TVM
Time value of money. A dollar today is worth more than a dollar tomorrow
Compounding
Process of accumulating interest in 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
Simple interest formula
Po x i
Principal
initial amount of money on which interest is paid
Future value factor
(1+i)^n
Present value factor is also called
discount factor
Present value factor
1/(1+i)^n
Discount Rate
the rate used to calculate the pv of future cash flows.
Relationship between discount rate and interest rate
If discount rate increases, the interest rate will decrease
Rule of 72
Used to determine how it will take you (in years) to double your money
Rule of 72 formula
TDM=72/i
Annuity
a level stream of cash flows for a fixed period of time
Annuity due
an annuity for which the cash flows occur at the beginning of the period
During what annuity do you need to change your calculator settings?
Annuity due
Perpetuity
An annuity in which the cash flows continue forever. also called a consol
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 loans
Simplest form of a loan. The borrower receives 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 at some point in the future
Amortized loans
Paying of a loan by making regular principal reductions
With typical interest-only loans, the entire principal is
repaid at some point in the future
The entire principal of an interest-only loan is the
Original loan amount
An annuity with payments beginning immediately rather than at the end of the period is called an
Annuity due
Which is the simplest form of a loan?
Pure discount loan
More frequent compounding leads to
Higher EARs