Time Value and Money

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Define the three rules of time travel and discuss why they are important. How can you use them to compare and combine cash flows? Financial decisions often require comparing or combining cash flows that occur at different points in time. Rule 1: Comparing and Combining Values: The first rule is that it is only possible to compare and combine values at the same point in time. To compare and combine cash flows that occur at different points in time, we need to convert the cash flows into the same units or move them to the same point in time.(Bark & Demurs, 2011, p. 88) Rule 2: Moving cash flows forward in time: The second rule stipulates that to move a cash flow forward in time, you must compound it. e.g., Suppose we have $100 today, and we wish to determine the equivalent amount in one year time would be $1000 x (1.10) = $1100, and in two years’ time $1100 x(1.10) = $1210, so on so forth. In the second year we earn interest on the interest , this effect of earning is known as compound interest. The type of growth which results from compounding is called geometric or exponential growth. (Berk & DeMarzo, 2011, p. 89) Rule 3: Moving Cash flows back in time: The third rule stipulates to move a cash flow back in time, we must discount it. The third rule describes how to move cash flows backward in time. Suppose you would like to compute the value today of $1000 you anticipate to receive in a year. If the current market rate is 10%, you can compute this value by converting units. ($1000 in one year) % (1.10$ in one year/$today) = $909.09 today This process of moving a value or cash flow backward in time-finding the equivalent value today of a future cash flow-is known as Discounting.(Berk & DeMarzo, 2011, p. 91) Summary: Drawing a timeline as the first step in solving a problem will often clarify any confusion about amount and/or timing of cash flows, making

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