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Questions and Answers
What is the main difference between simple interest and compound interest?
What is the main difference between simple interest and compound interest?
In the example of borrowing $10,000 for 3 years at 5% simple annual interest, what would be the total interest paid?
In the example of borrowing $10,000 for 3 years at 5% simple annual interest, what would be the total interest paid?
Which statement best defines 'future value' in financial management?
Which statement best defines 'future value' in financial management?
If $10,000 is borrowed for 60 days at 5% simple interest per year, what is the interest earned?
If $10,000 is borrowed for 60 days at 5% simple interest per year, what is the interest earned?
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What does the term 'present value' refer to in financial management?
What does the term 'present value' refer to in financial management?
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What does the time value of money (TVM) concept primarily assert?
What does the time value of money (TVM) concept primarily assert?
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Which of the following is NOT a reason why money has time value?
Which of the following is NOT a reason why money has time value?
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What are the two basic types of interest discussed in the time value of money?
What are the two basic types of interest discussed in the time value of money?
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Why is it said that "a birr today is worth more than a birr tomorrow"?
Why is it said that "a birr today is worth more than a birr tomorrow"?
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Which statement best describes the role of interest in financial management?
Which statement best describes the role of interest in financial management?
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Study Notes
Time Value of Money
- Money available at the present time is worth more than the same amount in the future due to its potential earning capacity.
- This concept is crucial in financial management for comparing investments and resolving loan, mortgage, and lease issues.
- A sum of money today is more valuable than a similar sum in the future, as it can be invested to earn returns.
Why Money Has Time Value
- Inflation: Money's purchasing power diminishes over time due to rising prices.
- Risk: Future cash flows are uncertain, potentially offering less value than present promises.
- Consumption preference: People typically prefer immediate gratification to delayed rewards.
Simple Interest
- Calculated only on the principal amount.
- Simple Interest = Principal × Interest Rate × Time
- Used for short-term financial decisions.
Compound Interest
- Calculated on the principal and accumulated interest from prior periods.
- Interest earned in one period is added to the principal to compute the interest for the next period.
- More valuable for long-term financial planning.
Number of Periods
- The intervals of time used in time value of money calculations.
- Intervals must align with compounding or payment periods.
Payments
- Cash flows (inflows or outflows).
- These values must represent all the inflows and outflows in a financial transaction.
Present Value
- The current worth of a future sum of money or stream of payments.
- The concept quantifies how much a future amount needs to be discounted to derive its current equivalent value.
Future Value
- The value to which an initial amount or a stream of payments will grow over time, given a specific interest rate and investment period.
- Future value usually exceeds present value due to accrued returns over time.
Interest
- A percentage cost of using money for a set duration.
- Usually expressed as a percentage of the amount borrowed or invested.
- Simple and compound are two primary forms of interest.
Future Value of Single Amount
- The future value is the amount an investment will reach on a future date with a fixed compounding interest rate.
- FV = PV × (1 + i)n
Future Value of Ordinary Annuity
- The future value of a series of equal payments made at the end of each period.
- FVOA = PMT × [(1 + i)n – 1] / i
Future Value of Annuity Due
- The future value of a series of equal payments made at the beginning of each period.
- FVAD = FVOA × (1 + i)
Present Value of Single Amount
- The present value is the current equivalent value of a future sum of money.
- PV = FV / (1 + i)n
Present Value of Ordinary Annuity
- The present value of a series of equal payments made at the end of each period.
- PVOA = PMT × [1 – (1 + i)-n] / i
Annuity
- A series of equal payments (or receipts) made at fixed, regular intervals.
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Description
Explore the concept of Time Value of Money, an essential principle in finance that illustrates how money's value changes over time due to factors like inflation, risk, and consumption preference. Understand the differences between simple and compound interest and their implications for financial decision-making.
