The Time Value Of Money Introduction - Financial Management

Understanding the time value of money is crucial to effective financial management. In fact, anyone who is involved with money should have some comprehension of the time value of money. Consider the following:

  • A banker who makes loans and other investments
  • A financial officer whose job includes the consideration of various alternative sources of funds in terms of their cost
  • A company manager who must choose among various alternative investment projects
  • A securities analyst who evaluates the securities that a firm sells to investors
  • An individual who is confronted with a host of daily financial problems ranging from personal credit account management to deciding how to finance a new home purchase

Each of these individuals makes frequent use of the time value of money.Many people fear that a working knowledge of the time value of money concept might be too difficult to master. However, the availability of interest tables, financial calculators, and spreadsheet programs such as Excel makes the subject readily accessible.

Although an understanding of the time value of money is useful in and of itself, it is also a necessary prelude to the following topics:

  • Valuation of securities and other assets
  • Capital budgeting (the analysis of investment projects)
  • The cost of capital
  • Working capital (short-term asset and liability) management
  • Lease analysis

This chapter introduces the concepts and skills necessary to understand the time value of money and its applications. The analysis in this chapter assumes that you will use either a financial calculator, an Excel spreadsheet, or the interest tables (Tables I through IV) at the end of the book to solve problems. Calculator and spreadsheet solutions are presented for many of the examples in this chapter. However, we are primarily interested in having you learn the principles of the time value of money.

A Word About Notation

A brief discussion of financial notation is in order before we begin our time value of money discussion. In finance, as a general rule, lowercase letters are used to denote percentage rates and lengths of time, whereas capital letters are used to denote money or dollar amounts. For example, we use i to denote the interest rate, n to denote the number of periods, PMT to denote cash payments, PV to denote the present value dollar amount, and FV to denote the future value dollar amount. One important exception in this text is that we use T to denote the tax rate instead of t. Lowercase t denotes time. Our use of i to denote the interest rate is similar to the notation used on most financial calculators. However, later in the text, for example in Chapter , when the interest rate becomes a specific required rate of return, we use k to denote required return, as is the custom used by many financial analysts.

CFM Excel Templates

Another feature of Contemporary Financial Management, tenth edition, is the availability of Excel templates to solve a wide range of complex financial management problems, including the loan amortization problems encountered in this chapter. These templates are designed to be used in conjunction with the Excel electronic spreadsheet program. The CFM Excel templates require no prior knowledge of Excel and are menu driven. The templates are available at the book’s Web site. As part of the problem section of selected chapters, we have included problems that can be solved using these templates. These problems are identified by an Excel icon printed next to the problem number.

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Financial Management Topics