FUND CH7 Time Value of Money Flashcards
Time Value of Money
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
Annuities
An annuity is a recurring cash flow, of an equal amount, and occurs at periodic (but regular) intervals
ordinary annuity
first payment is at the end of a period
Calculator in “End “ mode, starts in period 1(on timeline)
annuity due
first payment is at the beginning of the first period
calculator “Begin” mode starts in period 0(on timeline)
first payment occurs at time period zero
annuity due
payment occurs at time period one
ordinary annuity
Uneven Cash Flows
When an investment or project has periodic cash flows that are not even dollar amounts or not at even intervals
Net Present Value
Net Present Value (NPV) is used in capital budgeting by managers and investors to evaluate investment alternatives
NPV = Present Value of the Future Cash Flows – Cost of the Investment
– same as [PV] NPV is more flexible – nets out discounted present value [CFj] [I/YR][orange][NPV]
If NPV = 0 IRR =RR
If NPV + IRR > RR
If NPV – IRR < RR
Internal Rate of Return (IRR)
is a compounded annual rate of return
an interest rate that will cause the sum of the discounted present value of all the future cash flows to equal the cost of the investment
[orange] [IRR/YR] to get % per yr or Internal Rate or Return - IRR
Inflation Adjusted Rate of Return
or “Real Rate of Return” An inflation adjusted rate of return adjusts the nominal rate of return into a real (after inflation) rate of return
just less than the difference – chain mode [blue] [chain]
Nominal interest rates
actual rate of return earned on an investment
Real rates of return
adjusted for inflation’s impact
Real Rate of Return = [(1 + Rn) ÷ (1 + i) – 1] x 100
???Anytime inflation is involved???when to use Real return
Rn
nominal rate of return or investment rate of return
i
inflation rate
Serial Payments
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
use real return (discount rate)
Debt Repayments
Time value of money concepts can calculate the monthly,quarterly, or annual payment necessary to retire a debt obligation In addition to the payment required to retire the debt, the financial planner can determine the amount of interest and principal paid over a period of time ex. loans, credit cards, mortgages or car loans
Examples of Other Practical Applications;
cash rebate vs. zero percent
pay points to reduce their mortgage payment vs. not
lump-sum payment vs. annuity
Should a client take the cash rebate or zero percent financing on a new car?
Should a client pay points to reduce their mortgage payment when purchasing a new home?
Should a lottery winner receive a lump-sum payment or annuity over 20 years
Uneven Cash Flow Method good approach for what two situations
retirement funding calculations
education funding
The uneven cash flow method has two steps:
- Determine the net present value of the cash flow stream in today’s dollars.
- Determine the annual savings required to fund the retirement goal
Approach for solving TVM Calculations
- Start with a timeline
- Write down variables
- Clear Memory
- populate variables
- determine periods of compounding
- determine annuity due or ordinary annuity
- Cash flow (+/-) —–in or out of investor’s pocket
Periods of Compounding other then annual
Annual
Semi- Annual (N)x2, (i)/2
Quarterly (N)x4, (i)/4
Monthly (N)x12, (i)/12
Solving for Term (N)
provides the amount of time required to accomplish financial goal or retire debt ….like the old rule of 72
Solving for Interest Rate (I)
interest required to attain a certain goal
Amortization schedule
Mortgage- 1) find monthly payment 2) amortization
Always end mode – make monthly {x12}
Amortize:
[1] [input] [12][orange][AMORT][=]
Life of the loan
[1] [input] [360][orange][AMORT][=]