Time Value of Money and DCF Valuation Flashcards
Define interest rate
Coverting cash across time (r) is definition of an interest rate
Define simple interest
Interest earned only on the original principal amount is simple interest
Define compound interest
Compound interest means interest earned on both the initial principal and the interest reinvested from prior periods
It gives a greater total over time as interest is earned on the reinvestment of previous interest payments
Define future value
Amount to which investment grows after one or more periods with interest
Define compounding
Compounding is process of accumulating interest on an investment over time to earn more interest
Define FVIF(r,t)
Future value interest factor is (1+r)^t
Formula for future value
FV = 1 x (1 + r)^t
What is the effect of doubling the interest rate on the future value
Doubling interest rate more than doubles the future value
How do you find future values with multiple cash flows
Multiply each cash flow by Future value factor
Define present value
Current value of a future sum of money or stream of cashflows discounted at a certain rate of interest is the present value - reciprocal of inverse future value
Definition of discounting
Calculating the present value of a future amount
What is the formula for present value
FV x 1/(1+r)^t
Definition of a discount factor
its the present value interest factor = 1/(1+r)^t
What is another name for the discount rate
rate of return
Define DCF valuation
Calculating PV of future cash flow to determine its value today
Explain the rule of 72
if 5% < r < 20% then a good estimate of time taken to double your money is given by: 72/r% = t
What is the relationship between the discount rate and the Present Value
Length of time till payment grows Present Value declines - inversely related
How do you calculate the present value of a stream of cash flows
- Compute PV of each cash flow
2. Combine the present values
What is the assumed timing of cash flows in these problems
Assumed payments are at the end of the period
Define an annuity
A level stream of cash flows for a fixed period of time (inflows or outflows) - very common in the financial markets
What is the present value of an annuity of €C per period for t periods when rate of interest is r is given by what formulae?
C x [1/r - 1/r(1+r)^t]
What is the future value of an annuity of €C per period for t periods when rate of interest is r is given by what formulae?
C x ([(1+r)^t-1 ]/r)
Define annuity due
annuity for which the cash flows occur at the beginning of period. If 5 payments are to be made theyre in period 0,1,2,3,4
Know formulae for annuity due and growing annuity present value
//
define a perpetuity
Level stream of cash flows that continues forever - cash flow is perpetual ex: US Consol bonds
What is formula for PV of perpetuity
C/r
What is formulae for constant growth perpetuity present value
Pvt = Ct+1/(r-g)
Define nominal interest
expressed in terms of the interest payment made each period - quoted interest rate
Define EAR
Effective Annual percentage rate is interest rate expressed as if it were compounded once per year
Define APR
- Harmonised interest rate that expresses total cost of borrowing or investing as a % interest rate. - different in the us. it usually is smaller than EAR
Define continuous compounding
Tries to shorten periods as much as possible. Interest is being credited the instant it is earned so amount grows continuously- this will give you the highest interest rate
What is the formula for EAR
[1 + (quoted rate/m)]^m -1 where m is the number of periods a year
What is the formula for continuous compounding EAR
e^q - 1
