Inflation and Time Value of Money

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Questions and Answers

Why does money have different values at different points in time?

Due to government regulations on currency value.
Because future cash inflows are more certain than present value.
Due to preferences for immediate consumption, declining purchasing power from inflation, and the certainty of present value. (correct)
Because the cost of goods always remains the same.

If the nominal interest rate is 8% and the inflation rate is 3%, what is the approximate real interest rate?

2.67%
11%
24%
5% (correct)

What is the primary reason for computing the Effective Annual Rate (EAR)?

To minimize the impact of inflation on investment returns.
To accurately compare interest rates with different compounding frequencies. (correct)
To simplify the calculation of simple interest.
To comply with legal regulations on interest rate disclosures.

According to the content, what is compounding?

The process of determining the future value of a current sum of money, considering accumulated interest. (A) Signup and view all the answers

How does increasing the number of compounding periods in a year affect the effective annual rate (EAR), assuming the APR remains constant?

EAR increases (C) Signup and view all the answers

What is the key difference between an ordinary annuity and an annuity due?

Payments for an ordinary annuity occur at the end of each period, whereas payments for an annuity due occur at the beginning. (C) Signup and view all the answers

What happens to the present value of a future sum if the discount rate increases?

Present value decreases (B) Signup and view all the answers

What is a perpetuity?

A stream of equal payments that occur at regular intervals and continue forever. (B) Signup and view all the answers

If you invest $2,000 today and earn 7% interest compounded annually, what will be the approximate value of your investment after 3 years?

$2,450.00 (C) Signup and view all the answers

What does the Annual Percentage Rate (APR) generally represent?

The periodic interest rate multiplied by the number of periods in a year. (A) Signup and view all the answers

What is the primary implication of the time value of money principle?

A euro today is worth more than a euro in the future due to factors like inflation and potential earnings. (A) Signup and view all the answers

Why is it important to consider the effective annual rate (EAR) rather than just the annual percentage rate (APR) when evaluating financial products?

The EAR accounts for the effect of compounding, showing the true annual cost or return, while the APR does not. (A) Signup and view all the answers

If you deposit $500 into a savings account that earns 5% interest compounded annually, how does compound interest differ from simple interest in this scenario?

Compound interest calculates interest on the principal plus any accumulated interest. (B) Signup and view all the answers

What happens to the present value of a future cash flow as the time until the cash flow increases, assuming the discount rate remains constant?

The present value decreases because the future cash flow is discounted over a longer period. (A) Signup and view all the answers

How does an increase in inflation impact the real rate of return on an investment, assuming the nominal interest rate remains constant?

The real rate of return decreases as inflation erodes the purchasing power of the returns. (B) Signup and view all the answers

Which of the following best describes the key feature of an annuity due?

Payments are made at the beginning of each period. (D) Signup and view all the answers

What is the fundamental difference between an ordinary annuity and a growing annuity?

An ordinary annuity has fixed payments, while a growing annuity has payments that increase at a constant rate. (C) Signup and view all the answers

You are offered an investment opportunity that promises to pay you $1,000 per year forever. Assuming a constant discount rate, which type of financial instrument best describes this opportunity?

Perpetuity (A) Signup and view all the answers

What is the present value of an ordinary perpetuity that pays $500 annually, given a discount rate of 10%?

$5,000 (C) Signup and view all the answers

If you are comparing two investments with the same APR but different compounding frequencies, which investment will likely have the higher effective annual rate (EAR)?

The investment with more frequent compounding. (A) Signup and view all the answers

Flashcards

Time Value of Money

Money has different values at different points in time. Now is worth more than the future.

Inflation

An overall general rise in prices, eroding purchasing power.