Module 4: The Time Value of Money

Question 1

the amount an investment is worth after one or more periods

Answer 1

future value (the amount that money is going to grow to)

Question 2

the interest earned only on the original principal amount invested.

Answer 2

simple interest

Question 3

You deposit $100 into a savings account. Over time, this $100 will earn interest and grow beyond that, but the original $100 put in is called the ________ _______.

Answer 3

original principal

Question 4

T or F: Simple interest never grows, with the assumption that we don’t make any more deposits and the interest rate doesn’t change.

Answer 4

True; (you will continue to get that same simple interest amount each year)

Question 5

In year 1, simple interest is $10. How much will simple interest be in 56 years?

Answer 5

$10 (simple interest doesn’t grow)

Question 6

interest earned on both the initial principal and the interest reinvested from prior periods.

Answer 6

compound interest
(ex: we’ve got our $100 in original principal. The savings account earns 10%. So, we will earn $10 (100x10%), which will make the original principal grow to $110. Now, if we leave it in for more than one year, we will get another 10% on that $110, which will total to $121 (110x10%). In this case, the $10 of that $11 is just our simple interest.)

Question 7

T or F: Compound interest stays the same from year to year.

Answer 7

False; compound interest GROWS (will get bigger and bigger every year)

Question 8

T or F: Over short periods of time, the effect of compound interest is not that dramatic. But, over long periods of time, this will make a difference.

Answer 8

True

Question 9

the process of accumulating interest on an investment over time to earn more interest.

Answer 9

compounding

Question 10

Present value is just the ______ ______.

Answer 10

original deposit

Question 11

What buttons on the calculator are our main time value of money buttons?

Answer 11

N, I/Y, PV, PMT, FV

Question 12

PMT exemplifies a _______ ______ ____.

Answer 12

recurring cash flow

Question 13

For PMT (later on in notes), deposits will be (positive/negative) and withdrawals will be (positive/negative).

Answer 13

positive; negative

Question 14

P/Y on calculator should always be set to _____.

Answer 14

1

Question 15

How do you solve for simple interest?

Answer 15

Interest earned the first year x # of years.

Question 16

How do you calculate the interest earned the first year?

Answer 16

Deposit made x interest rate

Question 17

How do you calculate the compound interest you accumulate?

Answer 17

It is just the total interest we got, so you do the: computed FV - PV.

Question 18

Compounding becomes more important as:
- interest rate goes (up/down).
- the (shorter/longer) money is deposited.

Answer 18

up; longer

Question 19

What are the 3 benefits of compounding?

Answer 19

1. Increase with the interest rate.
2. Increase with time.
3. Increase with the frequency of compounding. (the more frequently it gets deposited will increase the effects of compounding)

Question 20

If we get Error 5 on our calculator, what do we need to do?

Answer 20

Change one of the signs of our cash flows (PV or FV; doesn’t matter which)

Question 21

the current value of future cash flows discounted at the appropriate rate

Answer 21

present value

Question 22

What is it called when we are calculating the present value of some future amount.

Answer 22

discounting

Question 23

When we calculate the present value and find out what that future cash flow is worth to us today, now we can ________ different cash flows, whether they occur in a year/10 years/100 years.

Answer 23

compare

Question 24

the rate used to calculate the present value of cash flows.

Answer 24

discount rate

Question 25

The discount rate is sometimes referred to as what two things?

Answer 25

1. Required return
2. Cost of capital

Question 26

The (higher/lower) our discount rate, the (bigger/smaller) return we need to earn, the more we’re going to discount it.

Answer 26

higher; bigger

Question 27

What two things affect how much we are going to discount a future cash flow by?

Answer 27

1. The discount rate
2. The number of years (how long it is into the future)

Question 28

T or F: the longer amount of time into the future we have to go, the less we’re going to discount those cash flows.

Answer 28

False; the MORE we’re going to discount those cash flows.

Question 29

When trying to choose between getting more money, or getting money sooner, we can compare these if we know what kind of _____ ____ ______ we can borrow or lend at, then we can discount both of these back, and find out what they are worth to us today.

Answer 29

rate of return

Question 30

T or F: we cannot compare cash flows until we have them at the same point in time.

Answer 30

True

Question 31

**As time increases:
- Present value (increases/decreases)
- Future value (increases/decreases)

Answer 31

• PV decreases
• FV increases

Question 32

** As interest rate increases:
- Present value (increases/decreases)
- Future value (increases/decreases)

Answer 32

• PV decreases
• FV increases

Question 33

If we have multiple cash flows, to add up the individual present values/future values, they must be:

Answer 33

stated in the same time period to be combined.

Question 34

How to decide if an investment is attractive/a good one to make: by looking at what other ______ we could get on investments that have a similar amount of _____.

Answer 34

returns; risk

Question 35

T or F: Riskier investments should return less to help compensate for taking on that additional risk.

Answer 35

False; should return MORE

Question 36

What are the two biggest assets we can have if we’re wanting to save? Which can you control?

Answer 36

1. Time (can control when we start investing)
2. Higher interest rate (can’t control)