chapter 4

Question 1

stream of cash flows

Answer 1

a series of cash flows lasting several periods. it is represented on a timeline.

Question 2

timeline

Answer 2

a linear representation of the timing of the expected cash flows. date 0 represents the present and date 1 is one time unit later and represents the end of this time unit. timelines identify events in a transaction or investment that are easy to overlook.

Question 3

compounding

Answer 3

the process of moving a value or cash flow forward in time. time value of money.

Question 4

time value of money

Answer 4

the difference in value between money today and money in the future. it reflects the fact that by having money sooner, you can invest it and have more money later as a result.

Question 5

compounding interest

Answer 5

the effect of earning ‘interest on interest’.

Question 6

discounting

Answer 6

the process of moving a value or cash flow back in time; finding the equivalent value today of a future cash flow.

Question 7

perpetuity

Answer 7

a stream of equal cash flows that occur at regular intervals and last forever.

Question 8

consol bonds

Answer 8

promise the owner a fixed cash flow every year, forever. the first cash flow does not occur immediately. it arrives at the end of the first period.

Question 9

payment in arrears

Answer 9

when the first cash flow does not occur immediately. it arrives at the end of the first period.

Question 10

annuity

Answer 10

a stream of N equal cash flows paid at regular intervals. an annuity ends after some fixed number of payments.

Question 11

growing perpetuity

Answer 11

a stream of cash flows that occur at regular intervals and grow at a constant rate forever. the first payment does not include growth.

Question 12

growing annuity

Answer 12

a stream of N growing cash flows, paid at regular intervals.

Question 13

internal rate of return (IRR)

Answer 13

the interest rate that sets the net present value of the cash flows equal to zero.

Question 14

effective annual rate (EAR)

Answer 14

indicates the actual amount of interest that will be earned at the end of one year including the effect of compounding. this is also called interest on interest or compounded interest.

Question 15

annual percentage rate (APR)

Answer 15

indicates the amount of simple interest earned in one year. that is, the amount of interest earned without the effect of compounding. because of this, the APR quote is typically less than the actual amount of interest you will earn.

Question 16

continuous compounding

Answer 16

the idea of compounding the interest every instant.

Question 17

amortising loans

Answer 17

loans where you pay interest on the loan plus some part of the loan balance each month.

Question 18

outstanding balance on a loan/outstanding principal

Answer 18

the present value of the remaining future loan payments, evaluated using the loan interest rate.

Question 19

nominal interest rate (r)

Answer 19

indicate the rate at which your money will grow if invested for a certain period. it is the rate quoted by banks and other financial institutions. it is used for discounting or compounding nominal cash flows.

Question 20

real interest rate (rr)

Answer 20

determines the rate of growth of your purchasing power after adjusting for inflation. it is the rate used for discounting or compounding real cash flows.

Question 21

term structure

Answer 21

the relationship between the investment term and the interest rate.

Question 22

yield curve

Answer 22

a graph that plots the term structure of interest rates.

Question 23

federal funds rate

Answer 23

the rate at which banks borrow cash reserves on an overnight basis. the federal reserve determines very short-term interest rates through its influence on the federal funds rate.

Question 24

after-tax interest rate

Answer 24

taxes reduce the amount of interest the investor can keep. this reduced amount is the after-tax interest rate.

Question 25

opportunity cost of capital

Answer 25

the best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted. it provides the benchmark against which the cash flows of a new investment should be evaluated.

Question 26

simple interest

Answer 26

interest earned without effects of compounding.

Question 27

linear amortising loan

Answer 27

the repayment amount is fixed but total payment is high initially. the amount of interest payment per period declines.

Question 28

annuity loan

Answer 28

payments are made at set intervals, typically monthly. each payment includes interest plus repayment. the amount of repayment is a variable amount.

Question 29

amortising loan

Answer 29

all periodic payments C are equal and the loan is fully repaid with final payment at time N.

Question 30

fair loan

Answer 30

the loan balance is equal to PV loan payments.

Question 31

term

Answer 31

the time length of an investment on which interest is calculated.

Question 32

bond issuer

Answer 32

the firm or government receives money when bond is issued.

Question 33

bond holder

Answer 33

invest this money in return for future coupon payments and a final repayment at the end of the bond contract.