Financial Fundamentals CH 7 TVM

Question 1

What are the 2 key values in the Time Value of Money ?

Answer 1

present value - the value today of one or more future cash flows discounted to today at an appropriate interest rate.

future value - the 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 1

What is the Time Value of Money (TVM) ?

Answer 1

Time Value of Money (TVM) is a mathematical concept that determines the value of money, at a point or over a period of time, at a given rate of interest.

Question 2

What are the 4 steps for the : APPROACH FOR SOLVING TIME VALUE OF MONEY CALCULATIONS ?

Answer 2

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 3

Name all 5 variables with the Time Value of money calculation

Answer 3

Present Value (PV): Represents the value of the cash flow today in dollars.

Payments (PMT): Represents any recurring payments, such as an income stream or debt repayment.

Future Value (FV): Represents the dollar value at some point in the future, of a current deposit(s), earning a rate of return over a period of time.

Periods (N): Represents the number of periods of compounding, which may be annual, semi-annual, quarterly, monthly, or daily. In the above timeline there are six periods. Interest Rate (i): Represents the rate being earned on an investment or interest paid on a loan.

Interest Rate (i): Represents the rate being earned on an investment or interest paid on a loan.

Question 4

Examples of POSITIVE cash inflows

Answer 4

CASH RECEIVED or INFLOWS
* Annuity payments each month during retirement.
* Loan to purchase a house
* Lump-sum amount that is accumulated after a period of savings.
* Any type of Income received during retirement, inheritance, or distribution of savings.

Question 5

Examples of NEGATIVE cash flow

Answer 5

CASH PAID or OUTFLOW
* Tuition payments.
* Periodic savings or a lump-sum amount contributed / deposited to a savings account.
* Periodic repayment of any type of debt.
* Purchase of a piece of equipment or investment.

Question 6

What are the 4 steps to the TVM approach ?

Answer 6

One such approach is 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 7

What is the present value ?

Answer 7

present value of a future amount of $1 is the current value today of that $1. The future amount is discounted over time using a discount
rate (an interest rate that reflects the individual’s risk or opportunity cost that could be earned on a similar project or investment) to arrive at the present value.

The present value of $1 is used when calculating how much should be deposited today to meet a financial goal in the future.

Question 8

What is the future value ?

Answer 8

The future value of $1 is the value of a present lump-sum deposit after earning interest over a period of time.

The future value of $1 is used when determining a future amount based on today’s lump-sum deposit that will be earning interest (e.g., a certificate of deposit).

Question 9

What is simple interest ?

Answer 9

When using simple interest, the interest rate is only applied to the original investment.

Question 10

What is compound interest ?

Answer 10

Compound interest involves earning interest on the original balance, plus interest on any previously accumulated interest.

Question 11

The more often the periods of compounding, the larger the future account balance because the interest rate is being compounded (or calculated on previous interest earnings) more frequently. This results in interest on previous interest earnings.
A true b false

Answer 11

A. True
The more often the periods of compounding, the larger the future account balance because the interest rate is being compounded (or calculated on previous interest earnings) more frequently. This results in interest on previous interest earnings

Question 12

What is a annuity?

Answer 12

An annuity is a recurring cash flow, of an equal amount that occurs at periodic (but regular) intervals.

Question 13

What is an Annuity Due ?

Answer 13

An annuity due occurs 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 calc to BEGIN mode

Question 14

What is an Ordinary Annuity ?

Answer 14

An ordinary annuity occurs when the 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. An annuity due occurs 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 calc to END mode ( default mode)

Question 15

Examples of an ordinary annuity:

Answer 15

• Most debtor payments (car loans, student loans, or mortgages)
• Many savings contributions to an IRA or 401(k) if regular and recurring and made at month, quarter, or year end

Question 16

Examples of an annuity due

Answer 16

• Rents Set calc to BEGIN mode
• Tuition payments
• Retirement income
  ( ALL usually paid at the beginning of the month or year in advance)

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.

Question 17

What is Net Present Value ? NPV

Answer 17

Used in capital budgeting by managers and investors to evaluate investment alternatives.
NPV 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 = Present Value of the Future Cash Flows – Cost of the Investment
or
NPV = PV of CF – Cost (initial outlay)

Question 18

What is Internal Rate of Return (IRR ) ?

Answer 18

The compound rate of return that equates the cash inflows to the cash outflows.
-allows for the comparison of projects or investments with differing costs and cash flows.
-An 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 19

What is Inflation Adjusted Rate of Return ?

Answer 19

An inflation adjusted rate of return 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  )  

I = Inflation rate
Rn = nominal rate of return

-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.
-used when there is an investment return at one rate and inflation (loss of purchasing power) at another rate. An inflation adjusted rate of return should be used in an education funding situation where there is a lump-sum amount growing at an investment rate of return and tuition expense is growing at a tuition inflation rate

Question 20

What are Serial Payments ?

Answer 20

-Serial payments are 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

Question 21

What is an Amortization Schedule ?

Answer 21

An amortization schedule 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 22

Explain the payment of points with a Loan

Answer 22

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 are a 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 23

What is the approx breakeven for a 30 year mortgage ?

Answer 23

Mortgage Reduction Techniques Over the life of a standard 30-year mortgage, the home owner will often pay as much or more in interest payments as principal payments.
-The breakeven interest rate is about 5.3 percent. However, even with interest rates of less than 5.3 percent, the home owner will pay a substantial amount of interest.
- There are many techniques to pay off a mortgage in less than 360 months by paying additional principal payments every month or every year

Question 24

Name 4 options to reduce a Mortgage .

Answer 24

1. Double the monthly payment -
2. Mortgage payment plus 10%
3. Extra payment each year - This additional payment would go directly to paying off principal
4. Extra $100 every month