Lecture 2-Time value of money

Question 1

What are the several ways to receive money in the future?

Answer 1

• A one off payment e.g. Lottery win

- A regular stream of payments e.g. salary and interest

Question 2

What is the future value?

Answer 2

-Is the actual amount you get, that is the number of pounds you receive in you hand at a future

Question 3

What is the present value?

Answer 3

-What the future cash flow is worth today

Question 4

What are the different types of interest rate?

Answer 4

• Fixed:stays the same for the whole life of the investment

- Variable:can change during the life of the investment

Question 5

Two basic types of interest rates:

Answer 5

• Simple interest: Interest is earned only on the original investment
• Compound interest: interest is earned on the original investment and on any interest already earned in previous periods

Question 6

What is APR?

Answer 6

APR is used to describe the true cost of borrowing money. It takes into account:

The headline interest rate
Interest frequency (e.g. monthly or annually)

Any initial fees for setting up the loan

Any other costs you HAVE to pay

Question 7

What is AER?

Answer 7

AER tells you the true rate of interest you will have received by the end of the year. So takes into account:

How often interest is paid
Promotional offers that disappear after an initial period

Question 8

Example interest rates

Answer 8

1month LIBOR

Halifax Standard Variable Mortgage Rate

Visa Credit Card Typical Rate

Question 9

PVs and FVs special rule

Answer 9

If receive the money now 4 years

• 100 x (1 + 0.1)^4 = £146.41 in year 4

If you receive the money next year

• 100 x (1+0.1)^3= £133.1 in year 4

PVs tell you what those FVs or cash flows are worth today

Question 10

What do PVs tell us?

Answer 10

-The total value of all cash flows today

Question 11

When to accept the PV?

Answer 11

If you are receiving money=Want PV to be as high as possible

If you are paying money=Want total PV to be as low as possible

Question 12

Moving money through time

Answer 12

To work out future value, we multiply by (1 + r) for each year so the amounts gets bigger

-To move money back in time, we work out present values, we divide by (1 + r) for each year so amounts get smaller

Question 13

What is an annuity?

Answer 13

An annuity is an equally spaced stream of identical cash flows for a fixed number of years

Question 14

What is a perpetuity

Answer 14

A perpetuity is an equally spaced stream of identical cash flows that never ends

Question 15

Rule for annuities and perpetuities

Answer 15

A standard annuity/perpetuity is one where the cash flows occur once a year and start exactly one year from today

Question 16

Timing of cashflows

Answer 16

• Start on the year doing PV

- calculate all the cashflows and subtract irrelevant ones

Question 17

What are the 2 types of cashflow?

Answer 17

-Nominal:cash flows are stated after inflation i.e. in prices at the time of the cash flow
These cash flows reflect the expected change (usually an increase) in prices

-Real:cash flows are stated before inflation
But after pure time value of money and risk
This is often called constant purchasing power

Question 18

How to calculate interest frequency?

Answer 18

Suppose you invest £200 at 8% for one year, but received interest every 6 months
After six months get 4% of £200 = 0.04 x 200 = 8 = £8

For the following six months:
	Receive interest on the original £200
	Receive interest on the £8 interest
So interest payment for second half of year:
				= 0.04 x 208 = 8.32 = £8.32
Total FV = £200 + £8 + £8.32 = £216.32