Unit 2. Time value of Money

Time value of money

refers to the fact that money (a dollar, a euro, or a yen) in hand today is worth more than the expectation of the same amount to be received in the future.

Principal

the original sum of money borrowed in a loan or put into an investment.

Interest

the cost of borrowing money, where the borrower pays a fee to the lender for the loan. The interest, typically expressed as a percentage, can be either simple or compounded.

Compounding

the process in which an asset's earnings, from either capital gains or interest, are reinvested to generate additional earnings over time. This growth occurs because the investment will generate earnings from both its initial principal and the accumulated earnings from preceding periods.

Present value

the current value of a future sum of money or stream cash flows given a specified rate of return. ___ states that an amount of money today is worth more than the same amount in the future or money received in the future is not worth as much as an equal amount received today. Unspent money today could lose value in the future by an implied annual rate due to inflation or the rate of return if the money was invested.

Net present value (NPV)

the difference between the present value of all future cash flows minus the present value of all current and future cash outflows.__ is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

Future value

the amount of money an investment will grow to at some date in the future by earning interest at some compound rate.

Opportunity cost of capital

the difference in return between an investment one makes and another that one chose not to make.

Yield to maturity (YTM) or internal rate of return (IRR)

the discount rate that makes the present value of the future cash inflows equal to the present value of cash outflows.

Effective annual rate

the actual annual rate which causes present value to grow to the same future value as under multi-period compounding.

Discounting

the process of calculating present values to know how much we have to invest now to reach some target amount at a date in the future.

Annuity

Often the future cash flows in a savings plan, an investment project, or a loan repayment schedule are the same each year. We call such a stream of cash flows or payments of an annuity.

Annuity contract

The term comes from the life insurance business, in which an annuity contract is one that promises a stream of payments to the purchases for some period of time. Immediate annuity

Ordinary annuity

If the cash flows start at the end of the current period rather than immediately, it is called an ordinary annuity.

Perpetuity (Perpetual annuity)

a stream of annuity cash flows that lasts forever.

Amortization

the process of paying off a loan‘s principal gradually over its term.

Norminal interest rate

the rate denominated in dollars or in some other currency

Real interest rate

the rate denominated in units of consumer goods

Fixed interest rate

an unchanging rate charged on a liability, such as a loan or mortgage

Variable interest rate

. an interest rate on a loan or security that fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically

discount rate

the rate of return used to discount future cash flows back to their present value

Simple Interest

the interest based on the principal amount of a loan or deposit.

Compound Interest

the interest based on the principal amount and the interest that accumulates on it in every period.

inflation rate

the rate at which prices increase over time, causing the value of money to fall

Annual Percentage Rate (APR)

the rate at which someone who borrows money is charged, calculated over a period of twelve months

Effective Annual Rate (EAR)

the actual rate of interest paid or charged over one year

lump sum

a single payment made at a particular time, as opposed to a number of

smaller payments or installments