Financial Management Exam 2

According to your textbook, what is Discounted Cash Flow (DCF) Valuation?

"Calculating the PV of a future cash flow to determine its value today."

Explain the differences between the APR and EAR

- APR is based on simple interest and is used on things like mortgages and auto loans - EAR is based on compounding interest and is used on things like credit cards

balloon or bullet payment

- a large payment due at the end of a balloon loan, such as a mortgage, commercial loan, or another type of amortized loan. - typically the last of the loan/mortgage/whatever is paid off with this payment

Explain the difference between an ordinary annuity and an annuity due

- annuity due is paid at the beginning of the period - ordinary annuity is paid at the end of a period

amortizing

- gradually write off the initial cost of an asset over a period - reduce/pay off a debt with regular payments

Explain why Effective Annual Rate (EAR) increases as the number of compounding periods per year increases.

Because if you increase the number of compounding periods per year, the EAR is compounding more often causing the value to increase

Explain how compound interest differs from simple interest

Compound interest: earned on principal and interest amounts Simple interest: only earned on principal amount

Explain what it means to amortize a loan

Decrease balance of loan/pay off some of the loan

Explain why the dollar amount of a Future Value of an annuity due is larger than the Future Value of an ordinary annuity

FV of an annuity due is larger than the FV of an ordinary annuity because when payments are made at the beginning of the period, there's more time for value to compound which will make the value higher

Explain why increasing the interest rate or the number of years causes the PRESENT value to DECREASE

Increasing the interest rate or number of years will decrease present value because if you increase one part of the formula, something else (PV) must decrease in order for the formula to equal a set FV.

Explain why increasing the interest rate or the number of years causes the FUTURE value to INCREASE

Increasing the interest rate will make the FV increase in value because it will be compounding at a higher value. Increasing the number of years will cause the FV to increase because the money will have a longer time to compound and earn interest.

compound interest

Interest earned on both the initial principal and the interest reinvested from prior periods.

simple interest

Interest earned only on the original principal amount invested

Explain why the dollar amount of the Present Value of an annuity due is larger than the Present Value of an ordinary annuity

PV of an annuity due is larger than PV of ordinary annuity because payments are made sooner

stated interest rate

The interest rate expressed in terms of the interest payment made each period. Also known as the quoted interest rate.

Describe how you would use the Rule of 72.

You would use the Rule of 72 to calculate how many years it would take to double your money. All you do to calculate this is divide your interest rate by 72.

annuity

a level of cash flows for a fixed period of time

interest-only loan

a loan in which the borrower pays only the interest for some/all of the term, with the principal balance unchanged during the interest-only period

amortized loan

a loan with scheduled that are applied to both principal and interest

ordinary annuity

a series of equal payments made at the end of consecutive periods over a fixed length of time

annuity due

an annuity for which the cash flows occur at the beginning of the period

perpetuity

an annuity in which the cash flows continue forever

consol

bond that pays interest in perpetuity

discounting

calculate the present value of some future amount

effective annual rate (EAR)

interest rate expressed as if it were compounded once per year

pure discount loan

promise to pay a certain sum of money in the future in exchange for borrowing money today

future value

the amount an investment is worth after one or more periods

present value

the current value of future cash flows discounted at the appropriate discount rate

annual percentage rate (APR)

the interest rate charged per period multiplied by the number of periods per year

compounding

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

discount rate

the rate used to calculate the present value of future cash flows