Reading 6 Time Value of Money

Question 1

Give the equation for continuous compounding.

Answer 1

FVN = PVerN

Question 2

What is an annuity due?

Answer 2

A finite set of level sequential periodic cash flows that occur at the beginning of every period.

Question 3

How is the nominal risk-free rate determined?

Answer 3

Real risk-free rate + Inflation premium

Question 4

In what 3 ways are interest rates interpreted?

Answer 4

The minimum rate of return required to defer receipt of a payment.

The discount rate applied to a future cash flow to determine its present value.

The opportunity cost of deferring enjoyment of the money today.

Question 5

Convert the stated annual rate with less-than-annual-compounding into the effective annual rate.

Answer 5

EAR = [1 + (SAR/m)]m – 1, where m indicates the number of sub-periods

Question 6

Define a perpetuity and give the formula?

Answer 6

A never-ending series of level payments, where the first cash flow occurs at the end of the period (at t = 1).

PV = PMT/(I/Y), where PMT is the periodic payment and r is the discount rate.

Question 7

What is the formula for calculating the present and future value of money?

Answer 7

PV = FVn/(1 + r)n

FVn = PV(1 + r)n

Question 8

Since PV and FV are separated in time, what 3 points are important to remember?

Answer 8

We can add sums of money only if they are being valued at the same point in time.

For a given interest rate, the future value (present value) increases (decreases) as the number of periods increases.

For a given number of periods, the future (present) value increases (decreases) as the interest rate increases.