FIN 300 – Chapter 5: Introduction to Valuation: The Time Value of Money
The time value of money refers to the fact that a dollar in hand today is worth more than a dollar
promised at some time in the future.
o One reason is that you can earn interest while you wait.
5.1 Future Value and Compounding
Future Value – The amount an investment is worth after one or more periods. Also compound
o The amount of money an investment would grow over some length of time at some given
Investing in a Single Period
If you invest for one period at an interest rate, r, your investment grows to (1 + r) per dollar
Investing for More than One Period
Compounding – The process of accumulating interest in an investment over time to earn more
o Leaving your money and any accumulated interest in an investment for more than one
period, thereby reinvesting the interest is compounding.
Interest on Interest – Interest earned on the reinvestment of previous interest payments.
Compound Interest – Interest earned on both the initial principal and the interest reinvested from
Simple Interest – Interest earned only on the original principal amount invested.
The future value of $1 invested for t periods at a rate or r per period is:
o Future Value = $1 + (1 + r) t
(1+r) is called the future value of interest factor (or future value factor)
5.2 Present Value and Discounting
Future value determines how much money you will make on an investment in the future, but
present value finds out how much money you need to invest to make a specific amount of money
in the future.