Chapter 6 – How Money Grows

‘Mathematics is a game played according to certain simple rules with meaningless marks on paper.’
David Hilbert

Overview

This chapter reviews the arithmetic of finance. We look at the relationships between proportions and percentages; growth, interest and discount rates; interest/discount rates, risk, and the present and future value of money. These are deeply intertwined, and they are critical elements in decisions about money when time is involved. They are also important for many other management issues, including growth in profits and inflation. The chapter concludes by looking at many practical applications of these relationships – and previews their use in assessing financial instruments and projects.

Mastering the arithmetic of money

After reading this chapter, you should be able to answer the following questions:

What is the relationship between percentages and proportions? Why is it useful?
How do percentages and proportions relate to growth?
What are simple and compound interest rates? What are their relationship to percentages and proportions?
What is the relationship between interest rates and discount rates?
What is the time value of money? How do interest rates and risk come into this issue?
What are the present and future value of money?
What are net present value and the internal rate of return?
How do you apply the foregoing to simple financial investments, loan repayments, discounts and rent-or-buy problems?
How do you apply the foregoing to financial markets and project assessment – the details of which are discussed in Chapters 19 and 21?
What do growth and inflation have in common?