Fundamental Financial Principles Flashcards
The percentage of the principal that a lender charges a borrower for the use of assets.
Interest Rate
The interest on the principal plus the interest on earned interest.
Compounding Interest
The interest earned only on the principal.
Simple Interest
The annual interest rate that is charged for borrowing money or that is earned through investment.
Annual Percentage Rate (APR)
The name for interest rate when used in time value of money calculations.
Discount Rate
The charges from the bank or the credit union’s perspective represent the {BLANK}. This is the rate that the lender requires the borrower to pay.
required rate of return
The cost to a firm to use an investor’s capital
Cost of Capital
What are three different names for interest rate?
- discount rate
- required rate
- cost of capital
{BLANK} is the interest only on the principal, while {BLANK} is the interest on the principal plus the interest on earned interest.
Simple interest; compound interest
What is the term for the percentage of the principal that a lender charges a borrower for the use of assets?
- Compound interest
- Simple interest
- Inflation rate
- Interest rate
Interest Rate
How is the interest rate expressed?
- As a dollar amount
- As a ratio
- As a percentage
- As a fractional probability
As a percentage
Interest is the percentage of the principal that a lender receives or that a borrower pays to use the money.
What is the main purpose of charging interest?
- It is what makes trading assets such as vehicles and land possible.
- It allows borrowers to pay to use the assets of another entity to accomplish their own goals.
- It allows financial analysts to accurately calculate the time value of money when evaluating a project.
- It funds private banking institutions.
It allows borrowers to pay to use the assets of another entity to accomplish their own goals.
Because the funds do not belong to borrowers, they must pay to use them. This payment is the interest rate.
What are three components of the interest rate, or required rate?
- opportunity cost
- risk
- inflation
The minimum return or compensation an investor requires in order to invest
Required Rate of Return
The loss of potential gain from other alternatives when one alternative is chosen.
Opportunity Cost
The required rate of return is also known as the {BLANK} in the context of corporate finance.
hurdle rate
The possibility that the realized or actual return will differ from the expected return.
Risk
Why would a long-term investment require a higher rate of return?
- There is greater risk involved and a higher opportunity cost.
- There is less risk involved and a lower opportunity cost.
- Projects with longer lives always produce a very high return
- Regulations require a higher rate of return on long-term investments.
There is greater risk involved and a higher opportunity cost.
There is greater risk because you cannot ensure the return of your investment for a longer period of time, and there is a higher opportunity cost because you cannot use that money for other things for a longer period of time.
The rate at which the average price level of a basket of chosen goods and services in an economy increases over a period of time.
Inflation
You just inherited $25,000 from a long-lost relative. You decide to put the money in a savings account for the time being. What would be considered an opportunity cost of putting the money in savings?
Having access to the money should you have some sort of financial emergency
The fees you must pay to your bank to hold the $25,000
Earning interest on the $25,000 you just put in savings
Buying a brand new car worth $25,000
Buying a brand new car worth $25,000
Buying a new car would be considered an opportunity cost because it is something you are giving up by keeping the money in your savings account.
What is a component of the required rate of return?
- Compound interest
- Hurdle rate
- Simple interest
- Opportunity cost
Opportunity cost
The required rate of return is composed of opportunity cost, risk, and inflation.
Five years ago, Ahmed decided he was going to save up to purchase a car with cash. The car he wants is priced at $15,000. He saved $245 a month in an account that gave him enough interest to have $15,000 in five years. Today, he pulled out $15,000 from his account to buy the car, but the price of the car is now $16,562. Which component of the required rate of return did Ahmed forget to consider?
Risk
Opportunity cost
Inflation
Interest rate
Inflation
The price of the car simply went up by $1,562 due to inflation.
What are the three causes of inflation?
- increased demand for goods and services
- rising costs
- built-in inflation.
Why is built-in inflation linked to adaptive expectations?
- Increased demand for goods and services becomes unbalanced with the supply of goods and services.
- Expectations of accidents or high demand cause expectations of price increases.
- Workers want higher wages to keep their standard of living as prices increase, which pushes the prices even higher.
- Regulations set by the authorities build an expectation of price increases.
Workers want higher wages to keep their standard of living as prices increase, which pushes the prices even higher.
When the prices of goods and services go up, employees expect and even demand higher wages to maintain their living standard, which will lead to further increases in prices.
Why does an increased demand for goods and services cause inflation?
- An increase in demand causes a decrease in prices because suppliers are not willing to meet the increased demand.
- An increase in demand causes people to want less goods and services because of increased competition, which will result in a decrease in market price.
- An increase in demand results in better-quality goods, which means that they will be more expensive.
- An increase in demand often causes an insufficient supply in the market, which causes prices to go up until the demand is once again equal to the supply.
An increase in demand often causes an insufficient supply in the market, which causes prices to go up until the demand is once again equal to the supply.
An increase in demand results in an increase in prices, which is the definition of inflation.
What happens to prices in a market in which there is inflation?
- Prices fall.
- Prices rise.
- Prices remain the same.
- Prices fluctuate from day to day, sometimes increasing and sometimes decreasing.
Prices rise
Prices rise because of increase in demand, increase in cost of goods, and adaptive expectations.
Rate = {BLANK} + {BLANK}
Rate = Risk-Free Rate + Risk Premium
Nominal Rate - Inflation Rate = {BLANK}
Nominal Rate - Inflation Rate = Real Rate
The rate of return on an investment with no risk.
Risk-free Rate
The compensation for the amount of risk taken on by investors.
Risk Premium
The rate at which invested money grows for a certain period of time.
Nominal Rate
An interest rate that is adjusted to remove the effects of inflation.
Real Rate
What is the compensation for risk given to investors called?
- Opportunity cost
- Risk premium
- Real rate
- Risk-free rate
Risk premium
Risk premium is the compensation that investors take for the risk they have to bear.
Which type of interest rate is the rate at which invested money grows for a certain period time?
- Risk-free rate
- Inflation rate
- Nominal rate
- Real rate
Nominal rate
The nominal rate is the rate at which invested money grows for a certain period of time and is the interest rate most often used in your daily life.
Which component of an interest rate is an indicator of inflation and opportunity cost?
- Risk-free rate
- Purchasing power
- Growth rate
- Risk premium
Risk-free rate
The risk-free rate describes the rate of return on an investment with no risk, so it just measures inflation and opportunity cost.
What is the name for the interest rate expressed on an annual basis?
- Real interest rate
- Compound interest
- Simple interest
- Annual percentage rate
Annual percentage rate
The APR is the annual interest rate that is charged for borrowing money or that is earned through investment, and it is calculated on an annual basis.
