1: Time Value of Money

Tuesday, 28 December 2021 10:18 PM

Module 1.1: EAY AND COMPOUNDING FREQUENCY

LOS 1.a: Interpret interest rates as required rates

of return, discount rates, or opportunity costs.

• Interest rates are a measure of the time

value of money, also known as discount rates
• Equilibrium interest rates are the required
rate of return for a particular investment
• Interest rates can also be seen as the
opportunity cost of current consumption.

LOS 1.b: Explain an interest rate as the sum of a

real risk-free rate and premiums the compensate
investors for bearing distinct types of risk

• Real risk-free rate of interest: theoretical

rate on a single-period loan that has no
expectation of inflation in it
• Real rate of return: investor's increase in
purchasing power (after adjusting for
inflation)
• Nominal risk-free rate = real risk-free rate +
expected inflation return
• Risk: Each added risk increases the required
rate of return on the security.
○ Default risk: borrowers will not make
the promised payments in a timely
manner
○ Liquidity risk: risk of receiving less than
fair value for an investment if it must
be sold for cash quickly
○ Maturity risk: longer maturity bonds
have more maturity risk than shorter-
term bonds and require a maturity risk
premium
LOS 1.c: Calculate and interpret the effective annual rate, given the stated annual
interest rate and the frequency of compounding
• Effective annual rate (EAR) or effective annual yield (EAY): the rate of interest
that investors actually realize as a result of compounding; it represents the
annual rate of return actually being earned after adjustments have been made
for different compounding periods. EAR may be determined as follows:

• Example:

LOS 1.d: Calculate the solution for time value of money problems with different
frequencies of compounding
Module: 1.2. Calculating PV and FV

LOS 1.e: Calculate and interpret the future value (FV) and present value (PV) of a
single sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and
a series of unequal cash flows

Future Value of a Single Sum

• Future value: or compound value is the amount to which a current deposit will
grow over time when it is placed in an account paying compound interest.
• Formula:

Present Value of a Single Sum

• Present value: of a single sum is today's value of a cash flow that is to be
received at some point in the future. It is the amount of money that must be
invested today, at a given rate of return over a given period of time, in order to
end up with a specified FV.
• Formula:
 •

Annuities
• Annuity: a stream of equal cash flows that occurs at equal intervals over a given
period.
• Recurring payments, such as rent on an apartment or interest on a bond, are
sometimes referred to as "annuities"
• 2 types of annuities:
○ Ordinary annuity: most common type, cash flows that occur at the end of
each compounding period
○ Annuities due: where payments or receipts occur at the beginning of each
period (ex. The first payment is today at t=0)
• Future value of an annuity: total value of payments at a specific point in time

• Present value: how much money would be required now to produce those
future payments
 • Present value: how much money would be required now to produce those
future payments

Present Value of a Perpetuity

- Security that pays for an infinite number of time
- Constant stream of identical cash flows with no end

Module 1.3 Uneven Cashflows

- A stream of annual single sum and uneven cash flows
- Example:
When compounding periods are other than annual

Compounding period
- Compounding typically refers to the increasing value of an asset due to the
interest earned on both a principal and accumulated interest.
- Compound interest: direct realization of the time value of money
- Compound interest works on both assets and liabilities. While
compounding boosts the value of an asset more rapidly, it can also increase the
amount of money owed on a loan, as interest accumulates on the unpaid
 - Compounding typically refers to the increasing value of an asset due to the
interest earned on both a principal and accumulated interest.
- Compound interest: direct realization of the time value of money
- Compound interest works on both assets and liabilities. While
compounding boosts the value of an asset more rapidly, it can also increase the
amount of money owed on a loan, as interest accumulates on the unpaid
principal and previous interest charges.

LOS 1.f: Demonstrate the use of a timeline in modeling and solving the time value of
money problems