time value of money chapter 2 notes

Understanding the Time Value of Money

The Time Value of Money (TVM) is a fundamental financial principle that illustrates how money's value changes over time due to potential earning capacity.

This concept is critical for making informed investment decisions and understanding personal finance. The core idea is that a dollar today is worth more than a dollar in the future due to its potential earning capacity. This principle can significantly impact financial planning, investment strategies, and overall wealth accumulation.

The Basics of Investment Growth

Investment growth is primarily driven by interest, which can be simple or compounded.

1. Simple Interest: This is calculated only on the principal amount of an investment. For example, investing $1 at a 10% interest rate for one year yields $0.10 in interest, totaling $1.10.

2. Compound Interest: This involves earning interest on both the initial principal and the accumulated interest from previous periods. For instance, if the investment grows to $1.10 in the first year, in the second year, interest is calculated on $1.10, yielding $0.11 in interest, totaling $1.21. This process continues, leading to exponential growth over time.

The difference between simple and compound interest can be illustrated through a basic example. If you invest $1 at a 10% interest rate for five years, the total amount will significantly increase due to compounding, demonstrating the power of reinvesting earnings.

Future Value Calculations

Future value calculations help determine how much an investment made today will grow over time.

• Future Value of a Dollar: This chart allows investors to see how much an investment will be worth after a certain number of years at a specified interest rate. For example, investing $1 at a 10% interest rate for five years results in approximately $1.61.

• Future Value of an Annuity: This involves regular contributions made over time. For instance, if you invest $1,825 annually for 50 years at a 10% interest rate, the future