13.2 The time value of money Flashcards
What is the main principle of time value of money?
Money obtained sooner is more valuable than money obtained later, and money spent sooner is more costly than money spent later.
Time value of money dictates that the value of money changes depending on when we receive or pay it out.
What are the advantages of having money sooner?
Having money sooner offers us numerous advantages:
- We’ can invest or otherwise use the money during the intervening year.
- We also eliminate the risk that the money might not be available next year.
- We don’t have to worry that inflation will shrink the purchasing power during the next year.
What does the time value of money capture?
The time value of money captures the effects of both opportunity costs and risk.
What is opportunity cost?
Opportunity cost is a measure of how much the deferred money could have earned in the intervening time.
Describe risk in terms of time value of money?
Risk captures the chances that:
- the money will be worth less (because of inflation)
- that changed circumstances could make the money unavailable during the intervening time
What is incorporated into the discount rate?
Economists and financial professionals bundle together the extent of risk and lost opportunities in a single discount rate that acts much like an interest rate on a savings account or credit card.
How do we distinguish between “$100 today” and “$100 a year from now” in a rational and consistent way?
Consider a choice of getting $100 today or $100 next year.
If the annual discount rate is 10%, then we would expect to need $110 dollars in a year in order compensate us for not having $100 today (or to purchase then what we could buy today with $100).
What is the formula for converting between present worth and future worth?
Consider: VF = $100, r = 10%, t = 3. What is the present value of the $100.
Consider the case where we have designed a system with an initial cost of $1000, annual maintenance costs of $100, and an overhaul cost of $300 in the third year. Further, the system is intended to last for five years.
Consider the case where we have designed a system with an initial cost of $1000, annual maintenance costs of $100, and an overhaul cost of $300 in the third year. Further, the system is intended to last for five years.
Present value of the total lifetime cost is $1604
