One question we are always trying to answer in finance is what is a dollar amount our firm will receive in the future worth to us today? As financial managers, we are most interested in this present value, or value today, because we have to make decisions today to maximize shareholder value (remember chapter one). In this chapter, we will first explore future value since that concept is easy for most people to grasp while present value is easy to learn but not as obvious as future value.
Present value depends upon three things: the dollar amount, the risk that we might not receive the cash flow in the future and when we think we will receive it. The underlying concept that we master in this chapter is time value of money (TVM), that is, the third item: how the timing of the cash flow affects its value to us today. Once we know how to answer this question, we can then compare our estimate of value with market prices or costs to make decisions about things like project selection (capital budgeting).
In chapter two, we learned about the magnitude of cash flows and how to measure those. We will learn how to project cash flows we think we will receive in the future, both size and timing, later on in the text in chapters 4, 5, 9 and 18. We will learn about risk in chapter 6, 7, 8 and 10. In this chapter, however, our goal is to learn the techniques to calculate value, so we must assume that we know the future expected cash flows and the risk associated with them.
As you can see from the summary here, this concept is one of the most important in finance. Give yourself some time to absorb and understand it. It might not be the easiest concept for most people to understand at first, but if you apply some of these principles to your own financial situation, TVM will make a lot more sense to you.
• What would you rather have: $1 today or $1 in one year?
o $1 received today is more valuable than $1 received one year... [continues]
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