FINANCE EXAM 1 - Chapter 5
Characteristics of annuities
-An annuity due earns more interest than an ordinary annuity of equal time. -Ordinary annuities make fixed payments at the end of each period for a certain time period. -A perpetuity is a constant, infinite stream of equal cash flows that can be thought of as an infinite annuity
Characteristics of a perpetuity
-The present value of a perpetuity is calculated by dividing the amount of the payment by the investor's opportunity interest rate -A perpetuity is a series of regularly timed, equal cash flows that is assumed to continue indefinitely into the future. -In a perpetuity, returns—in the form of a series of identical cash flows—are earned.
Opportunity cost of funds
A 6% return that you COULD HAVE earned if you had made a particular investment.
Annuity due
A cash flow stream that is created by a lease that requires the payment to be paid on the first of each month and a lease period of three years.
Ordinary annuity
A cash flow stream that is created by an investment or loan that requires its cash flows to take place on the last day of each quarter and requires that it last for 10 years.
Perpetuity
A cash flow stream that is generated by a share of preferred stock that is expected to pay dividends every quarter indefinitely.
Amortized loan
A loan in which the payments include interest as well as loan principal.
Example of an annuity
A perpetuity is a constant, infinite stream of equal cash flows that can be thought of as an infinite annuity
Amortization schedule
A schedule or table that reports the amount of principal and the amount of interest that make up each payment made to repay a loan by the end of its regular term.
Annual percentage rate
An interest rate that reflects the return required by a lender and paid by a borrower, expressed as a percentage of the principal borrowed.
Formula for Calculating FV using Simple Interest
FV = PV + (PV x I x N)
Formula for Calculating FV using Compound interest
FV = PV x (1 + I)^N
Formula for present value of a lump sum
FV/(1 + r)^n
Formula for Future Value using SIMPLE interest
FV_N=PV x (1 + I)N
T/F Mortgages always have a fixed nominal interest rate.
False
T/F An investment of $25 at an annual rate of 10% will return a higher value in five years than $50 invested at an annual rate of 5% in the same time.
False An investment of $25 at an annual rate of 10% will return a LOWER value in five years than $50 invested at an annual rate of 5% in the same time.
Example of Uneven Cash Flows
Franklinia Venture Capital (FVC) invested in a budding entrepreneur's restaurant. The restaurant owner promises to pay FVC 10% of the profit each month for the next 10 years.
Future value
One of the four major time value of money terms; the amount to which an individual cash flow or series of cash payments or receipts will grow over a period of time when earning interest at a given rate of interest.
Formula for a present value of an ordinary annuity.
PMT x {1 - [1 /(1 + r)^n]}/r
Equation to solve for the future value of an ordinary annuity
PMT x {[(1 + r)^n - 1]/r}
Formula for future value of an annuity due
PMT x {[(1 + r)nn - 1]/r} x (1 + r)
Example of Uneven Cash Flows
SOE Corp. hires an average of 10 people every year and matches the contribution of each employee toward his or her retirement fund.
Time value of money
The concept that states that the timing of the receipt or payment of a cash flow will affect its value to the holder of the cash flow.
Discounting
The process of determining the present value of a cash flow or series of cash flows to be received or paid in the future.
T/F All other factors being equal, both the simple interest and the compound interest methods will accrue the same amount of earned interest by the end of the first year.
True
T/F All other variables held constant, investments paying simple interest have to pay significantly higher interest rates to earn the same amount of interest as an account earning compound interest.
True
T/F Everything else held constant, an account that earns compound interest will grow more quickly than an otherwise identical account that earns simple interest.
True
T/F Other things remaining equal, the present value of a future cash flow decreases if the investment time period increases.
True
Formula for Future Value using COMPOUND interest
USE financial calculator Excel: = FV(rate, nper, pmt, [pv], [type])
Example of Annuity Payments
You have committed to deposit $600 in a fixed interest-bearing account every quarter for four years.
Example of Annuity Payments
You recently moved to a new apartment and signed a contract to pay monthly rent to your landlord for a year.
The process for converting present values into future values is called
compounding
Of the four time-value-of-money variables, which three are needed to calculate FV?
•The present value (PV) of the amount invested •The interest rate (I) that could be earned by invested funds •The duration of the investment (N)
