Chapter 5

Question 1

Compounding

Answer 1

Finding the FV of a cash flow or series of cash flows

Question 2

Solving for FV formula

Answer 2

FV= PV(1+I)^n

Question 3

Discounting

Answer 3

Finding the PV of a cash flow or series of cash flows.

The PV discounts a future cash flow to its value today

Question 4

Ordinary Annuity

Answer 4

Payments occur at the end of each period.
No PV is entered when solving for FV bc you neither pay nor receive any money except for the annuity payments, and vice versa

Question 5

Annuity Due

Answer 5

Payments occur at the BEGINNING of each period.

When using financial calc, must press BEGIN first.

Question 6

Perpetuity

Answer 6

PV=PMT/I

Question 7

Will the FV of a lump sum be larger or smaller if compounded more often?

Answer 7

Larger bc the more frequently compounding occurs, interest is earned on interest more often

Question 8

Nominal rate

Answer 8

Interest rate stated in contracts. Ignores compounding.
Aka quoted or stated rate.
Not used in calculations

Question 9

Periodic rate

Answer 9

Rate charged each period(semi-annual or monthly rate)

Nominal rate/#periods (M)

Question 10

Effective Annual Rate (EAR)

Answer 10

Annualized interest rate actually earned, considering intra-year compounding.
Used to compare returns on investments with different number of payments per year.

EAR=(1+nom/M)^M -1

Question 11

Why is it important to consider effective rates of return?

Answer 11

Investments with different compounding intervals provide different effective returns.
To compare investments with different compounding intervals, you must look at their effective returns (EFF% or EAR)

Question 12

Relationship b/w effective rate and nominal rate.

Answer 12

• Effective rate is equal to the nominal rate only if annual compounding is used (M=1)
• If M>1, EFF% will always be greater than the nominal rate