Finance Chapter 4

Compound interest

Compound interest means interest on interest.

future value interest factor (FVIF)

Future value = 1 x (1 + r)^t a factor multiplied by today's savings to determine how the savings will accumulate over time

Determining the discount rate

PV = FV / (1 +r)

Basic present value equation

PV = FV/(1+r)^t = FV x [1/(1+r)^t]

Discount rate

The interest rate on the loans that the Fed makes to banks -with PV, its the amount of interest that is discounted backwards to find the initial amount of the investment

Rule of 72

The number of years it takes for a certain amount to double in value is equal to 72 divided by its annual rate of interest.

Future Value (FV)

refers to the amount of money an investment will grow to over some period of time at some given interest rate

discounted cash flow (DCF) valuation

the process of valuing an investment by discounting its future cash flows

Present Value vs Future Value

-What we called the present value factor is just the reciprocal of (that is, 1 divided by) the future value factor Future value factor = (1 + r)^t Present value factor = 1/(1 + r)^t

Present value (PV)

-the current value of future cash flows discounted at the appropriate discount rate. -instead of compounding the money forward we discount it back to the present -Present value X 1.1 = 1

Compounding

Start: $100 + 10% interest Year one: 110 Year two: $110 + 10% of 110 process of leaving your money and any accumulated interest in an investment for more than one period, thereby reinvesting the interest. Interest n interest so compound interest.

Time value of money

Uses: Investing, borrowing, valuing, decision making, planning

Simple interest

With simple interest the interest is not reinvested so interest is earned on only the original principal.