Chapter 5: Time Value of Money- The Basics

EAR continuously compounded

EAR = (e^quoted annual rate) -1

timeline

a linear representation of the timing of cash flows; including cash received, cash spent, and interest rate earned; typically expressed in years

Rule of 72

a method for estimating the time it takes for an amount to double in value. to determine the approximate time it takes for an amount to double in value, 72 is divided by the annual interest rate

cash outflows

negative cashflow

periodic rate

periodic rate = quoted annual rate / compounding periods per year (m)

cash inflows

positive cashflow

compounding

process of accumulating interest on an investment over multiple time periods

effective annual rate (EAR)

the annual compounded rate that produces the same return as the nominal, or stated, rate EAR = ((1 + (quoted annual rate / compounding periods per year m)) ^m) - 1

simple interest

the interest earned on the principal

nominal or quoted (stated) interest rate

the interest rate paid on debt securities without an adjustment for any loss in purchasing power

annual percentage rate (APR)

the interest rate paid or earned in one year without compounding. it is calculated as the interest rate per period (for example, per month or week) multiplied by the number of periods during which compounding occurs during the year (m)

discount rate

the interest rate used in the discounting process

discounting

the inverse of compounding. this process is used to determine the present value of a future cash flow

compound interest

the situation in which interest paid on the investment during the first period is added to the principal and, during the second period, interest is earned on the original principal plus the interest earned during the first period

future value interest factor

the value (1 + i)^n used as a multiplier to calculate an amount's future value

present value

the value in today's dollars of a future payment discounted back to the present at the required rate of return what a cash flow would be worth to you today

future value

what a cash flow will be worth in the future FV = PV * (1 + interest rate) or FV_n = PV * (1 + interest rate)^n if multiple compounding periods per year, make sure to divide the interest rate by it