Time Value of Money and DCF Valuation

Question 1

Define interest rate

Answer 1

Coverting cash across time (r) is definition of an interest rate

Question 2

Define simple interest

Answer 2

Interest earned only on the original principal amount is simple interest

Question 3

Define compound interest

Answer 3

Compound interest means interest earned on both the initial principal and the interest reinvested from prior periods
It gives a greater total over time as interest is earned on the reinvestment of previous interest payments

Question 4

Define future value

Answer 4

Amount to which investment grows after one or more periods with interest

Question 5

Define compounding

Answer 5

Compounding is process of accumulating interest on an investment over time to earn more interest

Question 6

Define FVIF(r,t)

Answer 6

Future value interest factor is (1+r)^t

Question 7

Formula for future value

Answer 7

FV = 1 x (1 + r)^t

Question 8

What is the effect of doubling the interest rate on the future value

Answer 8

Doubling interest rate more than doubles the future value

Question 9

How do you find future values with multiple cash flows

Answer 9

Multiply each cash flow by Future value factor

Question 10

Define present value

Answer 10

Current value of a future sum of money or stream of cashflows discounted at a certain rate of interest is the present value - reciprocal of inverse future value

Question 11

Definition of discounting

Answer 11

Calculating the present value of a future amount

Question 12

What is the formula for present value

Answer 12

FV x 1/(1+r)^t

Question 13

Definition of a discount factor

Answer 13

its the present value interest factor = 1/(1+r)^t

Question 14

What is another name for the discount rate

Answer 14

rate of return

Question 15

Define DCF valuation

Answer 15

Calculating PV of future cash flow to determine its value today

Question 16

Explain the rule of 72

Answer 16

if 5% < r < 20% then a good estimate of time taken to double your money is given by: 72/r% = t

Question 17

What is the relationship between the discount rate and the Present Value

Answer 17

Length of time till payment grows Present Value declines - inversely related

Question 18

How do you calculate the present value of a stream of cash flows

Answer 18

1. Compute PV of each cash flow

2. Combine the present values

Question 19

What is the assumed timing of cash flows in these problems

Answer 19

Assumed payments are at the end of the period

Question 20

Define an annuity

Answer 20

A level stream of cash flows for a fixed period of time (inflows or outflows) - very common in the financial markets

Question 21

What is the present value of an annuity of €C per period for t periods when rate of interest is r is given by what formulae?

Answer 21

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

Question 22

What is the future value of an annuity of €C per period for t periods when rate of interest is r is given by what formulae?

Answer 22

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

Question 23

Define annuity due

Answer 23

annuity for which the cash flows occur at the beginning of period. If 5 payments are to be made theyre in period 0,1,2,3,4

Question 24

Know formulae for annuity due and growing annuity present value

Answer 24

//

Question 25

define a perpetuity

Answer 25

Level stream of cash flows that continues forever - cash flow is perpetual ex: US Consol bonds

Question 26

What is formula for PV of perpetuity

Answer 26

C/r

Question 27

What is formulae for constant growth perpetuity present value

Answer 27

Pvt = Ct+1/(r-g)

Question 28

Define nominal interest

Answer 28

expressed in terms of the interest payment made each period - quoted interest rate

Question 29

Define EAR

Answer 29

Effective Annual percentage rate is interest rate expressed as if it were compounded once per year

Question 30

Define APR

Answer 30

• Harmonised interest rate that expresses total cost of borrowing or investing as a % interest rate. - different in the us. it usually is smaller than EAR

Question 31

Define continuous compounding

Answer 31

Tries to shorten periods as much as possible. Interest is being credited the instant it is earned so amount grows continuously- this will give you the highest interest rate

Question 32

What is the formula for EAR

Answer 32

[1 + (quoted rate/m)]^m -1 where m is the number of periods a year

Question 33

What is the formula for continuous compounding EAR

Answer 33

e^q - 1