Ch. 5 Concept Questions

(5.1A) Describe how to calculate the future value of a series of cash flows.

2 ways: 1.) Compound the accumulated balance forward 1 year at a time 2.) Calculate the future value of each cash flow first and then add these up

(5.1B) Describe how to calculate the present value of a series of cash flows

2 ways: 1.) Discount back one period at a time 2.) Calculate the present values individually and add them up.

(5.3B) What is an APR? What is an EAR? Are they the same thing?

APR is the interest rate per period multiplied by the number of periods in a year. EAR is the actual interest earned. **They are NOT the same.

(5.1C) Unless we are explicitly told otherwise, what do we always assume about the timing of cash flows in present and future value problems?

Cash flows occur at the END of each period.

(5.3C) In general, what is the relationship between a stated interest rate and an effective interest rate? Which is more relevant for financial decisions?

EAR is more relevant for financial decisions. To compare different investments or interest rates, we will always need to convert to effective rates.

(5.2) What happens to the future value of an annuity if you increase the rate, "r"? What happens to the present value?

Future Value - increases Present Value - Decreases

(5.2A) In general, what is the present value of an annuity of C dollars per period at a discount rate of "r" per period? The future value?

PV = C x { 1 - [ 1 / ( 1 + r) ^ t ] } / r FV = C x [ ( 1 + r) ^ t - 1 ] / r

(5.2B) In general, what is the present value of a perpetuity?

Perpetuity PV = C / r

(5.1) As you increase the length of time involved, what happens to the present value of an annuity? What happens to the future value?

Present Value - Decreases Future Value - Increases

(5.4A) What is a pure discount loan?

Simplest form a loan. The borrower receives money today and repays a single lump sum at some time in the future.

(5.3A) If an interest rate is given as 12%, compounded daily, what do we call this rate?

The "stated" or "quoted" interest rate.

(5.4B) What does it mean to amortize a loan?

The process of paying off a loan by making regular principal reductions.