Section I.B.1 Time Value of Money

Question 1

Nominal interest rate

Answer 1

• A stated or reported rate which does not consider compounding within the annual period
• Rate of interest that has not been adjusted for the impact of inflation

Question 2

Effective interest rate

Answer 2

• An annualized rate that considers the frequency by which interest is compounded within a year

Question 3

Nominal rate of return

Answer 3

• Rate of interest that has not been adjusted for the impact of inflation

Question 4

Real rate of return

Answer 4

• Rate of interest (or return) that has been adjusted for inflation

Question 5

Present value

Answer 5

• The current worth (value) of a future sun or stream of cash flows that has been discounted at some specified rate of return for a specific amount of time
• Present value is always equal to or less than it’s future value

Question 6

Net present value (NPV)

Answer 6

• The sum of the present value of all cash flows of an investment
• The difference between present value of cash inflows and outflows of a project or investment
• Used in capital budgeting to analyze profitability
• The present value of future cash flows discounted at the required rate of return (i.e., the company’s cost of funds)
• Shows the amount of cash flow that a project or investment generates after repaying the invested capital and the required rate of return on the capital
• If a project or asset has NPV > 0, then the project increases shareholders’ wealth. If NPV < 0, then the project or asset decreases shareholders’ wealth

Question 7

Future value

Answer 7

• The worth (value) of an asset at some point in the future that is equal to its value today based on a specified rate of return and period of time

Question 8

Ordinary annuity

Answer 8

• A finite series of even, periodic cash flows where cash flow (incoming or outgoing) occurs at the end of the period
• The first cash flow occurs one period from the present

Question 9

Annuity due

Answer 9

• A finite series of periodic cash flows in which the cash flow (incoming or outgoing) occurs immediately

Question 10

Internal rate of return (IRR)

Answer 10

• Also called the effective interest rate
• A dollar weighted return
• The discount rate at which the net present value of all cash flows equal zero
• The discount rate at which present value of all future cash flows is equal to the initial investment or cash outlay (i.e., at which the investment breaks even)