Section 3: Time Value of Money Flashcards
What is a cash flow diagram
A tool to illustrate the size, sign, timing of cash flows. Consisting of reciepts (positive cash flows) and disbursments (expenses, negative cash flows)
How do you construct a cash flow diagram?
Create a time line of ‘periods’. At the end of each period, draw an up or down arrow indicating how much cash will be recieved/spent by that point. Up is a positive payment, down is a negative payment
Why do we need to analyze the time value of money
Money has different value over time. ie, due to inflation, money devalues over time.
What is interest?
The compensation for giving up the ability to use an asset presently. Examples: rent on an apartment, interest on a loan)
What is an interest rate?
The rate to calculate the size of the interest
What is a prime rate?
The prime rate is the rate used among major banks and financial institutions.
What specifies the prime rate?
Supply and demand dictates the prime rate, but it is influenced by the Central Bank
What is the difference between interest rate & rate of return
Two sides of the same coin, borrowers pay interest at an interest rate, lenders lend money and earn interest at a rate of return.
How to calculate simple interest?
Total Interest = Principal * interest rate * number of years
What is compound interest?
Interest is evaluated on the updated principal.
How do you calculate the total value with compound interest?
Value = P*(1+i)^n (n = number of compounding cycles)
How do we calculate the future worth(F) given interest rate i and number of periods(n) with a single payment cash flow?
F = P(i+1)^n or F = P(F/P, i, n) where P(F/P, i, n) = (1+i)^n
How do we calculate the present value using the discounting process (known future worth (F), i and n)
P = F/((1+i)^n) or P = F(P/F, i ,n) where F(P/F, i, n) = 1/(1+i)^n
What does the term n % interest rate mean?
Given no other info, assume n% annual compounding interest
What does “n%, compounding monthly” mean
n% annual interest rate, with a compounding peried of 1 month. The monthly rate is n/12
