Finance Exam

Time Value of Money

The fact that a dollar in hand today is worth more than a dollar promised at some time in the future

future value (FV)

The amount an investment is worth after one or more periods.

compounding

The process of accumulating interest on an investment over time to earn more interest.

interest on interest

Interest earned on the reinvestment of previous interest payments.

compound interest

Interest earned on both the initial principal and the interest reinvested from prior periods.

simple interest

Interest earned only on the original principal amount invested.

$1 x (1+r)^t

Future Value (FV) formula:

present value (PV)

The current value of future cash flows discounted at the appropriate discount rate.

discount

Calculate the present value of some future amount.

$1 / (1+r)^t

Present Value (PV) formula:

discount rate

The rate used to calculate the present value of future cash flows.

discounted cash flow (DCF) valuation

Calculating the present value of a future cash flow to determine its value today.

Rule of 72

a rough estimate for how long it takes an investment to double in value based on its interest rate

At the end of each period

When is it assumed that the cash flows occur?

annuity

A level stream of cash flows for a fixed period of time.

N = how long, I/Y = rate, PMT = payment

N, I/Y PMT:

annuity due

An annuity for which the cash flows occur at the beginning of the period.

perpetuity

An annuity in which the cash flows continue forever.

consol

A type of perpetuity.

Preferred stock (Preference stock)

Important example of a prepetuity:

stated interest rate

The interest rate expressed in terms of the interest payment made each period. Also known as the quoted interest rate.

effective annual rate (EAR)

The interest rate expressed as if it were compounded once per year.

annual percentage rate (APR)

The interest rate charged per period multiplied by the number of periods per year.

Pure discount loan

The simplest form of a loan where the borrower receives the money today and repays a single lump sum at some point in the future

interest-only loans

calls for the borrower to pay interest each period and to repay the entire principal (the original loan amount) at some point in the future

Amortized loans (Amortizing)

the lender may require the borrower to repay parts of the loan amount over time

(PMT/rate) = PV

Perpetuity formula: