Time Value of Money Flashcards
What are the three rules of money?
1) money sooner is worth MORE than money later
2) large cash flows are worth MORE than smaller cash flows
3) less risky cash flows are worth MORE than risky cash flows
Interest rates - can be thought of in 3 ways
1) required rate of return of an investor or lender: money today x (1+r) = money tomorrow
2) discount rate at which some future value is discounted to arrive at a value today: money tomorrow/(1+r) = money today
3) opportunity cost: the value an investor or lender forgoes by choosing a particular action
nominal risk-free rate formula
real risk-free rate for a single period + expected inflation
If I lend you $1,000, what five elements/risks do you expect to be compensated for?
risk free rate + inflation premium + default risk premium + liquidity premium + maturity premium
inflation premium
compensates for expected inflation
default risk premium
compensates for credit risk
liquidity premium
risk of loss vs. fair value if an investment needs to be converted to cash quickly
maturity premium
greater interest rate risk (i.e. price risk) with longer maturities. We will also have a premium for inflation uncertainty (the longer the time period, the more uncertain we are about the level of expected inflation)
Effective Annual Rate
= [(1+r/m)^(mxN)-1] or e^(rxN)
FV of Ordinary Annuity into an Annuity Due
Annuity Due is t=0 so the last payment needs to be FVed one period. just multiply the CPT FV by 1+r
Present Value of a perpetuity formula
PV = A/r A = periodic payment r = discount rate
Compound Annual Growth rate formula using FV and PV
g = (FV/PV) ^ (1/N) - 1
How long will it take to double using FV and PV formula?
FV = PV ( 1 + r)^N N = ln(FV/PV) / ln(1+r)
