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keown_perfin5_im_03

# keown_perfin5_im_03

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Solutions Personal Finance . Arthur J. Keown
Solutions Personal Finance . Arthur J. Keown

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07/18/2013

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CHAPTER 3UNDERSTANDING AND APPRECIATINGTHE TIME VALUE OF MONEY
CHAPTER CONTEXT: THE BIG PICTURE
This is the third chapter in the four-chapter section of the text entitled “Part 1: FinancialPlanning.” This section introduces building blocks that are fundamental to the remainder of thetext and serve as a foundation for financial planning. The first chapter focused on the importanceof the financial planning process, while the second focused on quantitative tools for measuringfinancial well-being and strategies for developing a budget based on financial goals. This chapter introduces another quantitative concept, the time value of money. Because applications of thisconcept are made in subsequent chapters on taxes, consumer credit, mortgages, life insurance,investments, and retirement planning, it is critical that the students understand the calculations aswell as the logic underlying the time value of money concepts.
CHAPTER SUMMARY
Compound interest and the time value of money are two important factors to consider whendeveloping a financial plan. This chapter explains the concept of the time value of money under three assumptions: 1) a single payment, “lump sum;” 2) a terminating fixed stream of payments,“annuity;” and 3) a never-ending fixed stream of payments, “perpetuity.” Calculations andapplications for present value and future value are illustrated using either a financial calculator or the interest factor tables. Using compound interest to generate returns is dependent on threefactors: length of the investment period, amount invested, and the rate of return, or interest rate.The use of these factors to determine the return on an investment is discussed and illustratedwith calculations. Finally, amortized loans and perpetuities are discussed and calculated.
LEARNING OBJECTIVES AND KEY TERMS
After reading this chapter, students should be able to accomplish the following objectives anddefine the associated key terms:1.Explain the mechanics of compounding.a.compound interest b.principalc.present value (PV)d.annual interest rate (i)e.future value (FV)f.reinvesting

40 Chapter 3
g.future-value interest factor (FVIF
i,n
)h.compound annuallyi.rule of 722.Understand the power of time and the importance of the interest rate in compounding.3.Calculate the present value of money to be received in the future.a.discount rate b.present-value interest factor (PVIF
i,n
)4.Define an annuity and calculate its compound or future value.a.annuity b.compound annuityc.future-value interest factor for an annuity (FVIFA
i,n
)d.present-value interest factor for an annuity (PVIFA
i,n
)e.amortized loanf.perpetuity
CHAPTER OUTLINE
I.Compound Interest and Future ValuesA.The compound interest equation—FV = PV(1 + i)1.PV = the present value, in today’s dollars, of a sum of money2.i = the annual interest (or discount) rate3.FV = the future value of the investment at a future point in timeB.Reinvesting—how to earn interest on interest
C.
Future Value Interest Factor—FVIF = (1 + i)
n

1.
This is the future-value interest factor for (i) and (n).2.Appendix A factor table
D.
The Rule of 72—estimates how many years an investment will take to double invalueE.Compound interest with non-annual periods1.The shorter the compounding period, the quicker the investment grows2.Effective annual interest rate
II.
Using an On-line or Handheld Financial Calculator A.The TI BAII Plus financial calculator keys
1.
N = stores (or calculates) the total number of payments or compounding periods
2.
I/Y = stores (or calculates) the interest (either compound or discount) rate
3.
PV = stores (or calculates) the present value
4.
FV = stores (or calculates) the future value
5.
PMT = stores (or calculates) the dollar amount of each annuity payment6.CPT = is the compute key

Understanding and Appreciating the Time Value of Money 41
B.Calculator Clues1.Set calculator to one payment “annual” per yea2.Set to display at least four decimals, due to how small percentages are indecimal format.3.Set to “end” mode, because most annuity payments are made or received at theend of the period.4.Every problem has at least one positive number and one negative number 5.Be sure to enter a zero for any unused variable6.Enter the interest rate as a percent rather than a decimalIII.Compounding and the Power of TimeA.The power of time, money saved now is much more valuable than money savedlater.B.Don’t ignore the bottom line, but also consider the average annual return.IV.The Importance of the Interest RateA.Historical returnsB.The Daily DoubleV.Present ValueA.Discount rate, or the interest rate used to bring future dollars back to present dollars
B.
Present-value interest factor (PVIF
i,n
)
C.
PV = FV
n
(PVIF
i,n
) or FV
n
/(1 + i)
n
D.Appendix B factor table
VI.
Annuities – a series of fixed (equal) payments recurring at fixed intervalsA.Compound annuities
1.
A series of fixed investments for which to find a future value
2.
Future-value interest factor for an annuity (FVIFA
i,n
)
3.
FV
n
= PMT(FVIFA
i,n
)4.Appendix C factor tableB.Present value of an annuity1.A series of fixed investments for which to find a present value
2.
Present-value interest factor for an annuity (PVIFA
i,n
)
3.
PV = PMT(PVIFA
i,n
)4.Appendix D factor tableVII.Amortized loansA.Loan obligation paid off in equal installments
B.
Examples include car loans and home mortgages
C.
Perpetuities—an annuity that last forever