Chapter 9 - The Time Value of Money: Compounding & Discounting

Question 1

Compounding

Answer 1

the ability of an asset to generate earnings that are then reinvested and generate their own earnings. The process of going from a value today to an expected buy unknown value in the future

Question 2

Discounting

Answer 2

to multiply a number by a rate less than one

Question 3

Positive Interest Rates

Answer 3

relates to the idea that “A dollar today is worth more than a dollar tomorrow”

Question 4

Risk Aversion

Answer 4

relates to the idea that “A safe dollar is worth more than a risky one.” Investors are risk averse, and would rather have lower risk associated with their investments

Question 5

Present Value

Answer 5

the amount that a future sum of money is worth today given a specified rate of return

Question 6

Future Value

Answer 6

The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. The amount an investment is expected to grow to at some future date

Question 7

Compound Interest

Answer 7

When an investment earns interest on both the original principal and the accumulated interest, or interest earned on interest

Question 8

Compound Rate

Answer 8

The rate at which an investment is compounded, used to determine the ability of an asset to generate earnings that are then reinvested and generate their own earnings

Question 9

Growth Rate

Answer 9

The variables r or i used in the compounding rate, the opportunity cost of capital or the return that is a hurdle rate for the investment

Question 10

Interest Rate

Answer 10

The variables r or i used in the compounding rate, the opportunity cost of capital or the return that is a hurdle rate for the investment

Question 11

Yield

Answer 11

The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. There are two ways to calculate FV: compound frequency and future value factor

Question 12

Compounding Frequency

Answer 12

The variable n, or the number of times the investment is compounded

Question 13

Future Value Factor

Answer 13

the number by which you multiply the present value of an investment to arrive at the future value of an investment

Question 14

Simple Interest

Answer 14

Earning interest only on the original deposit in the account, when an investment pays interest only on the original principle

Question 15

Rule of 72

Answer 15

A simple and inexact rule of thumb that provides a quick estimate of the yield on a single (one time) investment. Divide the number 72 by the interest rate to get the number of years in which the investment will double

Question 16

Single Period Investment

Answer 16

A one time investment

Question 17

Multiple Period Investment

Answer 17

An investment that is added to over a period of time

Question 18

Rate of Return

Answer 18

The gain or loss of an investment over a specified period, expressed as a percentage increase over the initial investment cost. Gains on investments are considered to be any income received from the security, plus realized capital gains

Question 19

Effective Annual Rate

Answer 19

The interest rate that is annualized by using the compound interest earned on an investment

Question 20

Annual Percent Rate

Answer 20

The interest rate stated in annual or yearly terms

Question 21

Marginal Tax Bracket

Answer 21

The amount of tax paid on an additional dollar of income. As income rises, so does the tax rate.

Question 22

After-Tax Rate of Return

Answer 22

the rate of return earned on an investment after taxes are paid on the investment. The after-tax rate of return is highest on municipal bonds

Question 23

Discount Rate

Answer 23

the rate used to calculate the present value of a future cash payment

Question 24

Discount Factor

Answer 24

The equation 1/(1+r), values that give the present value of a dollar that you are expected to receive at some time, n, in the future, discount at a rate, r

Question 25

Discounted Cash Flow Valuation

Answer 25

a valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of investment, the opportunity may be a good one

Question 26

Annuity Tables

Answer 26

a list of the discount factors used in calculating the present values and future values of annuities

Question 27

Single Period Investment

Answer 27

A one time investment

Question 28

Multiple Period Investments

Answer 28

An investment that is added to over a time period

Question 29

Trading at Premium

Answer 29

When a security trades at a price above its maturity value