chapter 4 Flashcards
stream of cash flows
a series of cash flows lasting several periods. it is represented on a timeline.
timeline
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.
compounding
the process of moving a value or cash flow forward in time. time value of money.
time value of money
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.
compounding interest
the effect of earning ‘interest on interest’.
discounting
the process of moving a value or cash flow back in time; finding the equivalent value today of a future cash flow.
perpetuity
a stream of equal cash flows that occur at regular intervals and last forever.
consol bonds
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.
payment in arrears
when the first cash flow does not occur immediately. it arrives at the end of the first period.
annuity
a stream of N equal cash flows paid at regular intervals. an annuity ends after some fixed number of payments.
growing perpetuity
a stream of cash flows that occur at regular intervals and grow at a constant rate forever. the first payment does not include growth.
growing annuity
a stream of N growing cash flows, paid at regular intervals.
internal rate of return (IRR)
the interest rate that sets the net present value of the cash flows equal to zero.
effective annual rate (EAR)
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.
annual percentage rate (APR)
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.
continuous compounding
the idea of compounding the interest every instant.
amortising loans
loans where you pay interest on the loan plus some part of the loan balance each month.
outstanding balance on a loan/outstanding principal
the present value of the remaining future loan payments, evaluated using the loan interest rate.
nominal interest rate (r)
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.
real interest rate (rr)
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.
term structure
the relationship between the investment term and the interest rate.
yield curve
a graph that plots the term structure of interest rates.
federal funds rate
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.
after-tax interest rate
taxes reduce the amount of interest the investor can keep. this reduced amount is the after-tax interest rate.
opportunity cost of capital
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.
simple interest
interest earned without effects of compounding.
linear amortising loan
the repayment amount is fixed but total payment is high initially. the amount of interest payment per period declines.
annuity loan
payments are made at set intervals, typically monthly. each payment includes interest plus repayment. the amount of repayment is a variable amount.
amortising loan
all periodic payments C are equal and the loan is fully repaid with final payment at time N.
fair loan
the loan balance is equal to PV loan payments.
term
the time length of an investment on which interest is calculated.
bond issuer
the firm or government receives money when bond is issued.
bond holder
invest this money in return for future coupon payments and a final repayment at the end of the bond contract.
