2015 Study Session # 2, Reading # 5

“THE TIME VALUE OF MONEY”

Compound Interest or Interest on Time Line Discounting Compounding

Interest Diagram of the cash Moving CF to the beginning Moving cash flow to the
Growth in the value of investment flows associated with a of an investment period to end of the investment
includes, interest earned on: TVM problem. calculate PV. period to calculate FV.
N

Original principal.  FV = PV (1 +i)

 = N

Previous period’s interest (1 + )ே (1+i) is FV factor
earnings.
1
(1 + )ܰ 
 


Required = Nominal RFR. + Default risk + Liquidity risk + Maturity risk

interest premium. premium. premium.
rate on a
security. ⇓ ⇓ ⇓
Premium for the Premium for Longer-term
Real RFR + Expected inflation rate. risk that borrower receiving less bonds have
will not make the than fair value more maturity
promised for an risk, because
payments in a investment if it their prices are
Reflects preferences of timely manner. must be sold more volatile.
individuals for current vs. quickly.
future real consumption.

Loan Amortization Perpetuity Annuity

Process of paying off a loan
Perpetual annuity. Stream of equal
with a series of periodic
Fixed payment at set cash flows
loan payments, whereby a intervals over an infinite accruing at equal
portion of the outstanding time period. intervals.
loan amount is paid off, or ଵ

is the discounting
௥
amortized, with each
factor for perpetuity. ⇓
payment.
Annuity Due Ordinary Annuity
Two
First cash flow ⇐ ⇒ First cash flow that
Cash flow Additivity occurs types occurs one period
PV of PV of immediately. from now.
Principle ordinary
annuity >
PV of any stream of cash due. annuity.
flows equals the sum of PV
of each cash flow as long
cash flows are indexed at
the same point in time.

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 2015 Study Session # 2, Reading # 5

Interpretations of
Interest Rate

Required rate of return.

Discount rate.

Opportunity cost.

Effective Annual Rate (EAR)

Rate of return actually being
earned after adjustments have
been made for different
compounding periods.
m

EAR = (1+ periodic rate) -1

Stated rate will be equal to the
actual (effective) rate only when it
is compounded annually.

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