Critical Finance Terminology Answers
BM200-1 Chapter 3
Bryan Sudweeks
The purpose of this handout is to define a specific base of terms that the non-financial
person should understand. Understanding these terms is critical to understanding the
power and the beauty of personal finance. If you will learn these terms and the methods
of calculation, I can (with almost 99% accuracy) promise you that at some point in the
future they will save you thousands of dollars.
Prior to the advent of the computer and the financial calculator, the only way people
could get much of this financial information was via hand calculations or the slide rule.
As such, investors developed a set of tables to help the student/investor understand the
relationships between time, interest rate, and compounding periods. These tables are
commonly referred to as the Compound Sum of $1 (page 586-587), Present Value of $1
(588-589, Compounding Sum of an Annuity of $1 for n Periods (590-591), Present Value
of an Annuity of $1 for n Periods (592-593), and Monthly Installment loan table with
interest payments compounded monthly. I require you to be able to use a financial
calculator, which you will need before Class Period #3.
1. Principle
This is the money that you have to invest or save, or the stated amount on a bond or
deposit instrument.
2. Interest or discount rate
The interest is the stated rate that you will receive for investing for a specified time at
a specified compounding period.
3. Effective Interest Rate
The actual rate (as opposed to the stated rate) received after taking into account the
effects of compounding and non-annual periods.
4. Reinvesting
This is the process of taking both principle and interest that you have earned on an
investment and investing it again in the same or similar investment.
5. Future Value (FV)
The value of an investment at some point in the future, used for planning and
forecasting purposes.
6. Present Value (PV)
The current value, that is the value in today’s dollars, of a future sum of money or
stream of money.
7. Compounding (annually, quarterly, daily, etc.)
The process of receiving interest on an investment, and then having both principle and
previously earned interest earn interest again (hence the interest earning interest
principle). The period is the number of times during the year where interest is
calculated. The shorter the compounding period, the higher the effective rate of
interest.
8. Future Value Interest Factor (FVIF) or Compound Sum of $1
The value of (1+interest)n used as a multiplier to calculate an amount of future value.
If you do not have a financial calculator, it can be accessed through the Compound
Sum of $1 tables on page 586-587.
This factor is used to answer the question: Assuming I have a specific dollar amount
now, what will be the value of that investment assuming I can invest it for a specific
number of years at a certain interest rate.
The formula for is FV = (PV) (1 + i)n, i.e, the Future Value = Present Value times
FVIF or (1 + i)n. Rearranging the terms, the FVIF or (1 + i)n = FV/PV
9. Present Value Interest Factor (PVIF)
A value of [1/(1+interest)n ] used as a multiplier which multiplied by your future
value, gives a value in today’s dollars.
This factor is used to answer the question: Assuming I will receive a specific dollar
amount at a specified number of years in the future, what is the value of that
investment in today’s dollars assuming I have to discount that future amount by a set
interest or discount rate.
10. Annuity
A series of equal dollar payments coming at the end of each time period for a specified
number of time periods, generally months or years.
11. Compound Annuity
An investment that involved depositing an equal sum of money at the end of each
year for a certain number of year and allowing it to grow
12. FVIF of an Annuity
A multiplier used to determine the future value of an annuity or future value of a
set of constant payments.
This is used to answer the question: Assuming I make a payment every year for n
years, and given the discount or interest rate i, what will be the value of my investment
when I retire in n years?
The formula is FVn = Payment * (FVIFAi,n)
13. PVIF of an Annuity
A multiplier used to determine the present value of an annuity or constant periodic
payments.
To compare annuities, you need to put them all on a constant basis and compare the
present value, in today’s dollars, of each. This factor is used to answer the question:
Assuming I will have payments every year for n years, and given the discount or
interest rate i, what is the current value of my investment in today’s dollars?
The formula is PVn = Payment * (PVIFAi,n)
14. Amortized Loan
A loan paid off in equal installments, both principle and interest is an amortized
loan. It is similar to an annuity.
It is used to answer the question: Assuming you want to borrow x dollars at i percent
interest, and you want to repay it in z annual payments. How much will you have to
pay each year?
The formula is PVn = Payment * (PVIFAi,n). Put your borrowed amount into the
equation, and solve for your payment.
15. Perpetuities
An annuity that continues forever. Every year from its establishment it pays the same
dollar amount and never stops paying.
The formula is Present Value = the dollar amount provided hear period/interest rate i.
16. Return or Nominal Return
The current value of the financial instrument plus any cash flows divided by the
original value of the investment.
This answers the question: Assuming I had a share of XYZ company that is worth $x
dollars today, paid a dividend of y dollars, and cost me z dollars 6 months ago, what
has been my return over that period.
The formula is (current price + dividends) / previous price. It is your return over a
specific period.
17. Real Return
The return after you separate out the impact of inflation. It is the return in real
purchasing power terms, i.e. in terms of what you could buy. While some
textbooks calculate the real return as your return less inflation, that is close but not
close enough. The correct formula is:
( 1 + nominal return)
(1 + inflation)
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Critical Finance Terminology Answers