Time Value of Money Concepts and Calculations

Question 1

Define “internal rate of return (IRR).”

Answer 1

The interest rate at which the NPV of all cash flows (positive and negative) equals zero.

Question 2

Define “annuity due” and “ordinary annuity.”

Answer 2

An annuity due is when payments take place at the beginning of each period.

In an ordinary annuity, payments occur at the end of each period.

Question 3

What is the formula for calculating the inflation-adjusted rate of return of a serial payment?

Answer 3

{[(1 + r) ÷ (1 + i)] – 1} × 100

where:

r = nominal or before-tax rate of return, and

i = assumed annual inflation rate

Question 4

List the two types of payments that can be calculated.

Answer 4

Fixed payments

Serial payments

Question 5

Identify the two primary methods for conducting a needs analysis.

Answer 5

1. The capital utilization method, which assumes all, or virtually all, accumulated funds will be depleted by the end of the period under consideration.
2. The capital preservation method, which assumes periodic payments made are interest only and the capital accumulated will be preserved.

Question 6

Serial payments increase each year based on what?

Answer 6

Rate of inflation

Question 7

List the three-step process for calculating a needs analysis.

Answer 7

1. Determine the income need for the first year of retirement.
2. Determine how much will be needed to fund each year’s income need throughout the entire retirement period.
3. Determine the required savings (yearly or monthly) to accumulate the necessary nest egg.

Question 8

How is net present value calculated?

Answer 8

Discounting each projected cash flow, at the investor’s required rate of return, and subtracting the initial investment