Series 65 Chapter 20

Time Value of Money

The concept that a sum of money is worth more now than the same sum will be worth in the future, because of its earning potential. Encompasses both present value and future value calculations.

Future Value

The formal term for what an amount invested today at a given rate will be worth at some point in the future. Depends on the rate of return (r) and number of years invested (n). Formula: FV = PV × (1 + r)ⁿ

Present Value

The formal term for the value today of the future cash flows of an investment, discounted at a specified interest rate. Formula: PV = FV ÷ (1 + r)ⁿ

Compound Rate of Return

A rate of return where the interest earned in a given period is reinvested at the identical rate for the number of years invested — the earnings themselves earn future returns.

Discount Factor

The factor (1 + r)ⁿ used in the present value formula — what you divide future value by to bring it back to today's dollars.

Rule of 72

A shortcut for finding how many years it takes an investment to double, assuming compounded earnings: 72 ÷ interest rate = years to double (and in reverse: 72 ÷ years = required rate).

Net Present Value (NPV)

The difference between an investment's present value (PV) and its current market value/cost (CMV). NPV = PV − CMV. Positive = worth more than it costs (good); negative = overpriced (avoid).

Internal Rate of Return (IRR)

The discount rate (r) that makes an investment's future value equal to its present value; represents its actual compound annual return. A bond's yield to maturity IS its IRR.

Iteration

The trial-and-error process used to determine IRR, since it can't be solved directly with a formula.