Summary Chapter 5: time value of money

Chapter 5: The time value of
money
1. Future values and compound interest

 Future value
= amount to which an investment will grow after earning interest
 Compound interest
= interest earned on interest
 Simple interest
= interest earned only on the original investment



Example – simple interest

Interest earned at a rate of 6% for five years on a principal balance of $100

Interest earned per year = principle balance × .06 = $ 6




Example – compound interest

Interest earned at a rate of 6% for five years on the previous year’s balance

Interest earned per year = prior year balance × .06

, Future value = FV




Example – FV

What is the future value of $100 if interest is compounded annually at a rate of 6% for five years?

 FV = $100 x (1 + 0.06)^5 = $133.82




2.
Present

values

Present value =
value today of a future cash flow

Discount factor = present value of a $1
future payment

Discount rate = interest rate used to compute present values of future cash flows



Present value = PV




 Discounted cash flow (DCF)
Method of calculating present value by
discounting future cash flows




 Example