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Time Value of Money: The Basics: Chapter
Time Value of Money: The Basics: Chapter
Time Value of Money: The Basics: Chapter
Chapter Overview
Time value of money is one of the most important concepts in finance. The basic premise of time value of
money problems is that time impacts the value of a dollar. That is, a dollar received today is worth more
than one received in the future. The principles of time value of money are used in a variety of applications
in finance, including capital budgeting, capital structure, cost of capital, and working capital management
decisions.
This chapter explores time value of money concepts as they apply to a lump sum or single cash flow.
Future value is the value of a sum of money compounded at a given interest rate for a specific period of
time. Present value is the current value of a sum of money to be received at a specified time in the future,
given a stated rate of interest.
Chapter Outline
5.1
5.2
Chapter 5
5.3
15
5.4
Effective Annual Rate (EAR) is the annual compounded rate that produces the same return as
the nominal, or stated, rate.
EAR = (1 + Quoted Annual Rate/Compounding Periods per year)
m1
C. Continuous Compounding occurs when the time intervals between when interest is paid is
infinitely small.
Learning Objectives
5-1. Construct cash flow timelines to organize your analysis of time value of money problems
5-2. Understand compounding and calculate the future value of cash flows using mathematical formulas, a
financial calculator, and an Excel spreadsheet.
5-3. Understand discounting and calculate the present value of cash flows using mathematical formulas, a
financial calculator, and an Excel spreadsheet.
5-4. Understand how interest rates are quoted and know how to make them comparable.
Lecture Tips
1.
2.
Use the Rule of 72 to explore how the growth rate significantly affects the time for a quantity to double.
Vary the growth rate to see how doubling is affected for such examples as population, sales, prices, etc.
3.
Use ads from various financial institutions showing interest rates on CDs to illustrate the concepts of
APR and EAR.
16
Titman/Keown/Martin
1.
2.
Explain what is meant by continuous compounding? How can compounding occur continuously?
3.
When you graduate from college, you are offered the choice between a job with a starting salary of
$30,000 per year which grows annually at 6% or a job with a arting salary of $40,000 per year which
grows annually at 4%. How would you determine which is the best job to take if you assume you will
stay in this position for 5 years? At what growth rate would you be indifferent between the two
positions?
The end-of-chapter problems are sorted below, according to their level of complexity.
Simple
1, 5, 17, 19-22, 29-30
Average
Complex
12, 25, 28
The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets
are available on the Instructors Resource Center at www.pearsonhighered.com. If you do not have a login
and password for this Web site, contact your Pearson sales representative.
Problems: 5-15-9, 5-115-18, 5-205-34, 5-375-38
Internet Resources
http://antwrp.gsfc.nasa.gov/htmltest/gifcity/e.5mil
http://tr.im/fabcam
www.kiplinger.com/tools/index.html
www.dinkytown.net
www.bankrate.com/calculators.aspx
www.interest.com
www.predatorylendingassociation.com
www.responsiblelending.org/payday-lending
www.responsiblelending.org/payday-lending/tools-resources/debttrap.html