Time Value Of Money Flashcards
In investment management applications the IRR is commonly referred to as
Dollar-Weighted rate of return
Market Risk in a revenue producing project can be adjusted for by :-
Adjusting the discount rate upward for increasing risk
Time Value of Money Purpose
-Time value of money concerns equivalence relationships between cash flows occurring on different dates
Three Ways to Consider Interest Rates
- Rates of return:* the minimum amount an investor must receive in order to accept an investment
- Discount rate:* the rate at which an amount of money is discounted to the present
- Opportunity cost:* the cost one is forgoing by spending money today
The Composition of the Interest Rate (r)
- Real risk-free interest rate
- Inflation premium
- Default risk premium
- Liquidity premium
- Maturity premium
-Real Risk-free Interest Rate
- The single-period interest rate for a completely risk-free security if no inflation were expected.
- In economic theory, the real risk-free rate reflects the time preferences of individuals for current versus future real consumption
-Inflation Premium
- Compensates investors for expected inflation and reflects the average inflation rate expected over the maturity of the debt
- Inflation reduces the purchasing power of a unit of currency
Default Risk Premium
-Compensates investors for the possibility that the borrower will fail to make a promised payment at the contracted time and in the contracted amount
-Liquidity Premium
Compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly
Maturity Premium
Compensates investors for the increased sensitivity of the market value of debt to a change in market interest rates as maturity is extended, in general
-The difference between the interest rate on longer-maturity, liquid Treasury debt and that on short-term Treasury debt reflects a positive maturity premium for the longer-term debt
Nominal Risk-free Interest Rate
The sum of the real risk-free interest rate and the inflation premium
Simple Interest
-Interest rate times the principal
Principal
The amount of funds originally invested
Compounding
The interest earned on interest
Single Cash Flow Investment Equation for Multiple Periods (FV)
FV = PV(1 + r)^N
Important Note about N and r
Both variables must be defined in the same time units
-For example, if N is stated in months, then r should be the one-month interest rate, unannualized
PEMDAS Order of Operations
Parentheses first
- Exponents second
- Multiply and divide (left-to-right)
- Add and subtract (left-to-right)
Single Cash Flow Investment Equation for Multiple Compounding Periods per Year (FV)
FV = PV(1 + r/m)^(m*N)
- r = stated annual interest rate
- m = number of compounding periods per year
- N = number of years
Single Cash Flow Investment Equation with Continuous Compounding (FV)
FV = PVe^(r*N)
-N = number of years
Effective Annual Rate (EAR) Equation with Multiple Compounding Periods
EAR = (1 + Periodic interest rate)^m - 1
-m = number of compounding periods per year
Effective Annual Rate (EAR) Equation with Continuous Compounding
EAR = e^r - 1
Annuity
-A finite set of level sequential cash flows
Ordinary Annuity
-Has a first cash flow that occurs one period from now (t = 1)
Annuity Due
Has a first cash flow that occurs immediately (t = 0)