Topic 3 - Time Value of Money & Principles of Valuation

Question 1

Define PV

Answer 1

Present Value is the amount that corresponds to today’s value of a promised future sum

Question 2

Define FV

Answer 2

Future value is the amount an investment is worth after one or more periods.
n = number of years between PV and FV
m = where there is more than on compounding period in a year (m), the number of periods is n x m
r = discounting or compounding rate

Question 3

Define discounting

Answer 3

The process of reducing a future value to an equivalent present value

Question 4

Compound vs simple interest

Answer 4

Compound interest = the process of accumulating interest in an investment over time to earn more interest
Simple interest = the method of calculating interest in which during the entire term of the loan interest is computed on the original sum borrowed

Question 5

What is an annuity?

Answer 5

A finite series of equal payments that occur at regular intervals.
An ordinary annuity is a series of equal payments that occur at the end of each period for a fixed number of periods
An annuity due is a series of equal cash flows that occur at the beginning of each period for some fixed number of periods
Perpetuity = infinite series of equal payments at regular intervals eg. preference share dividends

Question 6

Effective annual rate

Answer 6

EAR is the actual rate paid after accounting for compounding that occurs during the year
NIR = nominal interest rate (stated rate)
m = number of compounding periods