2.01 - Time Value of Money - Questions

Question 1

What is the definition of simple interest?

Answer 1

Simple interest does not include the reinvestment of any interest earned in a previous period in the calculation of a subsequent periods

Question 2

What is the definition of compound interest?

Answer 2

Compound interest adds the interest earned during in preceding period to the principal when calculating interest earned in a subsequent period.

Question 3

What is the definition of nominal interest?

Answer 3

Nominal interest is the basic rate charged / earned for any compounding period. Unlike effective interest, it is not necessarily expressed in annualized terms.

Question 4

What is the definition of effective interest (or effective yield)?

Answer 4

Effective interest allows investors to compare different yields using a common point of reference: the total annual return.

Question 5

What does “present value” refer to?

Answer 5

Present value defines the value of a sum of money received in the future in today’s dollars. It can also be used to assess the present value of a series of future payments instead of just one.

Question 6

What does “future value” refer to?

Answer 6

Future value refers to the final, terminal value of an investment after compounding at a given rate of return for a given period. It can also be used to calculate the future value of a series of investments made over a period of time.

Question 7

What is an ordinary annuity?

Answer 7

An ordinary annuity is where payments are made at the end of the period.

Question 8

What is an annuity due?

Answer 8

An annuity due is where payments are made at the beginning of the period.

Question 9

When calculating a deferred payment for an annuity, what two stages need to be included in the calculation?

Answer 9

The two stages are the “deferral stage” before payments begin, and the payment phase.

Question 10

How often are bond payments typically made?

Answer 10

Bonds typically pay semi-annually.

Question 11

What three factors determine the prices (present value) at which bonds are traded?

Answer 11

The present value of a bond in turn is a function of 1) current interest rates (IY) 2) the coupon rate (for calculating PMT) and 3) payments associated with the bond.

Question 12

What is the relationship between current bond prices and prevailing interest rates?

Answer 12

When interest rates rise, bond prices fall because (coupon < interest rates = “discount”); when interest rates fall, bond prices rise (coupon > interest rates = “premium”).

Question 13

What is the definition of “real rate of return”? What is the formula?

Answer 13

The rate of return is the nominal interest rate after adjusting for inflation.
Real Rate of Return = (i – infl) ÷ (1 + infl)

Question 14

What is the formula for the after-tax rate of return?

Answer 14

After-Tax Rate of Return = i x (1 – MTR)

Question 15

What is the formula for the real after-tax rate of return?

Answer 15

Real After-Tax Rate of Return = (i x (1 – MTR) – infl) ÷ (1 + infl)

Question 16

What is the formula for perpetuals?

Answer 16

PV = PMT per year ÷ I/Y

Question 17

What is the definition of net present value (NPV)?

Answer 17

The net-present value function solves for the present value of a series of future cash flows. By discounting all future cash flows to the present point in time using a nominal interest rate, the output is a net monetary gain (or loss) from a potential investment.

Question 18

What is an internal rate of return (IRR)?

Answer 18

IRR is net-present value expressed in the form of a percentage, rather than a dollar value. If a project has a positive NPV, it will also have an IRR greater than the cost of capital (or nominal interest rate).