Time value of money

Money that the firm has today is more valuable than money in future because the money it now has can be invested

and earn positive return

Future value

• The value at a given future date of a present amount placed on deposit today and earning interest at a specified rate. Found by applying compound interest over a specified period of time

Future value(cont…)

• Compound interest interest that is earned on a given deposit and has become part of the principle at the end of a specified period• PrincipleThe amount of money on which interest is paid• Future value interest factor: the multiplier used

to calculate, at a specified interest rate, the future value of a present amount as of a given time

Present value

• The current value of a future amount

• Discounting cash flow: the process of finding present values; the inverse of compounding interest

• Present value interest factor: the multiplier used to calculate, at a specified discount rate, the present value of an amount to be received in a future date

• Annuity: a stream of equal periodic cash flows

• Ordinary annuity: cash flow occurs at the end of each period

• Annuity due: cash flow occurs at the beginning of each period

• Mixed stream: a stream of unequal periodic cash flows that reflect no particular pattern

• Perpetuity: an annuity with an infinite life, providing continual cash flow

Compounding of interest

• Semiannual compounding

• Quarterly compounding

• Continuous compounding

Nominal and effective annual rates of interest

• Nominal (stated) annual rate

• Effective (true) annual rate