Time value of money Flashcards
Role of time value of money
The “time value of money” principle says that all things being equal, a dollar today is worth more than a dollar that will be received at some future date.
Basic cash flow patterns
Single Amount: One lump sum
Annuity: Series of cash flows of equal amount, received at equal time intervals
Mixed Stream: Series of cash flows that are not equal or a series of cash flows that are not received at equal time intervals
Single and compound interest
Simple Interest:
Interest paid on the principal sum only
Compound Interest:
Interest paid on the principal and on prior interest that has not been paid or withdrawn
What is future value?
Future value is the value at a given future date of an amount placed on deposit today and earning interest at a specified rate. Found by applying compound interest over a specified period of time.
What is compound interest?
Compound interest is interest that is earned on a given deposit and has become part of the principal at the end of a specified period.
Principal is the amount of money on which interest is paid.
Future value v Present Value
The future value technique uses compounding to find the future value of each cash flow at the end of the investment’s life and then sums these values to find the investment’s future value.
Alternatively, the present value technique uses discounting to find the present value of each cash flow at time zero and then sums these values to find the investment’s value today.
what is annuity?
An annuity is a stream of equal periodic cash flows over a specified time period
Two types of annuity?
Ordinary annuity: cash flow occurs at the end of each period
Annuity due: cash flow occurs at the beginning of each period
What happens to the present value of an annuity as the interest rate increases?
assuming positive cash flows and interest rates the present value will fall. the present value of an annuity will always be larger than the present value of an ordinary annuity.
