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Encyclopedia of Financial Models II by Frank J. Fabozzi

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Time Value of Money

PAMELA P. DRAKE, PhD, CFA

J. Gray Ferguson Professor of Finance, College of Business, James Madison University

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: Investing decisions require the valuation of investments and the determination of yields on investments. Necessary for the valuation and yield determination are the financial mathematics that involve the time value of money. With these mathematics, future cash flows can be translated to a value in the present, a value today can be converted into a value at some future point in time, and the yield on an investment can be computed.

In this entry, we introduce the mathematical process of translating a value today into a value at some future point in time, and then show how this process can be reversed to determine the value today of some future amount. We then show how to extend the time value of money mathematics to include multiple cash flows and the special cases of annuities and loan amortization. Finally, we demonstrate how these mathematics can be used to calculate the yield on an investment.1

IMPORTANCE OF THE TIME VALUE OF MONEY

The notion that money has a time value is one of the most basic concepts in investment analysis. Making decisions today regarding future cash flows requires understanding that the value of money does not remain the same throughout time.

A dollar today is worth less than a dollar some time in the future for two reasons:

Reason 1: ...

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