Time Value of Money Quiz

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Questions and Answers

What is the primary reason the net value of the investment is underestimated?

  • The calculation assumes money has the same value now and in the future. (correct)
  • The interest rate is too low.
  • The cost is expressed in dollars rather than in a percentage.
  • The calculation ignores the impact of inflation.

Which statement best describes the time value of money?

  • Future cash flows are always less significant than current cash flows.
  • Money can only lose value over time.
  • A dollar today can earn interest, making it more valuable than a dollar received in the future. (correct)
  • Money today and money in the future are considered equivalent.

Why is it stated that there are no arbitrage opportunities in an efficient market?

  • Identical cash flows must have the same price. (correct)
  • Investors cannot make decisions based on publicly available information.
  • Prices are always higher than their actual value.
  • Investors can always find a safer return elsewhere.

How does an interest rate function in financial terms?

<p>It serves as a conversion rate between money today and money in the future. (C)</p> Signup and view all the answers

What does the term 'benefit' refer to in the context of investment?

<p>The future cash inflow generated by the investment. (D)</p> Signup and view all the answers

Why might an investor prefer cash flows today rather than in the future?

<p>Investing cash today can generate additional returns through interest. (D)</p> Signup and view all the answers

What implication does the time value of money have on financial decision-making?

<p>It emphasizes the importance of immediate cash flows over distant cash flows. (C)</p> Signup and view all the answers

If there is a guaranteed payment of $1000 in one year, how does this affect the assessment of risk for this security?

<p>It eliminates the risk completely. (D)</p> Signup and view all the answers

Which of the following statements about the future value of money is accurate?

<p>The future value increases with the rate of interest and time. (D)</p> Signup and view all the answers

What is the primary purpose of a bond as described in the content?

<p>To provide a safe investment with guaranteed returns. (C)</p> Signup and view all the answers

What does present value (PV) represent in financial terms?

<p>The value of an investment today expressed in today's dollars (D)</p> Signup and view all the answers

What is implied when the present value of an investment is less than its initial cost?

<p>The investment results in a loss when considering its present value (C)</p> Signup and view all the answers

How is the discount rate interpreted in terms of future money's value?

<p>It represents the time value of money and reflects risk (B)</p> Signup and view all the answers

What determines the discount factor used to calculate present value?

<p>The interest rate applied to future cash flows (C)</p> Signup and view all the answers

What does a discount factor of 0.93458 indicate?

<p>Today's dollar can purchase less in the future (C)</p> Signup and view all the answers

Which of the following correctly describes a situation where an investment should be rejected?

<p>The investment's cost exceeds its present value (C)</p> Signup and view all the answers

When calculating present value, what is the main purpose of the discount factor?

<p>To adjust future cash flows to their worth today (B)</p> Signup and view all the answers

Flashcards

Present Value (PV)

The value of an investment expressed in terms of dollars today.

Future Value (FV)

The value of an investment expressed in terms of dollars in the future.

Discount Rate

The rate at which future dollars are discounted to present dollars. It's often represented as a percentage or decimal.

Discount Factor

A factor used to calculate the present value of a future amount. It's the reciprocal of (1 + discount rate).

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Discounting

The process of determining the present value of a future cash flow.

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Opportunity Cost

The difference between the cost of an investment and its present value. It shows the loss in value due to the passage of time.

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Time Value of Money

The principle that a dollar today is worth more than a dollar tomorrow due to the potential to earn interest.

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Future Value of an Investment

The amount you would have in the future if you invested a certain amount today.

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Simple Security

A financial instrument that promises a single payment to the owner in the future, with no risk of non-payment.

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Risk-Free Interest Rate

The rate of return an investor can expect on a risk-free investment, often represented by government bonds.

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Law of One Price (LOOP)

The principle that two investments with identical cash flows should have the same price in a normal market.

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Arbitrage

The process of finding an investment strategy that generates risk-free profits with no initial investment.

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Bond Price

The price at which a bond should trade in an efficient market, determined by its present value.

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Efficient Market

A market where prices reflect all available information, eliminating opportunities for arbitrage.

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Alternative Investment

Investing money at the risk-free interest rate to recreate the same cash flow as another investment.

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Interest Rate

The rate at which money can be exchanged between today and the future.

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Present Value

The value of an investment that is calculated by considering the time value of money. This means that future cash flows are discounted back to their present value.

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Future Value

The value of an investment at a specific point in the future, considering the impact of interest or growth.

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Discounted Cash Flow (DCF)

A method of calculating the present value of a stream of future cash flows, taking into account the time value of money.

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Internal Rate of Return (IRR)

The process of determining the rate of return that will make the present value of the future cash flows equal to the initial investment cost.

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Profitability Index (PI)

A measure of the profitability of an investment, calculated by dividing the net present value of the investment by the initial investment cost.

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Capital Budgeting

A financial decision-making tool used to determine the best allocation of resources among competing investment opportunities.

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Study Notes

Financial Decision Making and the Law of One Price

  • Financial decisions involve future consequences affecting firm value, incorporating both benefits and costs.
  • A good decision increases firm value by generating benefits exceeding costs.
  • Costs and benefits are complex as they occur at different times, using different currencies, and present different risks.
  • Valuation Principle: Current market prices can determine the current value of costs and benefits.
  • Net Present Value (NPV): Comparing costs and benefits in terms of today's dollars, used to assess if a decision increases wealth.
  • Valuation principle: The value of an asset equals the current market price of an equivalent good.
  • Normal market: A market without arbitrage opportunities where equivalent investment opportunities have the same price.
  • Law of One Price: Equivalent securities in competitive markets must trade at the same price.
  • Financial securities (securities): Investment opportunities trading in financial markets.
  • No-arbitrage price: The price of a security where no arbitrage opportunity exists.
  • Time Value of Money: A dollar today is worth more than a dollar in the future due to potential investment returns.
  • Risk-free interest rate (rf): The interest rate at which money can be borrowed or lent without risk.
  • Present Value (PV): The current value of a future cash flow.

Valuing Decisions

  • Financial managers make business decisions to maximize firm value for investors.
  • Decisions can include raising prices, increasing production, renting, or purchasing facilities, paying for facilities using cash or borrowing funds.

Example 3.1 Valuing Decisions

  • Consider trading 400 ounces of silver for 10 ounces of gold today.
  • Use current market prices to determine the value in terms of today's dollars.
  • The value of a good is independent of an individual's preferences, determined by the prevailing competitive market price.

Calculating Value

  • Evaluate costs and benefits in equivalent terms (cash today) to compare them.
  • Consider market prices to convert units of a good.
  • Determine the value of a good independently of a person's preferences.

Interest Rates and the Time Value of Money

  • Time differences in costs and benefits are significant for most investment projects.
  • Costs occur upfront, while benefits are in the future.

Present Value and NPV Decision Rule

  • Present value (PV) is a future cash flow's worth today.
  • Net Present Value (NPV) measures the difference between present values of benefits and costs.

No-Arbitrage and Security Prices

  • No-arbitrage prices for securities exist where there are no opportunities to benefit from price differences across markets.
  • Securities: A general description for any investment traded in a financial market.
  • Valuation Principle: Allows comparison of cost and benefit estimates, regardless of differing locations, times, and risks.

Competitive Market Prices

  • Determine cash values of goods and securities when trading exists in competitive markets, not affected by individual investor preferences.
  • Law of One Price: Helps avoid arbitrage opportunities with identical goods in multiple markets.

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