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Explain the concept of the time value of money
- Because money can be invested and interest earned on the investment, money has time value.
- An implication of money having time value is that $1 is worth less the later it is received, all other things equal
- Another implication of money having time value is that you cannot add amounts at different points in time; amounts have to be added at the same point in time
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Explain the benefits of compounding
With compound interest, you earn interest upon interest. So over time the value of an investment will grow considerably
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Explain the implications of changing the frequency of compounding
- The more frequently interest is compounded, the more interest that is earned, and, holding all else constant, the greater the future wealth from an investment
- With simple interest, interest is compounded once over the life of the investment
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Explain the relationship of effective interest rates and nominal interest rates
- The nominal interest rate is an interest rate stated over a certain period but that is not compounded at the same frequency as the period stated
- The effective interest rate is an interest rate stated over a certain period and that is compounded at the same frequency as the period stated.
- An effective annual interest rate is an interest rate compounded once per year
- A nominal annual interest rate is an interest rate stated on an annual basis but is not compounded once per year
- Interest rates can only be compared when they are compounded at the same frequency
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