chapter 5 - key concepts (time value of money)

Question 1

what is the time value of money?

Answer 1

Adjusting the VALUE of cash flows based on when the cash flows are received

more info:
- Money today is worth more today than money in the future due to inflation and risk
- Corporations and investors need to discount future cash flows by the proper discount rate to make investment decisions

Question 2

why is inflation so important for cash flows?

Answer 2

Money today is worth more today than money in the future due to inflation and risk

when we receive cash in the future we must account inflation because over time the value of money decreases

Question 3

compounding (definition)

Answer 3

The arithmetic process of determining the final value of a cash flow or series of cash flows when compound interest is applied

final value of cash flow/serious of cash flow after compounded interest

Question 4

discounting (definition)

Answer 4

• The process of finding the present value of a cash flow or a series of cash flows.
• Discounting is the reverse of compounding
  (find value in today’s dollars)

value of today’s dollar

Finding the PV of a cash flow or series of cash flows is called discounting (the reverse of compounding).

Question 5

compound interest

Answer 5

• Interest is earned on prior periods’ interest
• Money earned on original amount and the interest (interest on the interest)
• Find value of interest in the future

Question 6

understand how different compounding periods impact cash flows (which compounding period would you prefer?)

Answer 6

google: the more compounding periods throughout this one year, the higher the future value of the investment, so naturally, two compounding periods per year are better than one, and four compounding periods per year are better than two.

Question 7

(problem types you need to know how to solve) : time value of money

Answer 7

given 3 pieces of information, solve for the 4th
pmt = 0
solve for fv, pv, i/yr, n

Question 8

(problem types you need to know how to solve) : value of an annuity

Answer 8

with annuities, either pv or fv is = 0
pmt =/= 0 in this type of problem

Question 9

(problem types you need to know how to solve) : perpetuity

Answer 9

formula for an annuity that pays a cash flow forever
need to know formula
can’t use a calculator

perpetuity - paid the same amount of money, FOREVER

(formula) pv = pmt/1
fv = 0 in this case usually

Question 10

what is the difference between an ordinary annuity and an annuity due

Answer 10

annuity due: is an annuity with payment due or made at the beginning of the payment interval

ordinary annuity: generates payments at the end of the period.

Question 11

rates of return

Answer 11

EAR: Used to compare returns on investments with different payments per year. Used in calculations when annuity payments don’t match compounding periods.