Time Value of Money

Question 1

What is an interest rate

Answer 1

An interest rate can be interpreted as

the rate of return required in equilibrium for a particular investment
the discount rate for calculating the present value of future cash flows
the opportunity cost of consuming now, rather than saving and investing.

Question 2

Calculate FV

Answer 2

FV = PV(1 + I/Y)N

Question 3

Calculate PV

Answer 3

PV = FV / (1 + I/Y)N

Question 4

Calculate the PV of a Perpetuity

Answer 4

PMT / I/Y

Question 5

How do you compute the FV of a series of uneven cash flows?

Answer 5

The FV for the cash flow stream is determined by first computing the FV of each individual cash flow, then summing the FVs of the individual cash flows.

Question 6

How do you compute PV and FV for different compounding frequencies?

Answer 6

Keep the calculator in the annual compounding mode (P/Y = 1) and enter I/Y as the interest rate per compounding period, and N as the number of compounding periods in the investment horizon. Letting m equal the number of compounding periods per year, the basic formulas for the calculator input data are determined as follows:

I/Y = the annual interest rate / m

N = the number of years × m

M = number of compounding periods per year

Question 7

What is the EAR? and how is it computed?

Answer 7

What Is an Effective Annual Interest Rate? An effective annual interest rate is the real return on a savings account or any interest-paying investment when the effects of compounding over time are taken into account.

( 1 + Stated Annual Rate / M) m - 1

Each dollar will grow to ( 1 + Stated Annual Rate / M) m in one year