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Finance Chpt 2

Time Value of Money

QuestionAnswer
Future Value - formula, definition FV = P x 〖(1+r)〗^t Future Value - Amount to which an investment will grow after earning interest.
Distinguish between simple & compound interest Compound Interest - Interest earned on interest. Simple Interest - Interest earned only on the original investment; no interest is earned on interest.
Present Value PV = (FV or C)/ (1 + r)^t = future value (or cash flows) over (1+ discount rate) to the power of t. Present Value - Value today of a future cash flow.
Distinguish between discount factor and discount rate. Discount Factor - Present value of a $1 future payment. Discount Rate - Interest rate used to compute present values of future cash flows
Time Value of Money (applications) Value of Free Credit Implied Interest Rates Internal Rate of Return Time necessary to accumulate funds
Perpetuities Perpetuity - A stream of level cash payments that never ends. e.g., consols PV of perpetuity = c/r C = cash payment R = interest rate
Annuities Annuity - Equally spaced level stream of cash flows for a limited period of time. e.g., mortgage, car loan PV of t year’s annuity = C [ (1/r) - (1/(r (1+ r) ^t))
Perpetuities & Annuities Applications Value of payments Implied interest rate for an annuity Calculation of periodic payments Mortgage payment Annual income from an investment payout Future Value of annual payments FV = C [(1/r) - (1/(r (1+ r) ^t)) X (1 + r
Effective Annual Interest Rate Effective Annual Interest Rate - Interest rate that is annualized using compound interest (i.e. the rate a which invested funds grow over the course of a year). 1 + EAR =〖( 1+ monthly rate)〗_12
Annual Percentage Rate Annual Percentage Rate - Interest rate that is annualized using simple interest. APR = Monthly rate x 12
Inflation Inflation - Rate at which prices as a whole are increasing. Remember: Current dollar cash flows must be discounted by the nominal interest rate; real cash flows must be discounted by the real interest rate.
Nominal interest rate Nominal Interest Rate - Rate at which money invested grows. 1 + real interest rate = (1 + nominal interest rate)/(1+ inflation rate)
Real interest rate Real Interest Rate - Rate at which the purchasing power of an investment increases. Real interest rate ≈ nominal int. rate – inflation rate
Created by: wguate