FIN 3320 Time Value of Money

Dr. Bobby Merriman Finance 3320 Time Value of Money

time value of money

the rate of return you need to make you indifferent between choosing to keep money today or to use money today to receive more money in the future

investment

using money with the expectation of receiving more money in the future

rate of return

the compensation you require for delaying consumption and for the uncertainty of receiving money back; measured as the percent of money that returned back to you relative to the initial amount of money given; that is, the ending value of an investment less the beginning value of an investment divided by the beginning value of the investment written as a percent

delayed consumption

the time period you have to wait to use your money after giving it up today

uncertainty

the risk or lack of guarantee regarding the amount you will receive back in the future

consumption inclination

the preference for spending today; people with a higher consumption inclination prefer to spend today

risk aversion

the preference for less uncertainty; people with a higher risk aversion prefer to avoid uncertainty; they are less likely to take risk

present value

the current worth of a future sum of money based upon a rate of return which compensates you for your consumption inclination and risk aversion (your delay and uncertainty preferences)

future value

the worth of a current sum of money at some point in the future based upon a rate of return which compensates you for your consumption inclination and risk aversion (your delay and uncertainty preferences)

compounding

the process of determining the future value of a present sum of money by applying an interest rate

discounting

the process of determining the present value of a future sum of money by applying a discount rate

interest rate

a rate of return used to compound present cash flows to their future value; interest rates emphasize the amount of money you expect to earn from an investment (Note: many persons use interest rates and discount rates interchangeably, but technically, these two have drastically different functions; the reason for this confusion is for some investments we use the interest rate as the discount rate to determine the value of the investment)

discount rate

a rate of return used to discount future cash flows to their present value; discount rates emphasize the value of the investment today

cash flow

the amount of cash generated or used by an investment over a period of time

lump sum

a single payment of money (as opposed to a series of payments)

annuity

a series of equal payments made at regular intervals over a period of time

annuity due

an annuity where payments are made at the beginning of each period (as opposed to the end of each period)

perpetuity

an annuity that continues forever

growing annuity

an annuity where payments increase at a constant rate each period

growing perpetuity

a perpetuity where payments grow at a constant rate each period

uneven cash flows

a series of cash flows that vary in amount and are made at irregular intervals (as opposed to being consistent like annuity payments)

annual compounding

money compounds once per year

semiannual compounding

money compounds twice per year (every six months)