# WEEK 4 - Time Value of Money Flashcards

1
Q

A

As compensation for:

• Time
• Inflation
• Risk
2
Q

How do we calculate Future Value?

A

FV = PV(1+R)n

3
Q

What’s the difference between simple interest and compound interest?

A

Simple Interest is the interest on the initial investment

Compound interest is interest on interest (exponential growth)
(1+r)n - Compound Factor

4
Q

How do we calculate Present Value?

A

PV = FV/(1+R)n
OR
PV = FV X 1/(1+R)n

where n is to the power of

Where the discount factor 1/(1+r)t < 1 denotes PV of £1 received in future

5
Q

What is the calculation for the Future Value when we consider differing time period payments (i.e monthly, quartlerly etc.)

A

FV = PV (1+R/M)txm

txm is to the power of

Where:
R is annual interest
M number of compound periods per annum
t number of years

6
Q

What is the calculation for FV and PV when we are looking at continuous compounding?

A

FV= PV e (txr)

Where t x r is to the power of

PV = FV e (-t x r)

Where - t x r is to the power of

7
Q

What is the effective interest rate?

A

Actual annual interest rate paid on an investment or loan. It is used to compare the annual interest between investments, or loans with different compounding periods.

8
Q

How do you calculate the effective interest rate?

A

(1+r/m)m - 1

Where m is to the power of

9
Q

What is a simple annuity defined as?

A

Series of fixed payments of a fixed amount for specified number of periods

e.g. Bonds, regular savings, regular loan payments etc.

10
Q

What is a Perpetuity defined as?

A

Where cash flows last indefinitely

e.g real estate

11
Q

How do you calculate Perpetuity?

Present Value

A

PV = C/(1+R)1 + C/(1+R)2 ETC.

Formula given as:
PV = C/R

Where C is cashflow/coupon

12
Q

How do you calculate the ordinary annuity? (Present Value)

A

PV = C/R (1- 1/(1+R)t)

Where t is to the power of

13
Q

How do you calculate the Ordinary Annuity?

Future Value

A

FV = C/R x ((1+R)t - 1)

Where t is to the power of

14
Q

What is Holding Period Return?

A

The rate of return that investors obtain over a specific period of time

15
Q

How do you calculate the Holding Period Return?

A

r = (D1 +P1 - P0)/ P0

Where:
P0: Denotes value of investment at beginning of holding period
P1: Denotes value of investment at end of holding period
D1: Denotes dividend or interest payment received during that period

16
Q

How do you calculate the nominal rate of return?

A

Real rate of return x Inflation

e.g Real rate of Return = 8%
Inflation 4% (add it on to the existing 100%)

Looking at T0: £1000

1. 08 X 1.04 = 1.1232
2. 1232 X 100 = 1123.20 Nominal Cash flow T1
3. 20 is financially equal to 1000 in the last period

Can see the nominal rate of return is 12.32%

17
Q

What is Fisher’s equation?

A

The generalised relationship between real rates of return and
nominal (or market or money) rates of return and inflation

18
Q

How do you calculate Fisher’s equation?

A

(1 + Rt) = (1+Rt) (1+Etπt + 1)

π denotes inflation
P denotes price index

19
Q

According to the Fisher Equation what is the Ex-ante nominal interest rate?

A

Rt ≈ r + Eπ

20
Q

According to the Fisher Equation what is the Ex-post nominal Interest Rate?

A

R ≈ r + π

21
Q

What can you not calculate with the Fisher Equation?

A
1. Discount Money cash Flows with real discount rate

2. Discount real cash flows with the money discount rate