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Flashcards in Chapter 6 Deck (77):
1

Time value of money

Indicates a relationship between time and money.

2

The dollar received today is worth more than a dollar promises at some time in the future. Why?

Bc the opportunity to invest today's dollar and receive interest on the investment

3

Historical cost used for
Net realizeable value used for
Fair value used for

Equipment

Inventories

Investments

4

FASB requires the use of what to measure assets and liabilities?

Fair value

5

The most useful fair value measures are based on what?

Market prices in active markets

6

How can fair value be estimated

Based on expected future cash flows related to asset or liability

7

Notes

valuing incurrent receivables and payables that carry no stated interest rate or a lower than market interest rate

8

Leases

Valuing assets and obligations to be capitalized under long term leases and measuring the amount of the lease payments and annual leasehold amortization

9

Pensions and other post retirement benefits

Measuring service cost components of employers post retirement benefits expense and post retirement benefits obligations

10

Long term assets

Evaluating alt long term investments by discounting future cash flows.

Determining the value of assets acquired under deferred payment contracts. Measuring impairments of assets

11

Stock based compensation

Determining fair value of employee services in compensatory stock option plans

12

Business combinations

Determining the value of receivables payables liabilities accruals and commitments acquired or assumed in a purchase

13

Disclosures

Measuring the value of future cash flows from oil and gas reserves for disclosure in supplementary information

14

Environmental liabilities

Determine fair value of future obligations for asset retirements

15

Interest

Payment for use of money

16

Principal

Excess cash received or repaid over and above the amount lent or borrowed (principal).

17

How do business managers make investing and borrowing decisions ?

On th basis of rate interest involved rather than on the actual dollar amount of interest to be received or paid

18

How is interest rate determined?

One important factor is the level of credit risk involved.

19

The higher the credit risk, the higher

The interest rate

20

What are the variables in interest computation?

Principal -- the amount borrowed or invested

Interest rate -- a % of outstanding principal

Time -- the # of years or fractional portion of a year that principle is outstanding

21

Three relationships apply:

Larger principal amount the larger the dollar amount of interest

The higher the interest rate, the larger the dollar amount of interest

The longer the time period, the larger the dollar amount of interest

22

Simple interest

On the amount of principal only.

It is the return on (or growth of) principle for one time period.

23

Simple interest formula

Interest = p x i x n

P = principal
R = rate of interest for a single period
N = # of periods

24

Compound interest

Compute c.i. On principal and any interest earned that has not been paid or withdrawn

25

Compound interest uses what at the year end to compute interest in succeeding year?

Uses the accumulated balance

(Principal plus interest to date)

26

Any rational investor would choose _____ over ______ if available

Choose compound interest if available over simple interest

27

Which is the typical interest computation applied in business situations?

Compound interest

28

Simple interest usually applies to only what?

Short term investments and debts that involve a time span of one year or less

29

Future value of 1 table

Contains amounts to which 1 will accumulate if deposited now at a specified rate and left for a specified number of periods

30

Present value of 1 table

Contains the amounts that must be deposited now at a specified rate of interest to equal 1 at the end of a specified number of periods

31

Future value of an ordinary annuity of 1 table

Contains the amounts to which periodic rents of 1 will accumulate of the payments (rents) are invested at the end of each period at a specified rate of interest for a specified # of periods

32

Present value of an ordinary annuity of 1 table

Contains the amounts that must be deposited now at a specified rate of interest to permit withdrawals of 1 at the end of regular periodic intervals for the specified # of periods

33

Present value of an annuity due of 1 table

Contains the amounts that must be deposited now at a specified rate of interest to permit withdrawals of 1 at the beginning of regular periodic intervals for the specified number of periods

34

Interest is generally expressed as?

In terms of annual rate

35

But when businesses circumstances dictate a compounding period of less than one year..... a company must what?

Concert the annual interest rate to correspond to the length of the period

36

How to convert annual interest rate into compounding period interest rate ?

Divides the annual rate by the # of compounding periods per year

37

How to determine # of periods

Multiplying # of years involved by the # of compounding periods per year

38

Fundamental variables are

Rate of interest -- unless otherwise stated, an annual rate that must be adjusted to reflect the length of compounding period if less than a year

# of time periods -- # of compounding periods ( a period maybe equal to or less than a year)

FV -- the value at a future date of a given sum or sums invested assuming compound interest

PV-- the value now (present) of a future sum or sums discounted assuming compound interest

39

Single sum problems are classified into one of the following

1. Computing the unknown FV, of a known single sum of money that is invested now for a certain # of periods at a certain interest rate


2. Computing unknown PV of a known single sum of money in the future that is discounted for a certain # of periods at a certain interest rate

40

Rule for solving a FV

Accumulate all cash flows to a future point

In this instance, interest increases the amounts or values over time so that the FV exceeds PV

41

Rule for solving for a PV

Discount all cash flows from future to present

In this case discounting reduces amounts of values, PV is less than FUture amount

42

Present value is the amount needed to invest now,

To produce a known fv

43

Present value of a single sum

The present value is always smaller than

Known FV due to earned and accumulated interest

44

Present value of a single sum

In determining FV ,

The company moves forward in time using the process of accumulation

45

Present value of a single sum

In determining PV,

It moves backward in time using a process of discounting

46

In many business situations both the FV and PV are known but what could be unknown?

Interest rate or the number of periods

47

Annuity by definition requires the following

1. Periodic payments or receipts (called rents) of same amount

2. Same length interval between such rents

3. Compounding of interest once each interval

48

Future value of annuity

Is the sum of all rents plus the accumulated compound interest on them

49

If the rent occurs at the end of each period

It is classified as ordinary annuity

50

If rent occurs at beginning of each period,

Annuity is classified as an annuity due

51

What is one way in determine future value of annuity?

Compute value to which each of the rents in the series will accumulate and then totals their individual FV

52

Because of ordinary annuity consists of rents deposited at the end of each period, the rents earn no what?

No interest during the period in which they are deposited

53

When computing FV of an ordinary annuity , the # of compounding periods will always be

One less than the # of rents

54

Preceding analysis of an ordinary annuity assumes that periodic rents occur when?

At end of each period

55

Annuity due assumes periodic rents occur

At the beginning of each period

This means annuity due will accumulate interest during first period and ordinary annuity rent will NOT

56

How to find future value of annuity due factor?

Multiply the FV of an ordinary annuity factor by 1 plus interest rate

57

In determining FV of an annuity there will be one less interest period than if the rents occur

At the beginning of the period (annuity due)

58

Present value of an ordinary annuity

Present value of series of equal rents to be withdrawn at equal intervals at the end of th period

59

One approach to finding PV of annuity determines

PV of each of the rents in series and then totals their individual present values

60

Present value of ordinary annuity,

Discounted final rent based on # of rents periods

61

Determining PV of an annuity due

There is always one fewer discount period

62

To find PV of an annuity due factor

Multiplying PV of an ordinary annuity factor by 1 plus interest rate

(1 + i)

63

What are the other time value of money issues

1. Deferred annuities
2. Bond problems
3. PV measurement

64

Deferred annuity

Is the annuity in which the rent begin after a specified # of periods

65

A deferred annuity does not begin to produce rents until

Two or more periods have expired

66

Why is computing FV of a deferred annuity relatively straightforward?

There is no accumulation or investment on which interest may accrue, FV of a deferred annuity is the same as FV of annuity not deferred


That is, COMPUTING FV SIMPLY IGNORES DEFERRED PERIOD

67

Computing PV of deferred annuity must recognize what?

The interest that accrues on the original investment during the deferral period

68

To compute PV of deferred annuity

We compute PV of an ordinary annuity of 1 as if the rents had occurred for entire period

We then subtract PV of rents that were not received during deferral period

We are left with PV of rents actually received subsequent to the deferral period

69

Long term bond produces 2 cash flows

1. periodic interest payment during the life of bond

2. Principle (FV) paid at maturity

70


Valuation of long term bonds

Period interest payments represent what?


Principal represents

Annuity


Single sum problem

71

Effective interest method

The preferred procedure for amortization of a discount or premium

72

Under the effective interest method

1. Company issues bond first computes bond interest expense by multiplying the carrying value of bonds at beginning of period by effective interest rate





2. The company then determines bond discount or premium amortization by comparing bond interest expense with interest to be paid

73

The effect interest method produces what?

A periodic interest expense equal to a constant % of carrying value of the bonds

74

Expected cash flow approach

It uses range of cash flows and incorporates the probabilities of those cash flows to provide a more relevant measurement of PV

75

3 components of interest

1. Pure rate of interest (2-4%)

2. Expected inflation rate of interest (0%-?)

3. Credit risk rate of interest (0-5%)

76

A company should discount those cash flows by

Risk free rate of return

77

The rate is defined as

Pure rate of return plus the expected inflation rate