TIME VALUE OF MONEY Flashcards

1
Q

What do we mean by the time value of money?

A

In simple terms, it is about how we calculate the future value of an investment, or

how we work back from a future required value to calculate the present value.

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2
Q

Compounding is where we take the known present value and use this to calculate a the potential future value.

For example, John has invested £50,000 into his investment and wants to know, assuming 5% net, what this will be worth in 10 years time when he retires.

What would the formula look like?

A

The formula:

FV = PV (1+r)n

Where:

FV = Future value

PV = Present value

r = Rate of return

n = Number of years

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3
Q

Using John as an example, what would his investment be worth in 10 years time?

A

FV = PV x (1 + 0.05)10

FV = £50,000 x (1.05)10

FV= £50,00 x 1.6289

FV = £81,445

In AF4, you are recommended to have a financial /scientific calculator. You should have this before your course and be familiar with undertaking a calculation such as this.

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4
Q

Discounting is working from a known future value to determine the present value.

For example, Janet wants to provide university fees of £15,000 to her grandaughter in 12 years time. Assuming a 3% net return, how much must she invest now?

What would the formula look like? I’ll give you a clue, it uses all of the same elements as the compounding formula but in a different order.

A

Discounting formula:

                                      PV =    FV  /  (1+r)n Where:

PV = Present value

FV = Future value

r= Rate of retiurn

n = Number of years

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5
Q

Example. How much does Janet need to invest today for her grandchild’s university fees?

If you don’t have a calculator, work your way through the steps to the process required.

A

PV = FV / (1+r)n

PV = £15,000 / (1+03)12

PV = £15,000 / 1.4258

PV= £10,520

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6
Q

How do we find the annual compound interest rate when we know the present and future value along with the time frame?

A

r = [(FV / PV)1/n - 1] x 100

*FV = Future value
*PV = Present value
*r = Interest rate as a decimal e.g. 4% = 0.04
*n = Number of years

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7
Q

Kate requires £35,000 in 12 years time for little Hugo’s university fees. She has £21,000 available to invest now. What annual rate of return will be required to reach her goal?

If you don’t have a calculator, work your way through the steps to the process required.

A

r = [(FV / PV)1/n - 1] x 100

r = [(£35,000 / £21,000)1/12 - 1] x 100
r = [1.6671/12 - 1] x 100
r = [1.0435 - 1] x 100

r = 4.35%

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8
Q

How do we find the Annual Effective Rate (AER) when there are more than one payments in a year?

A

AER = [(1 + r/n)n - 1] x 100

FV = Future value
PV = Present value
r = Nominal interest rate
n = Number of payments made in a year

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9
Q

Best Bank pays a nominal interest of 3.2% gross per annum, paid monthly. Calculate, showing all your workings, the Annual Effective Rate (AER).

If you don’t have a calculator, work your way through the steps to the process required.

A

Best Bank:

AER = [(1 + r/n)n - 1] x 100

(1 + 0.032 / 12)12 – 1 x 100

(1.03247)12 – 1 x 100

= 3.25%

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