invest $10,000 for one year at 6%
- 10,000 x .06 x 1 = $600
- 10,000 x .06 x 4 = $2,400 for four years
- At the end of four years you have $12,400

Compound Interest

- Interest earning interest
- What if the interest earned each year is allowed to grow as part of the investment?
Yr 1: 10,000 + (10,000 x .06 x 1) = 10,600

Yr 2: 10,600 + (10,600 x .06 x 1) = 11,236

Yr 3: 11,236 + (11,236 x .06 x 1) = 11,910

Yr 4: 11,910 + (11,910 x .06 x 1) = 12,625

- You come out ahead by $225

Compound Interest

Compound interest is an exponential function: the bigger it gets the faster it grows

Future value = Present value x (1 + r)n

FV = $10,000 x (1 + .06)4

FV = $12,625

Variables

- Present Value (PV)
- The value of an investment or amount borrowed today
- Principle only, no time no interest

- Future Value (FV)
- Principle + interest at some time in the future

- N is the number of compounding periods
- Ris the interest rate per compounding period

Compounding vs. Discounting

Compounding is the process of adding interest: take a present value or principle payments and add interest to arrive at a future value

FV = PV x (1+r)n

Compounding vs. Discounting

Discounting moves in the opposite direction: take a future value with principle and interest and remove the interest

PV = FV /(1+r)n

Other Considerations

- Risk aversion
- Diversification (firm-specific risk vs. market risk)
- Risk vs. Return
- Asset valuation
- Value & Price
- Capital gains & dividends
- Random walk & index funds

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