CH 5 Time Value of Money

Time value of money

refers to the observation that it is better to receive
money sooner than later. Money that you have in hand today can be invested to
earn a positive rate of return, producing more money tomorrow

time line

A horizontal line on which time
zero appears at the leftmost
end and future periods are
marked from left to right; can
be used to depict investment
cash flows.

cash flow

both inflows and outflows�of a firm can be described by its general
pattern. It can be defined as a single amount, an annuity, or a mixed stream.

future value

The value at a given future
date of an amount placed on
deposit today and earning
interest at a specified rate.
Found by applying compound
interest over a specified period of time

compound interest

Interest that is earned on a
given deposit and has become
part of the principal at the end
of a specified period.

principal

amount of money in which interest is paid

present value

The current dollar value of a
future amount�the amount of
money that would have to be
invested today at a given
interest rate over a specified
period to equal the future
amount.

discounting cash flows

The process of finding present
values; the inverse of
compounding interest.

TRUE

Like future value, the present value depends largely on the
interest rate and the point in time at which the amount is to be received.

annuity

A stream of equal periodic
cash flows over a specified
time period. These cash flows
can be inflows of returns
earned on investments or
outflows of funds invested to
earn future returns.

ordinary annuity

An annuity for which the cash
flow occurs at the end of each
period.

annuity due

An annuity for which the cash
flow occurs at the beginning of
each period.

perpetuity

An annuity with an infinite life,
providing continual annual
cash flow.

mixed stream

A stream of unequal periodic
cash flows that reflect no
particular pattern.

semiannual compounding

Compounding of interest over
two periods within the year.

quarterly compounding

Compounding of interest over
four periods within the year.

nominal (stated) annual rate

Contractual annual rate of
interest charged by a lender
or promised by a borrower.

effective (true) annual rate
(EAR)

The annual rate of interest
actually paid or earned.
-The effective annual rate reflects the effects of compounding frequency,
whereas the nominal annual rate does not

annual percentage rate (APR)

he nominal annual rate of
interest, found by multiplying
the periodic rate by the
number of periods in one year,
that must be disclosed to
consumers on credit cards and
loans as a result of "truth-inlending
laws."
For example, a bank credit card that char

annual percentage yield (APY)

The effective annual rate of
interest that must be disclosed
to consumers by banks on their
savings products as a result of
"truth-in-savings laws.

TRUE

compounding for than once a year results in a higher effective interest rate because you are earning on interest on interest more frequently

True

effective interest rate is greater than the nominal (annual) interest rate

An ordinary annuity is an annuity in which cash flows occur at the beginning of each period

False

The amount to which an investment will grow after earning interest is a future value

True

An increase in future value of a single sum can be caused by an increase in the:
a. annual interest rate
b.number of compounding periods
c.original amount invested
d. both a & b

D. Both A and B
Annual interest rate, number of compounding periods