Week 5 Flashcards
Time Value of Money: The decision-making process with which TVM calculations can assist, requires an understanding of two concepts:
1) Compounding
2) Discounting
Compounding / discounting calculations are commonly applied to two types of cash flow:
A single lump sum:
We can use the concept of compounding to determine how much an investment of £100 would accrue at 5% per annum if it were left in the bank for 5 years.
We can use the concept of discounting to ascertain how much we must deposit now to accumulate a specified amount of money at some future point in time.
Compounding / discounting calculations are commonly applied to two types of cash flow:
An Annuity
Use compounding to determine how much an investment would be worth if we put £500 into a bank account each year for 10 years at 5% per annum.
Use discounting to determine whether we should accept a lump sum today or a guaranteed future income stream.
TVM Terminology
1) Present Value (PV) = the current value of a sum of money, or the value in today’s money of a future sum
2) Future value (FV) = value of an investment at some future point in time
3) Annual interest rate (i) = rate charged or paid for use of money on an annual basis
Present Value formula (PV)
For basic discounting (discounting is the opposite of compounding):
PV = FV / (1+i)ⁿ
Future Value Formula
For example, for basic compounding:
FV = PV x (1+ i) ⁿ
Where “n” is the number of years during which compounding occurs.
Ordinary (Deferred) Annuity
An ordinary (or deferred) annuity is a stream of equal payments (or receipts) that occur at the end of each time period An annuity due is where the payments occur at the start of each period.
Compounding
Compounding can be used to compare the return on different investments, and:
- Useful to calculate the effect of an assumed rate of inflation
- It demonstrates the value of investing early (e.g. pension calculations)
- Can also be used to find the future value of an annuity
More advanced compounding: APR
The annual percentage rate (APR) is a conventional method (ignores compounding effect completely)
- It is not a particularly helpful method
- APR = m x i,
- where m = number of periods in one year;
- and i = rate of return/ interest payable rate for one period
More Advanced Compounding: Effective Annual Rate
The effective annual rate (EAR) (or AER for savings) is arguably a better model:
This method compounds the periodic rate the number of times there are periods in the year
EAR = (1+ i) (m) - 1
Discounting
Discounting is the opposite of compounding and is about finding the present value of a sum (or sums) of money.
Provision from capital (1): This is the most flexible option and does not require as much forward planning Options include: Lump sum
-Lump sum payments in advance:
-Offered by some schools
-Pay lump sum in advance in return for guaranteed
-level of fee payment
ADV- Savings possible
DIS-What happens if family move elsewhere (or child doesn’t get into the school?)
Provision from capital (2) : This is the most flexible option and does not require as much forward planning Options include: Single Premium bond
- Invest a lump sum and then withdraw an “income” to pay for the school fees
- No tax charge on withdrawals for BR taxpayers
- For HR taxpayers, tax charge is deferred as long as not more than 5% of the sum invested is withdrawn each year
- This 5% can be rolled up – very useful!
Premium bond advantage and disadvantages
ADVANTAGES
- Might be tax efficient income (particularly if BR taxpayer)
- No CGT on policy proceeds (but HR IT) 20% vs 28%
DISADVANTAGES
-Underlying funds subject to tax
Provison from capital cont: Educational Trusts
- Pay a lump sum to trustees, who invest sum on behalf of investor (i.e. parent) in an annuity with insurance company
- Insurance company pay annuity instalment to trustees as school fees are required. Fees forwarded to parents by trustees.
- Tax effective
