tailieunhanh - Lecture Personal financial planning – Chapter 2: The time value of money

Lecture Personal financial planning – Chapter 2: The time value of money. The time value of money is one of the basic ideas in finance. As such, it is very important that you understand how to use it in decision making. | Chapter 2 The Time Value of Money Chapter Goals Develop a working understanding of compounding. Apply time value of money principles in day-to-day situations. Calculate values for given rates of return and compounding periods. Compute returns on investments for a wide variety of circumstances. Recognize the effect of inflation on the purchasing power of the dollar. The Time Value of Money Time value of money: the compensation provided for investing money for a given period. For example: You are offered the choice of $1,000 dollars today or $1,000 dollars two years from now. Which do you choose? You would choose to receive the money today. After all, if you receive the money today you can invest the money and in two years could have much more than the original $1,000. Compounding Compounding: the mechanism that allows the amount invested, called the principal, to grow more quickly over time. It results in a greater sum than just the interest multiplied by the principal. Once we compound for more than one period we not only receive interest on principal but interest on our interest. Compounding, cont. For example: Initial Principal $2000 Interest Rate 10% What is the principal at the end of years 1 and 2? Principal End of Year 1 = $2000 × = $2200 Principal End of Year 2 = $2000× × = $2420 Compounding, cont. Were it not for the compounding we would use a simple interest rate for two years as follows: 1 + .10 + .10 = The principal end of year 2 would then be: $2,000 × () = $2,400 The $20 difference between $2,420 and $2,400 represents the interest on interest. Compounding, cont. This table illustrates the impact of compounding over a five year period. Compounding, cont. This figure illustrates simple versus compound interest. Compounding, cont. This figure illustrates simple versus compound cumulative interest. Using a Financial Calculator Time value of money and other calculations can be performed using a . | Chapter 2 The Time Value of Money Chapter Goals Develop a working understanding of compounding. Apply time value of money principles in day-to-day situations. Calculate values for given rates of return and compounding periods. Compute returns on investments for a wide variety of circumstances. Recognize the effect of inflation on the purchasing power of the dollar. The Time Value of Money Time value of money: the compensation provided for investing money for a given period. For example: You are offered the choice of $1,000 dollars today or $1,000 dollars two years from now. Which do you choose? You would choose to receive the money today. After all, if you receive the money today you can invest the money and in two years could have much more than the original $1,000. Compounding Compounding: the mechanism that allows the amount invested, called the principal, to grow more quickly over time. It results in a greater sum than just the interest multiplied by the principal. Once we