FIN1FOF Fundamentals of Finance - Topic 2: Time Value of Money
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Questions and Answers

What is the future value of a $100,000 investment at an interest rate of 10% per annum for one year?

  • $110,000 (correct)
  • $100,000
  • $105,000
  • $95,454.55

    • What is the present value of a $110,000 cash flow received in one year at an interest rate of 10% per annum?

  • $105,000
  • $95,454.55
  • $110,000
  • $100,000 (correct)

    • What is the present value of a $105,000 cash flow received in one year at an interest rate of 10% per annum?

  • $105,000
  • $110,000
  • $100,000
  • $95,454.55 (correct)

    • What is the fundamental rule of financial decision-making that states that values can only be compared or combined if they are at the same point in time?

    <p>Rule 1</p> Signup and view all the answers

    What is the process of calculating a future value over many periods by repeatedly applying the calculation?

    <p>Compounding</p> Signup and view all the answers

    What is the frequency of compounding that takes into account the effect of interest on interest over an infinite number of periods?

    <p>Continuous Compounding</p> Signup and view all the answers

    What is the process of moving a cash flow from one point in time to another?

    <p>Discounting</p> Signup and view all the answers

    What is the term for the process of calculating the value of a cash flow at an earlier point in time?

    <p>Discounting</p> Signup and view all the answers

    What is the primary reason for converting the interest rate and time period when using the PV and FV formulas?

    <p>To align with the frequency of compounding</p> Signup and view all the answers

    If interest compounds semi-annually, how many times a year does it compound?

    <p>Twice a year</p> Signup and view all the answers

    What is the result of increasing the frequency of compounding infinitely in theory?

    <p>Continuous compounding</p> Signup and view all the answers

    To calculate n in the PV and FV formulas, what operation should be performed?

    <p>Multiply the number of years by the number of periods per year</p> Signup and view all the answers

    What is the purpose of moving cash flows across time in time value of money calculations?

    <p>To evaluate the present value or future value of a cash flow</p> Signup and view all the answers

    How often does interest compound if it compounds daily?

    <p>365 times a year</p> Signup and view all the answers

    What is the result of compounding interest more frequently than annually?

    <p>An increase in the future value of a cash flow</p> Signup and view all the answers

    What is the primary distinction between discrete compounding and continuous compounding?

    <p>The frequency of compounding</p> Signup and view all the answers

    What is the formula for the future value of a single cash flow?

    <p>FVn = C × (1 + r)^n</p> Signup and view all the answers

    What is the present value of a cash flow of $100 in 5 years, given an interest rate of 5% per annum?

    <p>$82.27</p> Signup and view all the answers

    What is the difference between the frequency of compounding and the number of years?

    <p>The frequency of compounding is always less than the number of years.</p> Signup and view all the answers

    What is the effect of continuous compounding on the future value of a cash flow?

    <p>It increases the future value of a cash flow.</p> Signup and view all the answers

    What is the relationship between the present value and future value of a cash flow?

    <p>The present value is always less than the future value.</p> Signup and view all the answers

    How does the frequency of compounding affect the present value of a cash flow?

    <p>It decreases the present value of a cash flow.</p> Signup and view all the answers

    What is the formula for the present value of a single cash flow?

    <p>PV = C / (1 + r)^n</p> Signup and view all the answers

    What is the effect of moving a cash flow across time on its present value?

    <p>It decreases the present value of a cash flow.</p> Signup and view all the answers

    How does the interest rate affect the present value of a cash flow?

    <p>An increase in the interest rate decreases the present value of a cash flow.</p> Signup and view all the answers

    What is the relationship between the frequency of compounding and the number of periods?

    <p>The frequency of compounding is always less than the number of periods.</p> Signup and view all the answers

    Study Notes

    Time Value of Money

    • Interest rates are usually quoted per annum (p.a.) and periods of time are quoted in years, so we need to convert the interest rate and time period to find r and n.

    Frequency of Compounding

    • Interest can compound:
      • Semi-annually (twice a year)
      • Quarterly (4 times a year)
      • Monthly (12 times a year)
      • Fortnightly (26 times a year)
      • Weekly (52 times a year)
      • Daily (365 times a year)
    • To calculate r in the PV and FV formulas:
      • Divide the annual interest rate by the number of periods per year
    • To calculate n in the PV and FV formulas:
      • Multiply the number of years by the number of periods per year

    Continuous Compounding

    • In theory, compounding periods could become infinitely small, and the number of compounding periods infinitely large
    • This is called continuous compounding
    • Although interest can’t literally be calculated in this way, many financial valuations involving growth in value other than from interest use continuous compounding

    Future Value of a Single Cash Flow

    • The general formula for the future value of a single cash flow is: FVn = C × (1 + r)^n
    • Where:
      • C = the cash flow
      • r = the interest rate per period
      • n = the number of periods
      • FVn = the future value of cash flow C in period n

    Present Value of a Single Cash Flow

    • The general formula for the present value of a single cash flow is: PV = C / (1 + r)^n
    • Where:
      • C = the future cash flow
      • r = the interest rate per period
      • n = the number of periods
      • PV = the present value of cash flow C paid in n periods

    Rules of Financial Decision-Making

    • Rule 1: It is only possible to compare or combine values at the same point in time
    • Rule 2: To calculate the future value of a cash flow, you must compound it
    • Rule 3: To calculate the value of a cash flow at an earlier point in time, you must discount it

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    Description

    This quiz covers the topic of time value of money in finance, including frequency of compounding and calculation of interest rates.

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