Chapter 14. Time Value of Money

Time value of money is a key concept in finance. It is used by almost everyone—knowingly or unknowingly. We use it unknowingly when we intuitively prefer to get paid today and make payments later. We also use it explicitly to make decisions about whether we should buy a house or continue to rent, to make retirement plans, and so forth. Corporations use the concept to make decisions about simple investments and financings to mega-mergers.

Although Excel provides several functions to do various types of time value of money calculations, they are based on certain assumptions that often do not hold in practical situations. You therefore need to learn the underlying theory and concepts well and be able to write your own formulas to do calculations that cannot be done using the built-in functions. You also need to learn the theory and concepts well to clearly understand how the built-in functions work and what their limitations are so that you can take full advantage of them and not use them incorrectly.

While we will use the time value of money concepts and calculations throughout the book, we will use them most heavily in Chapter 17: Bond Pricing and Duration. You may want to view that chapter almost as an extension of this chapter.

Review of Theory and Concepts

PRESENT AND FUTURE VALUES

The essence of the time value of money concept is that a dollar today is worth more than a dollar in the future. If you have the dollar today, you can invest it and earn a ...

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