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Mastering Finance Essentials: Time Value of Money Explained

Learn the fundamental concepts of the time value of money in finance, including compound interest, present and future values, and the impact of inflation. Understand the principles of simple and compound interest calculations, compounding versus discounting, and risk management strategies. Dive into asset valuation, capital gains, dividends, and the Enron case study to grasp the importance of financial tools in decision-making.

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Mastering Finance Essentials: Time Value of Money Explained

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  1. The Tools of Finance Chapter 27

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. Case Study: Enron

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