CFAi Level 1 2010 Book 1 Formulas & Notes

The Time value of money (Reading 5 page 181):

An interest rate, denoted r, is a rate of return that reflects the relationship between differently dated
cash flows.
r = Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity premium +
Maturity premium
An opportunity cost is the value that investors forgo by choosing a particular course of action.
The Future Value Of A Single Cash Flow: FVN = PV(1 + r)N (2)
PV = present value of the investment
FVN = future value of the investment N periods from today
r = rate of interest per period
The Frequency of Compounding: FVN = PV(1 + rs /m)mN (3)
Rather than quote the periodic monthly interest rate, financial institutions often quote an annual
interest rate that we refer to as the stated annual interest rate or quoted interest rate. We denote the
stated annual interest rate by rs .
r N
Continuous Compounding: FVN = PVe s (4)
Stated and Effective Annual Rates: EAR = ( 1 + Periodic interest rate)m – 1 (5)
r
With continuous compounding, the effective annual rate: EAR = e s – 1 (6)
The Future Value Of A Series Of Cash Flows:
An annuity is a finite set of level sequential cash flows.
• An ordinary annuity has a first cash flow that occurs one period from now (indexed at t = 1 ) .
• An annuity due has a first cash flow that occurs immediately (indexed at t = 0).
• A perpetuity is a perpetual annuity, or a set of level never-ending sequential cash flows, with the first
cash flow occurring one period from now.
() 
The Future Value of a N-Year Ordinary Annuity: FVN = A
(7)

The Present Value Of A Single Cash Flow: PVN = FVN (1 + rs) – N (8)
 
The Frequency of Compounding: PVN = FVN
 +  (m = # of compounding periods /year) (9)
   
The Present Value of a Series of Equal Cash Flows: PV=() + () +…+ () + () (10)
We find the present value by multiplying the annuity amount by a present value annuity factor
()
(the term in brackets in Equation 11 ) PVN = A
(11)

()
PV(Annuity due) = A
(1 + r).


The Present Value of an Infinite Series of Equal Cash Flows-Perpetuity: PV= A ∑

(12)
()

As long as interest rates are positive, the sum of present value factors converges and PV =  (13)
1/N
Solving for Interest Rates and Growth Rates: g=(FVN/PV) –1 (14)