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Chapter 1.

Understanding Money

Money: Standardised form of exchange, physical form is currency.
1 Euro = 1.2825 USD
1 UK (GBP) = 1.6050 USD
Interest: Amount earned on money which is lent
Simple Interest = P*n*r/100
All cash inflows/receipts are not incomes, they may be loan; all cash outflows/payments are not expense, they may
be repayment of loan.
Compound Interest: Interest earned on interest
CI = [P (1+r/100) ^n]-P; Amount = CI+P
Compounding frequency: the no of times interest is calculated per year
If CI is computed m times a year, CI = [P {1+r/ (100m)} ^ (n*m)]-P
As the compounding frequency increases, return or yield increases too.
CAGR: Compounded Annual Growth Rate = (Final value/Initial value)^(1/n)-1
It is the interest rate at which a given initial value will grow to a final value, in a given time.
Time value of Money: Since money earns interest with time, its value is different at different times.
1. Future value (FV): The amount todays money turns into in future, at the end of a given time period.
FV=PV (1+r/100) ^n
2. Present Value (PV): The amount to be invested today to earn a certain given amount in future.
PV = FV/ (1+r/100) ^n.
The process of calculating PV is called discounting as the value of PV is less than the value of FV.
3. Net Present Value (NPV): Sum of all PVs. It is a tool used to evaluate whether the rate of return of a series of
cash flows, is higher or lower than a comparison rate.
Inflows: +ve Outflows: -ve
Comparison rate is the rate of interest on some other option or the cost of borrowing an item.
NPV>0: Investment is earning more than the comparison rate
NPV=0: Investment is earning equal to the comparison rate
NPV<0: Investment is earning less than the comparison rate
4. Internal rate of return (IRR) or yield to maturity: The rate which makes the PV of all future cash inflows equal
to the cash outflows, i.e. NPV=0
Inflation: Rise in prices or decrease in value of money.
1. Nominal rate of interest (N): stated interest rate in the economy.
2. Inflation rate (I): rate at which money is losing value.
3. Real rate of interest (R): inflation adjusted rate of interest; it is the rate we actually get after deducting the
effect of inflation.
N-I=R
The price customers pay is different from the price that the wholesaler pays. So, we have:
1. Consumer Price Index (CPI)
2. Wholesale Price Index (WPI)
The index is decided by allotting a group of items (typical items of use) to each index and then deciding a
weightage for each item based on its typical proportion in the monthly budget.
Inflation is the rate of change of this weighted average price.

The way in which the inflation affects a bank (finance world) is the real rate. When the real rate is too small
(which can happen when inflation is growing fast) then savers realise that the return is negative.