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Financial ManagementLecture # 02
Time Value of Money
 
 
What Is The Time Value Of Money?
 
The principle of time value of money – the notion that a given sum of money is morevaluable the sooner it is received, due to its capacity to earn interest – is thefoundation for numerous applications in investment finance.
The Five Components Of Interest Rates
Real Risk-Free Rate
– This assumes no risk or uncertainty, simply reflecting differences intiming: the preference to spend now/pay back later versus lend now/collect later.
Expected Inflation
- The market expects aggregate prices to rise, and the currency'spurchasing power is reduced by a rate known as the inflation rate. Inflation makes realdollars less valuable in the future and is factored into determining the nominal interest rate(from the economics material: nominal rate = real rate + inflation rate).
Default-Risk Premium
- What is the chance that the borrower won't make payments ontime, or will be unable to pay what is owed? This component will be high or low dependingon the creditworthiness of the person or entity involved.
Liquidity Premium
- Some investments are highly liquid, meaning they are easilyexchanged for cash (U.S. Treasury debt, for example). Other securities are less liquid, andthere may be a certain loss expected if it's an issue that trades infrequently. Holding other factors equal, a less liquid security must compensate the holder by offering a higher interest rate.
Maturity Premium
- All else being equal, a bond obligation will be more sensitive tointerest rate fluctuations the longer to maturity it is.
 
 
Nominal Interest Rate: Rate at which money invested grows.Real interest rate = nominal interest rate – inflation rateReal Interest Rate: Rate at which the purchasing power of an investment increases.The real rate of interest is calculated by1 + real interest rate =1 + nominal interest rate ____________________ 1 + inflation rateEffective Annual Interest Rate: Interest rate that is annualized using compoundinterest.The effective annual yield represents the actual rate of return, reflecting all of thecompounding periods during the year. The effective annual yield (or EAR) can becomputed given the stated rate and the frequency of compounding.Effective annual rate (EAR) = (1 + Periodic interest rate)
m
– 1Where: m = number of compounding periods in one year, andperiodic interest rate = (stated interest rate) / m
Example: Effective Annual Rate
Suppose we are given a stated interest rate of 9%, compounded monthly, here iswhat we get for EAR:Annual Percentage Rate (APR): Interest rate that is annualized using simple interestrate.The effective annual rate is the rate at which invested funds will grow over thecourse of a year. It equals the rate of interest per period compounded for thenumber of periods in a year.Keep in mind that the effective annual rate will always be higher than the statedrate if there is more than one compounding period (m > 1 in our formula), and themore frequent the compounding, the higher the EAR.
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