Time Value Of Money

Question 1

What is interest rate?

Answer 1

A rate of return that reflects required compensation to receive same value of money in the future

Question 2

How can interest rate be considered?

Answer 2

• min rate of return for investor to accept investment
• discount rate- discount the future value to find the value today
• opportunity cost-value investors forgo choosing one investment over another

Question 3

Formula for interest rate?

Answer 3

real risk free interest rate + inflation premium + default risk + liquidity premium (risk of loss of value) + maturity premium

Question 4

What is nominal risk free rate?

Answer 4

Risk free rate plus inflation premium

Question 5

Formula for FV?

Answer 5

FV= PV(1+r)^N

Question 6

Formula for non annual compounding?

Answer 6

PV(1+r/m)^mN

Question 7

Formula for continuous compounding?

Answer 7

PV*e^rN

Question 8

What is effective annual rate formula?

Answer 8

EAR=(1+ periodic interest rate)^m-1

Question 9

How do you find periodic interest rate?

Answer 9

EAR^-m=periodic interest rate

Question 10

What’s annuity?

Answer 10

Series of payments made at equal time intervals

Question 11

What’s ordinary annuity?

Answer 11

1st cash flow that occurs one period from now

Question 12

What’s annuity due?

Answer 12

First cash flow immediately, at t=0

Question 13

What’s perpetuity?

Answer 13

Never ending sequence CF

Question 14

Formula for ordinary annuity?

Answer 14

A((1+r)^N-1/r))

Question 15

What’s a PV of a single CF?

Answer 15

PV=FV(1+r)^-N

Question 16

What’s PV of annuity?

Answer 16

A(1-1/(1+r)^N)/r))

Question 17

What’s formula for PV of perpetual annuity?

Answer 17

A/r

Question 18

How do you solve for interest rate?

Answer 18

r=FV/PV-1

Question 19

How do you solve for growth rate?

Answer 19

FV/PV^1/N-1

Question 20

What’s default risk premium?

Answer 20

Lenders charge for possibility that borrowers won’t meet their ovligations

Question 21

Liquidity premium?

Answer 21

Compensates investors for converting investment into cash

Question 22

Maturity premium?

Answer 22

Earned by investors willing to lend over longer periods

Question 23

Exercise on interest rate?

Answer 23

Usually 1 year government bond is risk free rate. Difference between 10 year gov. Bond and 1 year is maturity premium. Difference between corporate bond and 1 year government bond is the premium over nominal risk free rate (risk free plus inflation) and represents sum of default and liquidity risk