Time Value of Money Flashcards
Annuity Due definition
annuity begin at the beginning of a period (or at time period zero on the time line).
Annuity Due Calc Mode
BGN
Annuity Due examples
Examples of an Annuity Due include education tuition payments, retirement income, and rent payments.
Ordinary Annuity Definition
annuity can begin at the end of a period (or at time period 1 on the time line)
Ordinary Annuity Calc Mode
END
Ordinary Annuity Examples
Examples of an Ordinary Annuity include all debt payments such as a mortgage or car payment.
NPV decision Criteria
The NPV decision rule is to accept projects or investments with a positive or zero NPV and to reject projects with negative NPVs.
NPV Formula
NPV = Present Value of the Cash Flows – Cost or Initial Investment.
Interpret NPV = 0
An NPV of zero indicates that the cash inflows and the cash outflows of the investment are identical, and exactly ade-quate to repay the invested capital.
Accept the project
Which project should you select if projects are mutually exclusive. No capital rationing.
Project with the highest NPV.
Which project should you select if projects are mutually exclusive, consider capital rationing.
most affordable project with the highest NPV should be selected.
what happens to discount rate as risk increases
discount rate increases
What factors does the discount rate consider
Viewed as the opportunity cost of capital
- The risk of the investment (greater the risk, greater the discount rate)
- The cost of any opportunity forgone
Interpret Negative NPV
This result (a negative NPV) is a clear indication that the investment should be rejected on the basis that the cash flow of the project is inadequate to return to the investor the sum originally invested once risk or opportunity cost is fac-tored into the equation.
IRR definition
Discount rate in which NPV = zero
Breakeven interest rate
Rate at which cash inflow and outflow are identical
What happens if discount rate is more than IRR
Opportunity cost of capital is greater than internal rate of return. Reject project.
When should you not use IRR
When projects are mutally exclusive
Why is IRR limited due to its assumptions?
IRR assumes that cash inflows are going to be reinvested at IRR itself.
Issue when one of a kind project is being under-taken or extraordinary return has been obtained
When is it appropriate to use inflation-adjusted return?
When the following occurs
SIMULTANEOUSLY
1) You have an investment growing at one rate of return AND
2) You have an expense growing at a different rate of return.
2 step process when working through all Education & Retirement FUNDING questions
1) determine the NPV of the cash flow stream at time period zero.
2) determine the savings required
