Module 4: The Time Value of Money Flashcards
the amount an investment is worth after one or more periods
future value (the amount that money is going to grow to)
the interest earned only on the original principal amount invested.
simple interest
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 ________ _______.
original principal
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.
True; (you will continue to get that same simple interest amount each year)
In year 1, simple interest is $10. How much will simple interest be in 56 years?
$10 (simple interest doesn’t grow)
interest earned on both the initial principal and the interest reinvested from prior periods.
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.)
T or F: Compound interest stays the same from year to year.
False; compound interest GROWS (will get bigger and bigger every year)
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.
True
the process of accumulating interest on an investment over time to earn more interest.
compounding
Present value is just the ______ ______.
original deposit
What buttons on the calculator are our main time value of money buttons?
N, I/Y, PV, PMT, FV
PMT exemplifies a _______ ______ ____.
recurring cash flow
For PMT (later on in notes), deposits will be (positive/negative) and withdrawals will be (positive/negative).
positive; negative
P/Y on calculator should always be set to _____.
1
How do you solve for simple interest?
Interest earned the first year x # of years.
How do you calculate the interest earned the first year?
Deposit made x interest rate
How do you calculate the compound interest you accumulate?
It is just the total interest we got, so you do the: computed FV - PV.
Compounding becomes more important as:
- interest rate goes (up/down).
- the (shorter/longer) money is deposited.
up; longer
What are the 3 benefits of compounding?
- Increase with the interest rate.
- Increase with time.
- Increase with the frequency of compounding. (the more frequently it gets deposited will increase the effects of compounding)
If we get Error 5 on our calculator, what do we need to do?
Change one of the signs of our cash flows (PV or FV; doesn’t matter which)
the current value of future cash flows discounted at the appropriate rate
present value
What is it called when we are calculating the present value of some future amount.
discounting
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.
compare
the rate used to calculate the present value of cash flows.
discount rate
The discount rate is sometimes referred to as what two things?
- Required return
- Cost of capital
The (higher/lower) our discount rate, the (bigger/smaller) return we need to earn, the more we’re going to discount it.
higher; bigger
What two things affect how much we are going to discount a future cash flow by?
- The discount rate
- The number of years (how long it is into the future)
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.
False; the MORE we’re going to discount those cash flows.
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.
rate of return
T or F: we cannot compare cash flows until we have them at the same point in time.
True
**As time increases:
- Present value (increases/decreases)
- Future value (increases/decreases)
- PV decreases
- FV increases
** As interest rate increases:
- Present value (increases/decreases)
- Future value (increases/decreases)
- PV decreases
- FV increases
If we have multiple cash flows, to add up the individual present values/future values, they must be:
stated in the same time period to be combined.
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 _____.
returns; risk
T or F: Riskier investments should return less to help compensate for taking on that additional risk.
False; should return MORE
What are the two biggest assets we can have if we’re wanting to save? Which can you control?
- Time (can control when we start investing)
- Higher interest rate (can’t control)
