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Time value of money in making financial decisions

Kim has arranged a meeting with you and the head of manufacturing because she thinks you need to explain to him the time value of money. Kim is concerned that many of the manufacturing projects that have been pursued are based on the payback period and do not recognize that a dollar received 3 years from now is not the same as a dollar received today.

You decide to put an illustration together to review with Bob, the head of manufacturing, showing how much US$1 would decline at a 3% interest rate over a 5-year time period. You will describe the decline each year, starting with the current year. Since Bob is a strong believer in the payback period, you decide to also explain the pros and cons of the payback period.

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The future value of an amount given (or received) at a point in time is the amount that a rational person would expect to receive (or give back) after waiting a specific number of time periods. The present value of an amount to be received at a point in the future is the amount that a rational person would accept (or give) now in exchange for the right to receive the future amount. Future values always exceed the equivalent present values:

Present Value < Future Value

Future values. Why do rational individuals and businesses attach smaller present values to future amounts? Because they can invest the money they currently hold and earn additional funds during the time they would have to ...

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Time value of money in making financial decisions