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Financial Analysis With Microsoft Excel-Mayes, Shank - Chapter 7

CHAPTER 7 The Time Value of Money Explain the concept of the time value of money. Calculate the present value and future value of a stream of cash flows using Excel. Explain the types of cash flows encountered in financial analysis, and how to adjust for each type in making time value calculations in Excel. | 7 The Time Value of Money After studying this chapter you should be able to 1. Explain the concept of the time value of money. 2. Calculate the present value and future value of a stream of cash flows using Excel. 3. Explain the types of cash flows encountered in financial analysis and how to adjust for each type in making time value calculations in Excel. 4. Differentiate between the alternative compounding periods and use Excel to compare present and future values under different compounding schemes. A bird in the hand is worth more than two in the bush. That old aphorism when translated into the language of finance becomes A dollar today is worth more than a dollar tomorrow. Intuitively it probably makes sense but why Stated very simply you can take that dollar today and invest it with the expectation of having more than a dollar tomorrow. Because money can be invested to grow to a larger amount we say that money has a time value. This concept of a time value of money underlies much of the theory of financial decision making. 183 184 The Time Value of Money Future Value Imagine that you have 1 000 available to invest. If you earn interest at the rate of 10 per year then you will have 1 100 at the end of one year. The mathematics behind this example are quite simple 1 000 1 000 0.10 1 100 In other words after one year you will have your original 1 000 the principal amount plus the interest earned. Since you won t have the 1 100 until one year in the future we refer to this amount as the future value. The amount that you have today 1 000 is referred to as the present value. If at the end of the year you choose to make the same investment again then at the end of the second year you will have 1 000 1 000 0.10 100 0.10 1 000 0.10 1 210 The 1 210 at the end of the second year can be broken down into its components the original principal the first year s interest the interest earned in the second year on the first year s interest and the second year s interest on the