Reading 6: The Time Value of Money ("A Dollar Today does NOT HAVE the same value as a Dollar Tomorrow") Flashcards
LOS 6.a- Interpret interest rates as required rates of return, discount rates, or opportunity costs.
Why are interest rates called required rates of return?
Interest rates are called required rates of return because the interest rate that an investor accepts is the required rate of return that he is expecting back for giving his money.
LOS 6.a- Interpret interest rates as required rates of return, discount rates, or opportunity costs.
Why are interest rates called discount rates?
For the specific example, (a bank lends from federal reserve) an interest rate can be considered a discount rate because the federal bank’s rate is a discounted interest rate given to a state/local bank for the purpose of lending.
Another concept related to interest rates is discounted cash flows (DCF). The discounted cash flow takes interest rates and reflects them into the future to determine the ‘true cash flows.”
+ DCFs are applied into practice to calculate the NET
PRESENT VALUE of an INVESTMENT. It can be
used to help to determine IF THE INVESTMENT IS
(+ NET PROFIT) OR (- NET PROFIT)
LOS 6.a- Interpret interest rates as required rates of return, discount rates, or opportunity costs.
Why are interest rates called opportunity costs?
An interest rate is considered an opportunity cost because it is the foregone opportunity for an investor that ‘could technically buy today’ instead he chooses to invest because he believes that the “time value” of that investment is going to leave him better off somehow.
LOS 6.b- Explain an interest rate as the sum of a real risk free rate + premiums that compensate investors for bearing distinct types of risk.
How can you explain an interest rate as an equation?
**Think about it:
(IR= RFR + IR+ DRP +LP+ MP)
**[5 items in the INTEREST RATE]
INTEREST RATE=
RISK FREE RATE + LIQUIDITY PREMIUM+ DEFAULT PREMIUM +INFLATION PREMIUM + MATURITY PREMIUM
***RISK FREE RATE = T-BILLS Rate (Federal Bank)
LOS 6.c- Calculate & interpret the effective annual rate (EAR), given the stated annual interest rate and the frequency of compounding.
EAR= (1+ [STATED ANNUAL RATE/NUMBER OF COMPOUNDING)^)(N*M)]) -1
- **Stated Annual Rate= What is stated in the question
* N= Number of Years
* M= amount of compounding
LOS 6.c- Calculate & interpret the effective annual rate (EAR), given the stated annual interest rate and the frequency of compounding.
So, now we know how to calculate the EAR (EAY- “Effective Annual Yield”). So, then, how do you describe it? What is it?
The Effective Annual Rate/ Effective Annual Yield is the composite percentage yield for the entire year incorporating all the compounding.
***So, in other words, you do NOT HAVE TO compound multiple times and add up the values to figure out the compounding amount.
LOS 6.c- Before we understand EAR/EAY, there are some terms that we need to understand. The terms are- compounding, periodic rate of interest, & stated annual rate.
-What is compounding?
Compounding- compounding is a process of accumulating increasing principle through continuous periods of interest rate adding to the original principal.
LOS 6.c- Before we understand EAR/EAY, there are some terms that we need to understand. The terms are- compounding, periodic rate of interest, & stated annual rate.
-What is periodic rate of interest?
a periodic rate of interest is the set rate for each compounding period
LOS 6.c- Before we understand EAR/EAY, there are some terms that we need to understand. The terms are- compounding, periodic rate of interest, & stated annual rate.
-What is stated annual rate?
Stated annual rate is the annual rate that does NOT take into account compounding.
LOS 6.d- solve time value of money problems for different frequencies of compounding
FV= PV [1+(Stated Annual Rate/compounds)^(n*m)]
LOS 6.d- solve time value of money problems for different frequencies of compounding.
How to SOLVE using BAII Plus Calculator?
BA II Plus->
A.) Press–>
10,000 “FV”
4 X 3 “N”
10/4 “I/Y”
“CPT” + “PV”
B.) Display–>
FV= 10,000 N= 12 I/Y= 2.5 PV= -7,435.56
LOS 6.e- Calculate & interpret the:
a.) FV & PV of a single sum of money
FV= PV [1+(Stated Annual Rate/compounds)^(n*m)]
LOS 6.e- Calculate & interpret the:
b.) an ordinary annuity
An ordinary annuity- is defined as a finite series of cash flows, all with the same value, ends at a given set time.
-Starts at time 1 or END OF A PERIOD
LOS 6.e- Calculate & interpret the:
c.) an annuity due
An annuity due- is defined as a finite series of cash flows, all with the same value
- STARTS AT TIME “0” or BEGINNING OF A PERIOD
- MAKE SURE TO INDICATE ON THE CALCULATOR AS WELL
- “2ND + BGN + 2ND + SET = END/BGN Conversion”
LOS 6.e- Calculate & interpret the:
d.) a perpetuity (what is a perpetuity?)
A Perpetuity is a calculation that is an annuity that has “NO FIXED MATURITY DATE.”
- What does this mean? This means that a payment will go on forever. How much should you pay for a perpetuity?
PRESENT VALUE = (PAYMENT/ INTEREST RATE)
