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Everybody wants money, both now and later, and we instinctively know that now is better than later. How much better? Well, that is a major point of this chapter. In this chapter, we learn how to compute how much an investment made today will be worth at some future date, the present value of a lump sum to be received in the future, and how to find the return on investment when we know the present value and the future value. We will build on this expertise in future chapters. In Chapter 5, we will learn about evaluating cash flows. In later chapters, we will learn about using the time value of money to make decisions about investments. In class, I will show you how to use some of these same techniques for personal decisions, such as buying a house or car or purchasing on credit.
Sports figures often negotiate for financial deals spread over 10 years. They may think they are getting one figure, but the present value of the package may be far less than they think. In accident suits, victims are often offered their choice of several packages. Being able to put everything in terms of the present value allows both athletes and victims to see the current value of the offer and compare the offers properly. Lottery winners are often disappointed when they realize what they will actually get.
In a business, we need to look at investments in machinery, computer systems, and marketing campaigns in terms of expected return over a period of years, and see if the expenditure of cash now is warranted by the payback of the purchase.
Important Tip: Before you start to work problems in time value of money, make sure that your calculator is set up properly. Most calculators come with an assumption that payments will come at the end of each period, which is the case most of the time, so leave that setting. However, many come with 12 payments per period set as the default. I think it is easier to make your own adjustments to the period than to reprogram your calculator for yearly, quarterly or daily payments. Appendix D, which starts on page 551, has both help on setting up your calculator, and sample problems for the HP-10B and the Texas Instruments BA II Plus calculators. If you have another brand of calculator, such as the Sharp or Casio business calculators, use the instruction booklet that came with the calculator to determine how to configure your calculator and use it to solve these problems. The instruction booklets are quite helpful. If you do not have the instruction book for your calculator, you can download it from the web.
For the Texas Instruments BA-II plus, go to
http://education.ti.com/us/product/tech/baii/guide/baiiguideus.html to download the guide.
For the HP 10B, go to http://www.hp.com/cposupport/manindex/hp10bbusin20038_eng_man.html
We were unable to locate a manual for the Sharp EL-733A or 733B online, but according to the Sharp web site, you can call 1-800-BE-SHARP (1-800-237-4277) to get one.
Casio apparently is no longer making financial calculators, but some office supply stores may still have some of their older models. Their support line is CASIO SUPPORT LINE
800-962-2746.
Click here for more help on Chapter 4.
Key terminology
Compound interest
Compounding
Discount
Discount rate
Discounted cash flow valuation
Future value
Future value factor (see page 102, Table 4.4)
Interest on Interest
Present value
Present value factor (see page 102, Table 4.4)
Simple Interest
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