Study Guide Test 2.docx - Study Guide Test#2 Chapter 5 The Time Value of Money 1 The Time Value of Money is the difference between a dollar in hand

# Study Guide Test 2.docx - Study Guide Test#2 Chapter 5 The...

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Study Guide Test #2 Chapter 5: The Time Value of Money 1. The Time Value of Money: is the difference between a dollar in hand today and a dollar promised in the future. A dollar today is worth more than a dollar in the future because we can earn interest on today’s dollar. 2. Future Value: measures the value of an investment after it earns interest for one or more periods. (Compounding) FV = PV (1+ i ) n 3. Single Period Investment & Two Period Investment: Single-period Investment: o We can determine the balance in an account at the end of a period if we know the interest rate earned on the principal o If principal of \$P 0 is loaned for one period at the interest rate i , the account balance will increase to \$P 0 (1 + i ) 1 o The term (1+ i ) n is the future value interest factor, or future value factor Two-period Investment: o A two-period loan is two consecutive single-period loans o Interest earned is added to the account at the end of the first period and the new account balance is the amount that earns the interest rate i during the second period o The account balance is \$ P 0 (1 + i ) 1 at the end of the first period and \$ P 0 (1 + i ) 2 at the end of the second period 4. Principle: is the amount of money on which interest is paid. 5. Simple Interest, Compound Interest, Interest on Interest: Simple Interest: is the amount of interest paid on the original principle amount. Interest on Interest: is the interest earned on the reinvestment of previous interest payments. Compound Interest: consists both simple interest and interest on interest. 6. Compounding: is the process by which interest earned on an investment is reinvested so that in future periods, interest is earned on the interest previously earned as well as the original principle. 7. Present Value: measures the current value of future cash flows discounted at the appropriate interest rate. (Discounting) Time and the discount rate affect present value o The greater the amount of time before a cash flow is to occur, the smaller the present value of the cash flow o The higher the discount rate, the smaller the present value of a future cash flow 8. Discounting & Discount Rate: The process of calculating the present value is called discounting , and the interest rate i is known as the discount rate.
9. The Rule of 72: is a shortcut to estimate the number of periods it takes for an amount to double This shortcut is fairly accurate for interest rates between 5% and 20% The time to double your money (TDM) where i is the rate of return is: TDM = 72 i Chapter 8: Bond Valuation and Bonds Notes 1. Types of Corporate Bonds (Vanilla, Convertible, Zero Coupon): Vanilla bond

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