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Chapter 4

The document discusses time value of money concepts including future value, simple and compound interest, and present value. Future value is the amount an investment will grow to over time at a given interest rate. Compound interest means earning interest on interest by reinvesting accumulated interest over multiple periods. Present value is the current worth of future cash flows when discounted at an appropriate rate.

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Jayesh Desai
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29 views

Chapter 4

The document discusses time value of money concepts including future value, simple and compound interest, and present value. Future value is the amount an investment will grow to over time at a given interest rate. Compound interest means earning interest on interest by reinvesting accumulated interest over multiple periods. Present value is the current worth of future cash flows when discounted at an appropriate rate.

Uploaded by

Jayesh Desai
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Chapter 4: Introduction to Valuation: Time Value of Money

1. Future value (FV) refers to the amount of money an investment will grow to over some
period of time at some given interest rate. Put another way, future value is the cash
value of an investment at some time in the future. In general, if you invest for one
period at an interest rate of r, your investment will grow to (1 + r ) per dollar invested.
For example, r is 10 percent, so your investment grows to 1 + (1 x 0.10) = 1.1 dollars
per dollar invested. Future value = PV x (1+ r)t

2. Simple and Compound Interest: Going back to our $100 investment, what will you
have after two years, assuming the interest rate doesn’t change? If you leave the entire
$110 in the bank, you will earn $110 + (110 x 0.10) = $11 in interest during the second
year, so you will have a total of $110 + 11= $121. This $121 is the future value of $100
in two years at 10 percent. Another way of looking at it is that one year from now you
are effectively investing $110 at 10 percent for a year. This is a single-period problem,
so you’ll end up with $1.10 for every dollar invested, or $110 x 1.10 = $121 total. This
$121 has four parts. The first part is the $100 original principal. The second part is the
$10 in interest you earned in the first year, and the third part is another $10 you earn in
the second year, for a total of $120. The last $1 you end up with (the fourth part) is
interest you earn in the second year on the interest paid in the first year: $10 x 0.10 =
$1. This process of leaving your money and any accumulated interest in an investment
for more than one period, thereby reinvesting the interest, is called compounding.
Compounding the interest means earning interest on interest, so we call the result
compound interest. With simple interest, the interest is not reinvested, so interest is
earned each period only on the original principal.

3. Present Value (PV): The current value of future cash flows discounted at the
appropriate discount rate. Present value is thus just the reverse of future value. Instead
of compounding the money forward into the future, we discount it back to the present.

3.

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