Time Value of Money (TVM)
Understanding how the time value of money works can be most easily explained by taking your initial investment let us say $10 by the end of year five it could be worth $100. This means you have earned $90 in the last five years. Next year, you invest $10 and at the end of year five it is worth $80 because interest has not accumulated on the time that was lost between year 1 and year 2. My example of this is that my fiancé put $3000 in each of his children's name when they were born, by the time they are ready to attend college or serve a mission; there should be enough money in there to pay for a large portion of that. I am currently working on investing this for my three children ages; 11, 6, and 3. I must put in a larger dollar amount in my 11 year old account so that she may end up equal to my three year old.
Interest Rates and Compounding
Interest Rate Risk should be evaluated any time that you invest money. Where will your dollar make the most profit? Typically, the rule is when markets required returns increase, price of assets decreases. It is smart to buy when returns decrease because it means that the price of the asset is increasing. This is often seen in bonds and can be figured by how much interest you require in order to make it worth it for you. Compounding is figuring the amount you have today and then figuring what it will be worth say in 3 years at a 10% interest rate. This table would start at 0 because that is today and then go up to $110 end of year one, then $121 at the end of year two and so forth. Compounding is typically used when trying to determine a future value.
Annuities # 3
Present Value or Discounting determines what the actual investment made was. It gives you a number that is figured with interest over a period of time and to figure out what the initial investment was to see if you made your required return. This is a backwards...