Basic Concepts in Time Value of Money

Question 1

• is the idea that money that is available at the present time is worth more than the same amount in the future, due to its potential earning capacity.

Answer 1

Time Value of Money (TVM)

Question 2

Five Variables

Answer 2

Present Value (PV)
Future value (FV)
The number of periods (N)
Interest rate (I)
Payment amount (PMT)

Question 3

This is your current starting amount. It is the money you have in your hand at the present time, your initial investment for your future.

Answer 3

Present Value (PV)

Question 4

This is your ending amount at a point in time in the future. It should be worth more than the present value, provided it is earning interest and growing over time.

Answer 4

Future value (FV)

Question 5

This is the timeline for your investment (or debts). It is usually measured in years, but it could be any scale of time such as quarterly, monthly, or even daily.

Answer 5

The number of periods (N)

Question 6

This is the growth rate of your money over the lifetime of the investment. It is stated in a percentage value, such as 8% or .08.

Answer 6

Interest rate (I)

Question 7

These are a series of equal, evenly-spaced cash flows.

Answer 7

Payment Amount (PMT)

Question 8

can be a charge or an income, depending on whether you are borrowing money or lending/investing money. It is stated as a percentage over a specific period of time.

Answer 8

Interest

Question 9

is computed on the original amount as the return on that principal plus all unpaid interest accumulated to date.
- It is always assumed in TVM problems.

Answer 9

Compound Interest

Question 9

interest is computed on the original amount as the return on that principal for one time period.

Answer 9

Simple Interest

Question 10

is a straightforward rate that remains constant during the life of the loan or investment.

Answer 10

Fixed Interest Rate

Question 11

it changes during the life of the loan and is usually tied to the prime rate. It can go up or down depending on the prime rate set forth by the Federal Reserve.

Answer 11

Variable interest rate

Question 12

it changes from fixed to variable or from variable to fixed. It has some merits depending on your situation, but it is not a rate you would want to choose for a long-term investment or debt.

Answer 12

Mixed interest rate

Question 13

• Most of financial decisions such as the acquisition of assets or procurement of funds, affect firm’s cash flows in different time periods.
• If the timing of cash flows is not considered, the firm may make decisions which may falter its objective of maximizing the owner’s welfare.

Answer 13

Significance in Financial Decision-Making

Question 14

Time Preference for Money

Answer 14

1. Availability of Better Investment Opportunities
2. Due to Risk and Uncertainty of Cash Flows
3. Due to Inflationary Conditions
4. Preference for Present Consumption
5. Due to Urgency/Emergency

Question 15

There are investment opportunities, where people can invest their cash and earn some interest or return through lending or investment.

Answer 15

Availability of Better Investment Opportunities

Question 16

Future is uncertain with plenty of risks. In this environment cash outflows (i.e., investment made at ‘0’ period) are in investors control but the cash inflows (i.e. incomes earned from investments) return on investment and recovery of investments are not in investor’s control. The receipt from outsiders is uncertain. Hence, the investors prefer to receive cash now rather than receiving the same in future.

Answer 16

Due to Risk and Uncertainty of Cash Flows

Question 17

In the inflationary condition the purchasing power of money is decreasing. In this condition a rupee today has more purchasing power than a rupee tomorrow. So people prefer to receive cash now rather than tomorrow.

Answer 17

Due to Inflationary Conditions

Question 17

It is human tendency to prefer present consumption of goods, commodities and services; than to postpone their consumption to future periods. Hence people prefer to possess cash for current consumption, rather to postpone or cancel.

Answer 17

Preference for Present Consumption

Question 18

People prefer to receive cash today than in some future date, to meet some urgent needs or to meet emergency requirements.

Answer 18

Due to Urgency/Emergency