Introduction to Finance

9.1
Basic Time Value Concepts
FINANCE
In Chapter 1, we identifi ed six principles of fi nance. These principles serve as the 
foundation of fi nance:
1. Money has a time value.
2. Higher returns are expected for taking on more risk.
3. Diversifi cation of investments can reduce risk.
4. Financial markets are effi
cient in pricing securities.
5. Manager and stockholder objectives may diff er.
6. Reputation matters.

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C H A PT E R 9 Time Value of Money
The pricing and valuation of fi nancial securities, including bonds, stocks, and real asset invest-
ments, are best understood in the context of the fi nance principles. The 
time value of money
is the math of fi nance whereby a fi nancial return (e.g., interest) is earned over time by saving 
or investing money.
In addition to investors requiring compensation or a fi nancial return for lending or investing 
their fi nancial capital, they also want to be compensated with higher expected returns for taking 
on more fi nancial risk. For example, we explored in Chapter 8 the concept of default risk premi-
ums for investing in corporate bonds relative to investing in Treasury bonds. Higher default risk 
premiums are required by investors in corporate bonds relative to government bonds, because 
there is a higher likelihood or probability that corporations will miss paying on time their interest 
and principal payment obligations. Risk-return trade-off s will be addressed in greater detail in 
future chapters. The ability to diversify away some investment risk through holding diversifi ed 
portfolios of securities also is important to investors when making investment decisions.
The actions of individuals to seek out undervalued and overvalued investment opportun-
ities contribute to making fi nancial markets reasonably effi
cient—that is, current prices refl ect 
the underlying intrinsic valuations of real and fi nancial assets. We also know that management 
objectives may diff er from owner objectives. Methods of getting managers to manage for the 
best interests of equity investors will be discussed in Part 3 of this textbook. The fi nal principle 
is based on the belief that “reputation matters” and considers the ethical behavior of individu-
als and organizations as to legal, fair, and honest treatment of others.
We concentrate on the time value of money fi nancial principle in this chapter. Money 
can increase, or grow, over time if we can save (invest) it and earn a return on our savings 
(investment). Let’s begin with a savings account illustration. Assume you have $1,000 to save, 
or invest; this is your 
principal
. The 
present value 
of a savings or an investment is its amount 
or value today. For our example, this is your $1,000.
A bank off ers to accept your savings for one year and agrees to pay to you an 8 percent 
interest rate for use of your $1,000. This amounts to $80 in interest (0.08 × $1,000). The total 
payment by the bank at the end of one year is $1,080 ($1,000 principal plus $80 in interest). 
This $1,080 is referred to as the future value, or value after one year in this case. The