1.1.1 Time Value of Money

Question 1

Explain the concept of Time Value of Money (TVM)?

Answer 1

Money today worth more than money in future (due to possible interest earnings & Inflation)

Question 2

What are the three ways to interpret interest rates?

Answer 2

Required rate of return
Discount rate
Opportunity cost

Question 3

Explain the definition of Required rate of return?

Answer 3

Required rate of return is the return required by investors or lenders to postpone their current consumption.

Question 4

Explain the definition of Discount rate?

Answer 4

Discount rate is the rate used to discount future cash flows to allow for the time value of money (that is, to bring a future value equivalent to present value).

Question 5

Explain the definition of Opportunity cost?

Answer 5

Opportunity cost is the most valuable alternative investors give up when they choose what to do with money.

Question 6

Why interest rate is considered as Risk-Free Rate?

Answer 6

In a certain world, the interest rate is called the risk-free rate.
For investors preferring current to future consumption, 【the risk-free interest rate is the rate of compensation required to postpone current consumption.】
For example, the interest rate paid by T-bills is a risk-free rate of interest.

Question 7

What are two factors that complicate / affect interest rates?

Answer 7

Inflation and Risk

Question 8

How Inflation complicates the interest rate?

Answer 8

Inflation:
【When prices are expected to increase, lenders charge not only an opportunity cost for postponing consumption but also an inflation premium that takes into account the expected increase in prices. 】
The nominal cost of money consists of the real rate (a pure rate of interest) and an inflation premium.

Question 9

How do Risks complicate the interest rate?

Answer 9

Risk:
Companies exhibit varying degrees of uncertainty concerning their ability to repay lenders. 【Lenders therefore charge interest rates that incorporate default risk.】
The return that borrowers pay thus comprises the nominal risk-free rate (real rate + an inflation premium) and a default risk premium.

Question 10

What is Compounding ?

Answer 10

Compounding is the process of accumulating interest over a period of time.

The compounding period = the number of times per year that interest is paid.

Continuous compounding occurs when the number of compounding periods becomes infinite; interest is added continuously.

Question 11

What is Discounting ?

Answer 11

Discounting is the calculation of the present value of some known future value.

Discount rate is the rate used to calculate the present value of some future cash flow.

Discounted cash flow is the present value of some future cash flow.

Question 12

1. Which of the following statements is true?
   A. Simple interest applies when an investor receives payment while compound interest applies when an investor makes payments.
   B. Simple interest annualized rates while compound interest allows interest to be stated in any time period.
   C. Simple interest pays interest only on principal whereas compound interest also pays interest on interest.
   D. Simple interest relates to present value whereas compound interest relates to future value.
   E. Simple interest relates to future value whereas compound interest relates to present value.

Answer 12

Correct Answer: C. Simple interest pays interest only on principal whereas compound interest also pays interest on interest.

Question 13

2. The time value of money underlies ______.
   I. rates of return, interest rates, and required rates of return
   II. discount rates and opportunity costs
   III. inflation and risk

Answer 13

Correct Answer: I, II and III

Question 14

3. In an uncertain world, two factors complicate interest rates, namely ______.
   A. inflation premium and risk
   B. opportunity cost and risk
   C. inflation and risk

Answer 14

Correct Answer: C inflation and risk

Question 15

3. In an uncertain world, two factors complicate interest rates, namely ______.
   A. inflation premium and risk
   B. opportunity cost and risk
   C. inflation and risk

Answer 15

Correct Answer: C inflation and risk

Question 16

4. If other factors are equal, a decrease in the expected rate of inflation will most likely result in a decrease in ______.
   A. the real risk-free rate
   B. the nominal risk-free rate
   C. both real and nominal risk-free rates

Answer 16

Correct Answer: B The nominal risk-free rate of return includes both the real risk-free rate of return and the expected rate of inflation. A decrease in expected inflation rate would decrease the nominal risk-free rate of return, but would have no effect on the real risk-free rate of return.