Chapter 4: The Time Value of Money

Question 1

Time Line

Answer 1

• a linear representation of the timing of potential cash flows
• drawing helps visualize the financial problem
• differentiate between two types of cash flows (in and out flows)

Question 2

Inflows

Answer 2

positive cash flows

Question 3

Outflows

Answer 3

negative cash flows which are indicated with a − (minus) sign

Question 4

Future Value

Answer 4

the amount by which an investment made today would grow to over some period of time at a given interest rate

Question 5

Simple Interest

Answer 5

interest is earned only on the original investment

Question 6

Compound Interest

Answer 6

• the combined effect of earning interest on the original principal plus interest on accrued interest
• interest earned on interest
• this time you earn interest on interest
• interest earned per year = previous year’s balance x interest rate

Question 7

Compounding

Answer 7

computing the return on an investment over a long horizon by multiplying the return factors associated with each intervening period

Question 8

Compound Annual Growth Rate (CAGR)

Answer 8

geometric average annual growth rate; year-over-year growth which, if applied to the initial value and compounded, will lead to the final value

Question 9

Present Value

Answer 9

• the value of a cost or benefit computed in terms of cash today
• the current value of a future amount discounted by an appropriate discount rate for a given period of time

Question 10

Doubling Investments

Answer 10

• rule of 72
• years it takes to double= 72/ interest rate

ex. 72/6 = 12
it will take 12 years to double the investment

Question 11

Interest Rate Forward Contract

Answer 11

a contract today that fixes the interest rate for a loan or investment in the future

Question 12

Time Value of Money

Answer 12

the difference in value between money today and money in the future; also, the observation that two cash flows at two different points in time have different values

Question 13

Discount Rate

Answer 13

• the rate used to discount a stream of cash flows
• the cost of capital of a stream of cash flows

Question 14

Discounting

Answer 14

finding the equivalent value today of a future cash flow by multiplying by a discount factor, or equivalently, dividing by 1 plus the discount rate

Question 15

Regular Perpetuity

Answer 15

a stream of equal cash flows that occurs at regular intervals and lasts forever

Question 16

Consol

Answer 16

a bond that promises its owner a fixed cash flow every year forever

Question 17

Regular Annuity

Answer 17

is a stream of “n” equal cash flows paid over constant time intervals

Question 18

Annuity

Answer 18

a stream of periodic cash flows that ends after some fixed number of payments

Question 19

Growing Perpetuity

Answer 19

a stream of cash flows that occurs at regular intervals and grows at a constant rate forever

Question 20

Growing Annuity

Answer 20

• a stream of “n” growing cash flows paid at regular intervals
• eventually ends

Question 21

Annuity Spreadsheet

Answer 21

• an Excel spreadsheet that can compute any one of the five variables of NPER, RATE, PV, PMT, and FV
• given any four input variables the spreadsheet computes the fifth

Question 22

Arbitrage

Answer 22

the practice of buying and selling equivalent goods or portfolios to take advantage of a price difference

Question 23

Arbitrage Opportunity

Answer 23

any situation in which it is possible to make a profit without taking any risk or making any investment

Question 24

Financial Security

Answer 24

an investment opportunity that trades in a financial market