Lecture 2: The Time Value of Money Flashcards
What is the basic prinicple of the time value of money?
The Time Value of Money principle:
“ A dollar TODAY is worth more than a dollar in the FUTURE”
What is another name for the present value?
The present value of a future value amount is also called discounted cash flow
What is the discount rate?
The Discount Rate is the interest rate used to compute the Present Value of a future amount.
What is the required rate of return?
Required Rate of Return: Is the interest rate (or rate of return) required/demanded from an investment
What is the opportunity cost of capital?
The Opportunity Cost of Capital Is the forgone return of the best alternative investment
What is a series of cashflow?
When there are multiple cash flows in different points in time, then we have a series (sequence) of cash flows
What is the rule for finding the present or future value of a seies of cashflows?
RULE:
FIRST find the present (or future) value of each cash flow and
THEN add them together
What are perpetuties?
A perpetuity is a investment that pays out a fixed amount of money indefinitely, without a maturity date
What is an annuity?
An annuity is a written contract typically between you and a life insurance company in which the insurance company makes a series of regularly spaced payments to you in return for a premium or premiums you have paid
what do annuity questions look like?
annuity questions have a finite period (T) and can involve you either buying an annuity or borriwng an annuity for a car or from a bank
What is the effective annual rate of Return?
The Effective Annual Rate is the interest rate which takes into consideration the effect of compounding.
How is inflation measured?
Inflation is measured By comparing the pounds needed for purchasing a basket of goods from one year to another
A famous index used to measure Inflation is the Consumer Price Index (CPI).
Explain the difference between real and nominal amounts?
real is the amounbt includng the effect of inflation while norminal is just the number.
Nominal Cash Flow (NCF): The amount or cash flow which is unadjusted from inflation (does not show the purchasing power of the cash flow)
Real Cash Flow (RCF): The amount or cash flow which adjusts for the inflation (it shows the purchasing power of the cash flow relative to today)
What is the general rule for disounting cashflows with nominal and real interest rates?
In general:
Nominal Cashflows must be discounted with the nominal interest rate
Real Cashflows must be discounted with the real interest rate. THEY MUST GIVE THE SAME ANSWER!
