Time Value of Money Flashcards
Why is a dollar today worth more than a dollar in the future?
inflation, interest, earning potential
Interest
the cost of borrowing money
2 types of interest
simple and compound
Principal
the amount of money involved in the debt or investement
Invested Capital
the amount of money invested into a company, project, or asset
Interest Rate
the cost of money expressed as a percent over time
Interest Period
the frequency that interest is calculated
Duration/Length
the period of time that the loan/investment applies
Receipt
positive cash flow over a length of time (income)
Disbursements
negative cash flow over a length of time (expenses)
Present Value
the amount that a future sum of money of worth today due to rate of return
Total Interest
the total amount of money earned/paid over a period of time due to interest
Simple Interest
interest is earned only on the principal amount during each interest period
Compound Interest
interest is earned on the principal and accumulated interest each interest period
Factors affecting Interest Rate
Inflation and risk
Inflation
the change in purchasing power of a dollar
Risk
the potential that the income will not be achieved; a debt not repaid
Cash Flow Diagram
graphical representation of the key elements of the problem
4 Key Principals of Economic Equivalence
- When comparing alternatives, they must have the same time basis
- Equivalence depends on interest rate
- May require the conversion of multiple cash flows to a single cash flow
- Equivalence is maintained regardless of point of view
What does the time value of money depend on?
purchasing power and earning potential
5 Basic Types of Cash Flow
- Single cash flow
- Uniform series
- Linear-gradient series
- Geometric-gradient series
- Irregular series
Single Cash Flow
a single transaction at one point in time
Rules of 72
N=72/i; calculates the amount of time for money to double by an interest rate (i)
Uniform Series
same amount of money transacted over 2 or more periods
Deferred Annuity
an equal series cash flow that starts later than one interest period in the future
Linear-Gradient Series
transactions increase or decrease by a constant amount
Geometric-Gradient Series
transaction increase or decrease by a constant rate
Irregular Series
random transactions
