Time Value of Money Terminology
Terminology (AKA jargon) can be a major impediment to understanding the concepts of finance. Fortunately, the vocabulary of time value of money concepts is pretty straightforward. Here are the basic definitions that you will need to understand to get started (calculator key abbreviations are in parentheses where appropriate):
A banker's year is 12 months, each of which contains 30 days. Therefore, there are 360 (not 365) days in a banker's year. This is a convention that goes back to the days when "calculator" and "computer" were job descriptions instead of electronic devices. Using 360 days for a year made calculations easier to do. This ...view middle of the document...
The frequency is simple a shortcut to save both time and memory. If a cash flow occurs more than one time in a row, then you would enter the number of times that it occurs (in most cases, you will leave it at 1). The next cash flow that is entered will be the next different cash flow.
This term refers to the value of a cash flow (or series of them) at some specific future time. Any cash flow that is scheduled to occur sometime later than today is referred to as a “future value.” Literally translated, future value means “what will it be worth at some future point in time?” For example, if an investment promises to pay $100 one year from now, then the $100 is the future value of the investment because that investment will be worth $100 at that point in time.
Internal Rate of Return
The compound average annual rate of return that is expected to be earned on an investment, assuming that the investment is held for its entire life and that the cash flows are reinvested at the same rate as the IRR. Investments that have an IRR that is greater than or equal to the cost of funds (WACC) should be accepted.
Modified Internal Rate of Return
The compound average annual rate of return that is expected to be earned on an investment, assuming that the investment is held for its entire life and that the cash flows are reinvested at a rate that is different from the IRR. Typically, the reinvestment rate is assumed to be the WACC. Investments that have an MIRR that is greater than or equal to the cost of funds (WACC) should be accepted. Note that the difference between MIRR and IRR is in the assumed reinvestment rate.
Net Present Value
The present value of the future cash flows less the cost of the investment. The NPV is a direct measure of "cost versus benefit." It represents the economic profit to be earned by making an investment. Rational investors will take all investment opportunities that have an expected NPV greater than or equal to zero. If you use Excel (or any other spreadsheet program) you should read my post about the misleading nature of the NPV function.
Number of Periods
The total number of periods is a key variable in all time value of money problems. It is important to distinguish between the number of periods and the number of years. For example, we may refer to a “30-year mortgage.” However, unless the payments are made annually, the number of periods is not 30. Instead, the number of periods would be 360 (= 30 years x 12 months per year). Similarly, we may say that “this bond has 10 years to maturity.” In this case, the number of periods would be 20 (= 10 years x 2 semiannual periods per year) because bonds typically pay interest semiannually.
The payment is the amount of a cash flow. Typically, payment refers to the amount of the cash flow in an annuity. This is especially true when using financial calculators or spreadsheet functions.
A period is simply a unit of time. Note that, depending on the...