M

Financial Management: Time Value of Money Basics

Principle Applied

  • Principle 1: Money has a Time Value.

Using Timelines to Visualize Cashflows

  • A timeline identifies the timing and amount of payments (cash received/spent) along with the interest rate.

  • Critical first step for solving financial problems.

  • Typically expressed in years, but can be other units of time.

Compounding and Future Value

  • Future Value (FV): what a cash flow will be worth in the future.

  • Compound Interest: Interest earned on both the initial principal and the accumulated interest from prior periods.

  • Non-Annual Compounding: Interest compounded more frequently (e.g., monthly, quarterly).

    • More frequent compounding leads to higher future values.

Discounting and Present Value

  • Present Value (PV): The value today of a future cash flow.

  • Discounting: The process of determining the present value of an expected future cash flow.

  • The term (1/(1+i)^n) is known as the Present Value Interest Factor (PVIF).

Solving for Number of Periods (n)

  • Determines how long it takes to accumulate a specific future amount.

  • Best solved using a financial calculator or Excel.

  • Rule of 72: Approximates the number of years to double an investment.

Solving for Rate of Interest (i)

  • Determines the interest rate required for an investment to grow to a desired future value.

  • Can be solved using a mathematical equation, financial calculator, or Excel.

Making Interest Rates Comparable

  • Annual Percentage Rate (APR): The stated or nominal interest rate earned or paid in one year, without considering compounding effects.

  • Effective Annual Rate (EAR): The actual annual rate of interest earned or paid, considering compounding. Used to compare loans/investments with different compounding periods.

  • Continuous Compounding: When interest is compounded infinitely often.

  • Always compare EARs for different investments/loans to understand the true cost or return.