FInancial Fundamentals - Ch 7

Question 1

What is the Time value of Money ?

Answer 1

mathematical concept
-Determines the value of money,
at a point or over a period of time,
at a given rate of interest

Question 2

What is the Present value ?

Answer 2

Value today of one or more future cash flows

discounted to today at an appropriate interest rate.

Question 3

What is the future value?

Answer 3

Value at some point in the future of a present amount or amounts

after earning a rate of return

for a period of time.

Question 4

What is the 4 step method to solve time value of money ?

Answer 4

The following four-step method:

1. Start with a timeline of cash flows.
2. Write down the TVM variables.
3. Clear all registers in the financial calculator.
4. Populate the TVM variables in the calculator

Question 5

Examples of cash inflows ?

Answer 5

Cash Inflows, Positive amounts going into your pocket !

• Annuity payments received during retirement.
• Loan to purchase a house (the loan amount received
• Lump-sum amount that is accumulated after a period of savings.
• Income received during retirement, inheritance, or distribution of savings.

-When dealing with lump sum amounts to solve for the number of periods or the interest rate, either PV or FV must be a positive number (inflow) and the other must be a negative number (outflow) since you cannot receive something in the future without giving something up today (or vice versa).

-If both PV and FV are entered as positive numbers the following error messages will appear on the calculator display

Question 6

Examples of outflows ?

Answer 6

Cash Outflows, NEGATIVE amounts, Going out of your pocket !!!

• Tuition payments.
• Savings or lump-sum contributed / deposited to a savings account.
• Repayment of any type of debt.
• Purchase of a piece of equipment or investment.

Question 7

Simple interest rate ?

Answer 7

Interest rate is only applied to the original investment.

Question 8

Compound interest rate ?

Answer 8

Earning interest on the original balance + interest on any previously accumulated interest

Question 9

What is an Annuity ?

Answer 9

Recurring cash flow, of an equal amount that occurs at periodic (but regular) intervals

Question 10

What is an ordinary annuity ?

Answer 10

When timing of the first payment is at the end of a period. The period may be the end of a week, month, quarter, or the end of a year.

Set calculator to END

Examples of an ordinary annuity:
* Debt payments (car loans, student loans, or mortgages)
* Contributions to an IRA or 401(k) if regular and recurring and made at month, quarter, or year end

Question 11

What is an Annuity Due ?

Answer 11

When the timing of the first payment is at the beginning of the period. The period may be the beginning of a week, month, quarter, or year.

-Set calculator to BEGIN Mode

-The future value of an annuity due will always be greater than the future value of an ordinary annuity by exactly the interest earned on the first payment of the annuity due over the total term

Examples of an annuity due:
* Rents (usually paid in advance)
* Tuition payments (usually paid at the beginning of the term in advance)
* Retirement income (usually paid at the beginning of the month or year in advance)

Question 12

What does CFj on calculator represent ?

Answer 12

CFj: Periodic cash flows.
“j” represents each period of cash flows

Question 13

What does Nj represent on the calculator ?

Answer 13

Number of consecutive times the periodic cash flow is an equal amount going in the same direction (inflow or outflow).

This key allows you to reduce the number of keystrokes in the calculation by entering the number of consecutive times a periodic cash flow occurs.

Question 14

What is NPV ?

Answer 14

Used in capital budgeting by managers and investors to evaluate investment alternatives.

Measures the excess or shortfall of cash flows based on the discounted present value of the future cash flows, less the initial cost of the investment.

NPV uses the investor’s required rate of return as the discount rate. NPV assumes that the cash flows generated from the project are reinvested at the required rate of return or discount rate.

The formula for NPV is:
NPV = Present Value of the Future Cash Flows – Cost of the Investment

NPV = PV of CF – Cost (initial outlay)

Question 15

What do positive and negative cash flows indicate with NPV ?

Answer 15

Positive NPV = project or investment is generating cash flows in excess of what is required based on the required rate of return.

Negative NPV = project or investment is not generating cash flows sufficient enough

Question 16

What is The Internal Rate of Return (IRR) ?

Answer 16

The Internal Rate of Return (IRR)

Compound rate of return that equates the cash inflows to the cash outflows.
-IRR allows for the comparison of projects or investments with differing costs and cash flows.
-Investment is considered acceptable when the IRR equals or exceeds the client’s required rate of return.
-Alternatively, an investment should be rejected if the IRR is less than the client’s required rate of return

Question 17

What is Inflation Adjusted Rate of Return ?

Answer 17

Adjusts the nominal rate of return into a real (after inflation) rate of return.
Nominal interest rates are the actual rate of return earned on an investment.
Real rates of return are adjusted for inflation’s impact. The formula for the real rate of return is:

(1 + Rn )
————— -1 x 100 = real rate of return
( 1 + I )

Where: Rn = nominal rate of return or investment rate of return
i = inflation rate

The inflation adjusted rate of return should be used when there is an account balance growing at one rate of return and simultaneously an expense is growing at a different rate of return. In addition, it is used when there is an investment return at one rate and inflation (loss of purchasing power) at another rate.

Question 18

What are serial payments ?

Answer 18

Different from annuity payments in that annuity payments are an equal dollar amount throughout the payment period.

Serial payments are adjusted upward periodically throughout the payment period at a constant rate, usually in order to adjust for inflation’s impact.

Each serial payment will increase, to maintain the real dollar purchasing power of the investment

Serial payment calculations make use of the concept of inflation adjusted discount rates. As a result, the current cost or present value of what is being funding can be used as the future value in the calculation

Question 19

What is an Amortization Schedule ?

Answer 19

Illustrates the repayment of debt over time.

Each debt payment consists of both interest expense and principal repayment.
The further into the repayment of a debt, the bigger the portion of the payment that is applied to the outstanding principal.

Question 20

What are points with regard to a mortgage?

Answer 20

Another type of financing decision a client may consider is whether or not to pay points on a mortgage to reduce the interest rate.

Points = percentage of the amount being borrowed that is paid by the borrower to the lender.
The higher the points paid, the lower the interest rate on the loan. The decision to pay (or not pay) points is primarily a function of the time of ownership of the property, so the borrower can recoup the points paid through savings on a lower interest rate (interest expense)

Question 21

There are many techniques to pay off a mortgage in less than 360 months by paying additional principal payments every month or every year.

What are the 4 options ?

Answer 21

1. Double the monthly payment - This technique calls for increasing the monthly mortgage payment by 100 percent or doubling it.
2. Mortgage payment plus 10% - This technique calls for paying an extra 10 percent of the mortgage payment. Naturally, the increase could be more or less than 10 percent. Even at a 10 percent increase, the term of the mortgage will be noticeably reduced. For example, if a mortgage payment was $600 per month then the owner would pay $660 per month.
3. Extra payment each year - This technique calls for making an additional mortgage payment at the end of each year. This additional payment would go directly to paying off principal
4. Extra $100 every month - This technique calls for paying an extra $100 every month that goes to pay down the mortgage debt. This amount could be an extra $20 or an extra $1,000. Any additional payments will result in less total interest over the life of the loan and will shorten the loan.

Question 22

Solve for FV, PV, I (compound rate of return) , and PMT :

Determine Monthly car payment :
EXAMPLE:
$45,000
$5,000 down payment
36 mns
6% rate

Answer 22

3x12= 36 N
6/12 =.5 I
+$40,000 PV
PMT = - $ 1,216.87
0 FV

Question 23

Mortgage Questions:
-Solve for PMT, Interest paid, and principal paid

STEPS ARE :
- Calculate monthly payment first
- Calculate Interest and principal paid in 20xx

EXAMPLE:
finance $240,000 , 15 yrs 4% interest, 1st payment made on April 1 20xx

Answer 23

15 x 12 = 180 N
4 / 12 = .3333 I
$240,000 PV
PMT = - $ 1,775.2510
0 FV

April May June July Aug Sept Oct Nov Dec
1 2 3 4 5 6 7 8 9

AMORTIZE the Loan:_________
1 input 9
orange shift AMORT
= < 8,895.2039 > Principal paid
= < 7,082.0551 > Interest Paid
= <231,104.7961 > Balance at end of year

• Debt repayments are ordinary annuities (they are made in arrears), so repayment calculations are in END mode.
• mortgage payments are made at the beginning of the month, the repayment is still an ordinary annuity (because each payment includes a portion of principal repayment and interest expense incurred from the loan being outstanding for the previous month

Question 24

1. SOLVE of NPV “ Net Present Value “
2. Solve for IRR

EXAMPLE
Machine cost = $55,000
CF1 = $12,000
CF2 $15,000
CF3 $20,000
CF4 $25,000
Interest rate = 8%
NPV =
IRR =

Answer 24

1. ## Solve for NPV = PV of CF - Cost ( initial outlay )-55,000 CFj (negative outflow to buy equipment)
   12,000 Cf 1
   15,000 Cf 2
   20,000 CF 3
   25,000 Cf 4
   8 I /yr
   Orange shift NPV = $ 3,223.5846
2. ## Solve for Internal Rate of Return ( IRR )-55,000 CFj (negative outflow to buy equipment)
   12,000 Cf 1
   15,000 Cf 2
   20,000 CF 3
   25,000 Cf 4
   orange shfit IRR = 10.3023 %

Question 25

Ann recently purchased a house for $220,000. She made a down payment of $20,000 and financed the balance over 15 years at 6%. If Ann’s first payment is due on October 1st of the current year, how much of her current year’s payments will be applied to the outstanding principal on the loan?

A.  $2,989.67
B.  $5,885.09
C.  $3,288.63
D.  $2,073.47

Answer 25

D. $2,073.47

N = 15 × 12

I = 6 ÷ 12

PV = 200,000

PMT = ?

FV = 0

PMT Answer: 1,687.7136

1 INPUT 3

Orange shift key, AMORT, =

PRIN Answer: 2,073.4740

Question 26

All of the following statements regarding NPV are true EXCEPT

A. A positive NPV indicates the present value of the cash flows exceeds the initial investment.

B. A negative NPV indicates the present value of the cash flows is less than the initial investment.

C. An NPV equal to zero indicates the present value of the cash flows is equal to the initial investment.

D. The internal rate of return is the discount rate that causes the initial investment to exceed the present value of the cash flows.

Answer 26

D. The internal rate of return is the discount rate that causes the initial investment to exceed the present value of the cash flows.

Question 27

Darrin and Kathi recently gave you the following financial information.

Current Assets $9,243

Current Liabilities $6,921

Monthly Non-discretionary Expenses $4,693

Yearly Income $70,000

Annual Debt Expenses (excluding monthly housing costs) $22,084

What would Darrin and Kathi’s Emergency Fund Ratio be?

A. 1.2430 months
B. 1.3355 months
C. 1.9695 months
D. 3.1697 months

Answer 27

The correct answer is C.

9,243 / 4,693 = 1.9695 months

Current Assets includes cash and cash equivalents or anything that can be converted to cash within a year.