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) -1

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# Critical Finance Terminology Answers