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Time Value of Money
The financial management process calls for making judgements about projects with cash flows far out in the future. This makes comparisons hard. For example:
- Your firm has $1 million to invest. Two alternatives are available:
1. Build a plant in Jamaica that will bring in $110,000 a year for 10 years starting five years from now.
2. Buy a 747 (used) to transport products around the world. Benefits expected to be $210,000 a year for the next five years
- Do you see the problem in evaluating these investments? The cash flows all occur at different times. What's better, getting $110,000 a year for 10 years starting five years from now or getting $210,000 a year for the next five years? Hard to say.
- In order to evaluate investments like the ones above you need a way to compare everything as of the same time, like what is it worth right now today? There is a way to do that, and it's called discounted cash flow analysis, or calculating "present value."
Discounted cash flow/Present Value Analysis
** Note: This is the Most Important Concept in Finance - Remember it well! **
- The present value (and future value, which we'll also consider) 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.
First, let's define some terms:
- 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 are the terms that describe that 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 1 year has passed, given a rate of return of...
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