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# Module 1 Tools of Finance Summary

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Module 1 Tools of Finance
Understanding the time value of money concept is key to developing a good grasp of how finance
works. The time value of money means it is better to receive money sooner than later. The money
received sooner can be invested to gain a return, which results in more money.
Cash flows that are received in the future have a lower value than cash flows in the present time.
This is important for companies and it is necessary that managers can use the tools of finance to
value these cash flows. Cash flows occurring at different points in time can be brought back to a
current time value known as the present value. Bringing cash flows back to the current time allows
The basic set of tools that managers use are the techniques of present value and future value, using
annuities to assist the valuations and expected return and standard deviation. The latter two tools
gives an answer to the questions of what is the return an investment will make and what is the risk
that is involved in producing that return.
It is essential that the present value techniques are learned and understood. This is necessary for a
better understanding of the valuation processes for bonds, stocks and projects. Without a good
grasp of these techniques you will find it difficult to gain a proper understanding of finance.
What you will learn here is how to value simple cash flows and how to use the statistical tables in
the appendix. You will also learn where these techniques are used in everyday activities. It is
important that you learn how to use the financial tables. Financial calculators will also help provide
the answers to different problems, but they do not help build an intuitive feel for finance in the way
the financial tables do. Financial calculators will deliver quick answers to complex problems, but for
the finance course and for the exams a financial calculator is not necessary. A scientific calculator is
enough to work through the problems in this text.
Types of cash flows
Single cash flow: This will be a single cash flow that is expected at some point in the future or is
invested today for a number of periods, eg, £10,000 to be received at the end of five years or £5,000
invested today.
Annuity cash flow: This is a stream of equal cash flows over a period of time, eg, £2,000 per annum
for five years. The period does not have to be a year, the financial tables are for any period of time;
it could be years, or months or weeks or half-years. The cash flows in this example would be £2000
at the end of the first year, then £2000 at the end of year 2, £2000 at the end of year 3, £2000 at the
end of year 4, and finally £2000 at the end of year 5.
Mixed cash flows: This is a stream of cash flows that are not equal, eg, £2000, £3000, £3500,
£4000. This is not an annuity and cannot be valued using the annuity tables.

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Which table to use?
There are four present value and future value tables in the appendix. There is the present value of a
single cash flow (Table A1.1), present value of an annuity (Table A1.2), the future value of a single
cash flow (Table A1.3) and the future value of an annuity (Table A1.4).
When using the tables the assumption is that the cash flow occurs at the end of the period. With a
cash flow of £100 expected at the end of year 1, you would look up Table A1.1, one period and read
across for the relevant interest rate and then down to obtain what is known as the present value
interest factor (PVIF
i,n
).
For all four tables;
Table A1.1 Present value single cash flow PVIF
i,n
Table A1.2 Present value annuity cash flow PVAIF
i,v
Table A1.3 Future value single cash flow FVIF
i,n
Table A1.4 Future value annuity cash flow FVAIF
i,n
Timeline
A useful device to use to picture the cash flows you are trying to value is a timeline. This is a linear
representation of the timings of the expected cash flows. This will show you what you are doing in
the valuation exercise. This helps cement the concepts of present value and future value.
For example, you expect to receive £1000 in year 3 and £2000 in year 4. This would be represented
on a timeline as follows;
Year 0 1 2 3 4
Today £1000 £2000
In the timeline, Year 0 represents the present time. Year 1 is the end of the first year and is one year
later. Year 2 is the end of the second year and is two years from now.
Year 1 both represents the end of year one and the start of the second year. The timeline is useful
for tracking the cash flows. On the timeline, cash inflows will be positive and cash outflows will be
negative and will be signalled with a negative sign, eg, a payment by you of £4000 would be
represented as -£4000.
Timelines are very useful when you are first learning how to understand the present value and
future value techniques, as it might seem a bit abstract moving cash flows backwards and forwards
in time. But timelines should be something you keep using as you progress through finance. Cash
flows will become more complex and using the timeline is a good way of simplifying the problem and
representing it as a picture.

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Module 1 Tools of Finance Understanding the time value of money concept is key to developing a good grasp of how finance works. The time value of money means it is better to receive money sooner than later. The money received sooner can be invested to gain a return, which results in more money. Cash flows that are received in the future have a lower value than cash flows in the present time. This is important for companies and it is necessary that managers can use the tools of finance to value these cash flows. Cash flows occurring at different points in time can be brought back to a current time value known as the present value. Bringing cash flows back to the current time allows cash flows to be compared and for more informed decisions to be made on company investments. The basic set of tools that managers use are the techniques of present value and future value, using annuities to assist the valuations and expected return and standard deviation. The latter two tools gives an answer to the questions of what is the return an investment will make and what is the risk that is involved in producing that return. It is essential that the present value techniques are learned and understood. This is necessary for a better understanding of the valuation processes for bonds, stocks and projects. Without a good grasp of these techniques you will find it difficult to gain a proper understanding of finance. What you will learn here is how to value simple cash flows and how to use the ...
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