Lecture 6 Flashcards
what is time value of money principle?
money can grow or increase over time if we can save/invest it and earn a return on our savings/investment
what is the definition of time value of money?
math of finance whereby a financial return (e.g., interest) is earned over time by saving or investing money
present value = ?
value of a savings amount or an investment today at the present time
future value = ?
value of a savings amount or an investment or an investment at a specified time/date in the future
simple interest = ?
interest earned only on the principal of the initial investment
e.g., £1000, 5% simple interest = £1000*5% = £50 interest annually
compounding = ?
arithmetic process whereby an initial value increases at a compound interest rate over time to reach a future value
compound interest = ?
involves earning interest on interest in addition to interest on the principal/initial investment
e.g., £1000, 2 years, 5% interest = 1000*1.05 to the power of 2 = £1102.5
compound interest equation = ?
PV(1+r) to the power of n = FV
compound interest allows the value of savings to grow…
exponentially
discounting = ?
arithmetic process whereby a future value decreases at a compound interest rate over time to reach a present value
opposite of compounding
e.g., bank agrees to pay £1000 after 2 years when interest rates are compounding at 8% per year
what is the present value?
PV = 1000/1.08 to the power of 2 = £857.34
discounting equation = ?
PV = FV/(1+r) to the power of n
compounding tries to find…
discounting tries to find…
compounding finds future value
discounting finds present value
what is the equation to find interest rates?
(FV/PV) to the power of (1/n) - 1 = r
e.g., PV = 1000, FV = 1403, n = 5
1403/1000 to the power of 1/n - 1 = 7%
what is the equation to find time requirements?
lnFV/PV / ln(1+r) = n
e.g., PV = 1000, FV = 1403, r = 7%
ln(1403/1000) / ln(1.07) = 5
