time value of money

• option a - take rs1000 today

  option b - wait one year time and take rs1000

  with option a in 1 year if that amount of rs1000 is saved or invested we will be having an amount superior than rs1000 whereas with option b we will be having only rs1000 in 1 year. therefore a rational individual would prefer option a over option b .

  so when cash flows are occuring at different time period they should be converted to the same time period and then be taken for investment decision
• example 2

  option a - rs1000 today at an interest rate of 10% per year.

  option b - rs1500 in one year time

  answer - option b- given that at T= 1 it offers the higher amount [rs1500 greater than rs1000 + 100[interest]]

  NOTE - cash flows should be compared at the same time period either by calculating the future value that is the value at any fututre period or by calcualting the present value that is the value today or at T=0
• FUTURE VALUE

  if the initial amount invested is known as well as th interst rate and thime period of investment then the future value of the investment can be calculated.

  for the calculation of interest either a simple interest or a compound interest will be used.
• simple interest -$interest rate *$$initial amount invested at T=$$0$
• COMPOUND INTEREST

  it represent another tyoe of interest paid on investment . so the interest at first time period when applying compound interest is the same as simple interest that it consist on multiplying the initial rate. the interst obtain at the first time period will be invested over the subsequent time period of the investment . likewise the interst obtain at the second tiem period at the subsequent time period .

  FORMULAE - $FV=$$PV[1+r]n$