ABOUT THIS CONTENTNotes from various chapters in the core finance textbook, Financial Management, Concepts and Applications by Ramesh K.S. Rao.
Source: Financial Management, Concepts and Applications by Ramesh K.S. Rao
- Higher interest rates indicate that people’s time preference is increasing. That is, that people want money now instead of later because they believe they can earn a greater return on the money and are willing to accept less (discounted at a higher rate). This indicates that the productivity of capital is increasing – the rate of return on the use of that capital is expected to be greater in the future.
- Compounding is the process of extrapolating a future value of a cash flow or series of cash flows at a given interest rate. It determines the future value of those cash flows. Discounting is the opposite, where the present value of future cash flows is determined as of today (or a earlier point in time).
- Simple interest earns a rate of return on an investment at a fixed percentage over time but does not earn interest on the interest. Compound interest allows interest to earn interest by allowing the interest earned to accrue through reinvestment.
- The future value of investment decreases when the interest rate decreases. The present value of an investment increases when the interest rate decreases.
- An ordinary annuity includes cash flows that occur at the end of given time intervals. An annuity due’s cash flows occur at the beginning of the time intervals. An insurance premium paid in advance is an annuity due while a house payment is an ordinary annuity. The timing is significant because of the time value of money. Annuity dues start earning interest earlier (by one period) than ordinary annuities.
- An annuity is a schedule of cash flows that occur at fixed intervals through time until a certain date. A perpetuity is a series of cash flows that continue indefinitely.
- A stock variable has no time dimension. It is simply a number at a particular point in time. A flow variable is a stream of cash flows over time. Examples:
- The amount of cash in your wallet – stock variable
- Monthly social security payments made to senior citizens – flow variable
- The value of your car – stock variable
- The monthly payments on your car – flow variables
- The GNP in the US – stock variable
- Rent on an apartment – flow variable