The time value of money simply means
that the value of money, i.e. purchasing power,
changes over time.
It is based on two fundamental ideas.
The first is that invested money earns income over time.
We call this "interest" usually.
The second is that cash received sooner
is preferred over cash received later.
Let's dive into both of these concepts,
starting with interest.
Generally, there are two ways to calculate interest.
Simple interest is when interest is only calculated
on the principal amount.
Compound interest is when interest
is calculated on the principal amount
and on the interest earned to date.
Here's an example of simple interest.
As you can see, $10,000 earning 5% annually
results in $500 of interest per year.
Over five years, that's $2,500 of interest earned.
Here is an example of compound interest.
The same $10,000 earning 5% annual compounding interest
results in $2,763 of interest over that same time period.
My good friend and yours, Albert Einstein,
is credited with the following quote.
"Compound interest is the eighth wonder of the world.
He who understands it earns it.
And he who doesn't--
pays it."
The other basic concept of the time value of money
is we would prefer to receive cash sooner rather than later.
This is because $1 received today is worth more than $1
received tomorrow.
Or perhaps a better example is $1,000
receives a day is worth more than $1,000 received next year.
You all know this to be inherently true
even if you don't know why.
Ask yourself, if your grandpa offered you
$1,000 today or $1,000 when you graduate college,
which would you choose?
Of course you would choose today.
The reason is because today's dollar
can be invested so that you would
have more than $1 tomorrow or more than $1,000
when you graduated college.
Let's wrap up this video by learning some terms that
will be used when we apply time value of money
to capital budgeting.
The principal amount, or the initial investment,
or a single amount, or one-time cash flows--
they can occur any time over the life of the project.
They can be an inflow and outflow.
However, the initial investment occurs at the beginning.
And it is a cash outflow.
An annuity is a recurring cash inflow
or outflow of equal amounts made at equal time intervals.
So there are regular cash flows occurring year
after year rather than a one-time amount.
There are two classifications of annuities.
Ordinary annuity is when the cash flow occurs
at the end of the period.
And an annuity due is when the cash flow occurs
at the beginning of the period.
For capital-budgeting purposes, it."
annuities are ordinary annuities.
In accounting, the only example that I
can think of where we use an annuity due
is when we price capital leases.
Future value is the value an asset will be worth
in the future, in terms of future dollars.
For example, an investment will be worth $1 million
when I retire.
The problem with future value is we
aren't sure about the purchasing power of $1 million 20 years
from now.
Present value is the value of an asset in today's dollars.
So let's assume that my investment will
be worth a million dollars when I retire.
But it has a present value of $350,000.
Now the problem is resolved because I
understand the purchasing power of $350,000 today.
So in accounting, we only use present value
for our calculations finance uses future value.
But accounting does not.
The interest rate is the annual percentage
earned on the investment or the cost of funds
used to finance the investment.
It has some other names that are shown on the slide.
And finally, the number of periods
is the length of time from the beginning of the investment
until the end.
It could be divided into interest-payment periods
or annual-cash flows.
So you will be seeing these terms in action
in the next several videos.