chapter 5 flashcards

Question 1

what is Future Value?

Answer 1

the amount to which a present value will grow after earning interest

Question 2

there are two kinds of interest that money can earn?

Answer 2

• simple interest
• compound interest

Question 3

what is Simple Interest?

Answer 3

interest is arened only on the original investment and no interest is earned on interest

Question 4

what is Compound Interest?

Answer 4

interest is earned on interest

Question 5

Interest Earned Per Year
formula

Answer 5

previous years balance x interest rate

Question 6

the formula for the future value of I dollars at r% interest per period for T periods is…

Answer 6

FV=I x (1+r)t

Question 7

how do we calculate Present Value
formula

Answer 7

future values after t periods / (1+r)t

r= discount rate (interest rate used to compute present values of future cash flows)

Question 8

how do we write the Present Value formula if their a discount factor ?
formula

Answer 8

future payment x 1/(1+r)t

the discount factor measures the present value of $1 to be received in t years from today at a discount rate of r%

Question 9

how do you know which Present Value options are better at the present ?

Answer 9

for the buyer, the option where they have to pay less would be better. the opposite goes for the dealer, the option with more money would be best

Question 10

what is a Annuity ?

Answer 10

equally spaced, and level stream of cash flows
ex: loan payments for automobiles, home mortgage

Question 11

what is a Perpetutiy?

Answer 11

stream level of cash payments that never ends (infinite period)

Question 12

how do we value Perpetuties?

Answer 12

• the PV of a perpetuity is calculated b y dividing the level cash flow (C) by the interest rate (r)
• cash payment from perpetuity = interest rate x present value
  C= r x PV
• Present value of perpetuity = Cash Payment / interest rate

Question 13

how do we calculate PV of t-period annuity?
formula

Answer 13

C x [1/r - 1/r(1+r)t]

Question 14

how do we calculate FV of t-period annuity ?
formula

Answer 14

C [(1+r)t - 1 / r]

Question 15

whats the difference between a t-year ordinary annuity and a t-year annuity due ?

Answer 15

• t-year Ordinary Annuity: when you don’t have an immediate payment, but you pay for t-years
• t-year Annuity Due: you start with an immediate payment + the rest of the year you have to pay

Question 16

what is Growing Perpetutity?

Answer 16

an INFINTIE stream of cash flows growing at a constant rate

Question 17

what is Growing Annuity ?

Answer 17

a FINITE stream of cash flows growing at a constant rate

Question 18

whats the formula for PV at a growing perpetuity?
formula

Answer 18

[C1 / r-g]
C1= payment to occur at the end of the first period
r=discount rate
g=growth rate of the payments

Question 19

what is the formula for PV of growing annuity ?
formula

Answer 19

C1 / r-g (1 - [1+g/1+r]t)
C1= payment to occur at the end of the first period
r=discount rate
g=growth of the payments
t=the number of payments

Question 20

what is Inflation?

Answer 20

rate at which prices as a whole are increasing

Question 21

what is Nominal Interest Rate?

Answer 21

rate at which money invested grows

Question 22

what is Real Interest Rate?

Answer 22

rate at which the purchasing power of an investment increases

Question 23

how do we calculate the real rate of interest ?
formula

Answer 23

1+real rate=1+nominal rate/1+inflation rate

OR

real rate of interest=nominal rate of interest - inflation rate

Question 24

what is Effective Annual Interest Rate(EAR)?

Answer 24

interest rate that is annualized using compound interest

Question 25

what is Annual Percentage Rate (APR)?

Answer 25

interest rate that is annualized using simple interest

Question 26

what is the formula for EAR?
(m is the number of compounding per year)

Answer 26

EAR= {1 + APR/m}m - 1