WEEK 4 - Time Value of Money Flashcards
Why do we need to add a rate of return to assets?
As compensation for:
- Time
- Inflation
- Risk
How do we calculate Future Value?
FV = PV(1+R)n
What’s the difference between simple interest and compound interest?
Simple Interest is the interest on the initial investment
Compound interest is interest on interest (exponential growth)
(1+r)n - Compound Factor
How do we calculate Present Value?
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
What is the calculation for the Future Value when we consider differing time period payments (i.e monthly, quartlerly etc.)
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
What is the calculation for FV and PV when we are looking at continuous compounding?
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
What is the effective interest rate?
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.
How do you calculate the effective interest rate?
(1+r/m)m - 1
Where m is to the power of
What is a simple annuity defined as?
Series of fixed payments of a fixed amount for specified number of periods
e.g. Bonds, regular savings, regular loan payments etc.
What is a Perpetuity defined as?
Where cash flows last indefinitely
e.g real estate
How do you calculate Perpetuity?
Present Value
PV = C/(1+R)1 + C/(1+R)2 ETC.
Formula given as:
PV = C/R
Where C is cashflow/coupon
How do you calculate the ordinary annuity? (Present Value)
PV = C/R (1- 1/(1+R)t)
Where t is to the power of
How do you calculate the Ordinary Annuity?
Future Value
FV = C/R x ((1+R)t - 1)
Where t is to the power of
What is Holding Period Return?
The rate of return that investors obtain over a specific period of time
How do you calculate the Holding Period Return?
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
