Finance Chapter 5

Amortized Loan

A loan that is repaid in equal payments over its life.

Uneven Cash Flow

A series of cash flows where the amount varies from one period to the next.

Annuity

A series of equal payments at fixed intervals for a specified number of periods.

Perpetuity

A stream of equal payments at fixed intervals expected to continue forever.

Amortization Schedule

A table showing precisely how a loan will be repaid. It gives the required payment on each payment date and a breakdown of the payment, showing how much is interest and how much is repayment of principal.

Annuity Due

An annuity whose payments occur at the beginning of each period.

Ordinary Annuity

An annuity whose payments occur at the end of each period.

Time Line

An important tool used in time value analysis; it is a graphical representation used to show the timing of cash flows.

FV formula for simple interest

FV = PV + (PV x I x N)

FV formula for compound interest

FV = PV x (1 + I)^N (to power of N)

After the end of the second year and all other factors remaining equal, a future value based on compound interest will never exceed the future value based on simple interest.

False

I

Interest Rate earned per year

Compound Interest

Occurs when interest is earned on prior periods' interest.

Simple Interest

Occurs when interest is not earned on interest.

Future Value (FV)

The amount to which a cash flow or series of cash flows will grow over a given period of time when compounded at a given interest rate.

Effective Annual Rate (EAR or EFF&)

The annual rate of interest actually being earned, as opposed to the quoted rate.

Compounding

The arithmetic process of determining the final value of a cash flow or series of cash flows when compound interest is applied.

Annual Compounding

The arithmetic process of determining the final value of a cash flow or series of cash flows when interest is added once a year.

Semiannual Compounding

The arithmetic process of determining the final value of a cash flow or series of cash flows when interest is added twice a year.

Annual Percentage Rate (APR)

The contracted interest rate.

Nominal interest rate

The contracted interest rate.

Discounting

The process of finding the present value of a cash flow or a series of cash flows; discounting is the reverse of compounding.

Opportunity Cost

The rate of return you could earn on an alternative investment of similar risk.

Present Value (PV)

The value today of a future cash flow or series of cash flows.

After the end of the second year and all other factors remaining equal, a future value based on compound interest will exceed a future value based on simple interest.

True

All other factors being equal, both the simple interest and the compound interest methods will accrue the same amount of earned interest by the end of the first year.

True

All other variables held constant, investments paying simple interest have to pay significantly higher interest rates to earn the same amount of interest as an account earning compound interest.

True

Everything else held constant, an account that earns compound interest will grow more quickly than an otherwise identical account that earns simple interest.

True

The process of earning compound interest allows a depositor or investor to earn interest on any interest earned in prior periods.

True

Cash Flow

designates a cash flow that's not part of an annuity

INT

dollars of interest earned during the year

Payment (PMT)

equal cash flows coming at regular intervals

N

number of periods involved in the analysis