Week 2 Project

Basic Elements of TVM

Money can be received or given in two main ways. The �rst is as a one-time amount—either an in�ow or out�ow, today or tomorrow. This is a lump sum. If we are determining the value today, it is a present value. If we are talking about a value to be received or paid in the future, it is a future value.

Second, the money might be received in a series of cash �ows over time, such as an annuity or a payment. This is a series of cash �ows. The �ow or stream may be an even amount each period, or uneven.

Finally, money may come in as a combination of a series of cash �ows and/or a lump sum. For example, a bond, debt issued by corporations or governments, has periodic cash �ows, interest payments, and a lump sum—the principal or par value of the bond.

Interest is the way we recognize that compensation is needed for waiting until the future to use money. We have to pay for getting the money sooner, or be compensated for waiting until later.

An interest rate is the interest payment divided by the principle or balance of a loan. The interest payment may be received annually, semiannually, monthly, and so on. You may earn interest on interest and principal. This is compounding, or the inverse of discounting. When you deposit money in the bank and earn interest over time you are receiving compound interest.

The interest element represents the opportunity cost of using money. John Maynard Keynes, an economist, suggested we hold money for three motives: transactions, precautionary, and speculative. That is, we hold money because we need it for making purchases in the short term, to have in case of emergencies, or to have in case we �nd a “good deal.”

Here is an example of using a �nancial calculator for a car loan.

You want to buy a car with a $1,000 down payment. The loan amount is $9,000. The annual interest rate is 6% and the loan is for 60 months. What are your payments?

First, set your calculator to monthly payments.

Be sure to set your calculator to the appropriate payments per year. Most problems are annual—one payment per year.