Week 6 Basic Concepts of TVM
Week 6: Lecture
Basic Concepts of TVM
Time value of money concepts deal with cash flows and when they are to be paid or received. These concepts allow us to compare alternatives which involve different amounts to be received or paid at different times.
Definitions
Suppose you had $100, and you put it in the bank in an account that paid 5% annually. At the end of a year you would have $105. Here is a picture of the situation:
Here are the terms that describe the situation:
- We call the $100 you have today the Present Value (PV) of the $105 you expect to receive a year from now, given a rate of return of 5% annually.
- We call the $105 you get a year from now the Future Value (FV) of $100 today, after one year has passed, given a rate of return of 5% annually.
- We call the 5% interest rate the interest rate (i), or rate of return (r). The rate is usually symbolized in formulas as i, but you sometimes see it as r, or even k. (We'll use i for now to match the chapter in your text) In time value of money problems i is variously referred to as the Discount Rate, the Interest Rate, the Required Rate of Return, or the Cost of Capital. Don’t let the different names confuse you. They all refer to the same thing.
- The number of periods of compounding involved in time value of money problems is symbolized as “n" or "N”. In the example above with the $100 and $105, n = 1 year. Most real world problems, however, involve multiple periods (years, months, or days).