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What components make up the required rate of return?
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The required rate of return includes the real risk-free rate, inflation premium, default risk premium, liquidity premium, and maturity premium.
Why might the discount rate differ from the required rate of return?
The discount rate may differ from the required rate of return due to differences in risk, inflation expectations, and the investment horizon associated with the cash flows being discounted.
How do you adjust the present value formula for multiple compounding periods within a year?
Adjust the present value formula by dividing the annual interest rate by the number of compounding periods per year and multiplying the number of years by the number of compounding periods.
What is the Effective Annual Rate (EAR) and how is it calculated?
The Effective Annual Rate (EAR) is the interest rate that is adjusted for compounding over a given period. It is calculated using the formula: EAR = (1 + (r/m))^m - 1, where r is the nominal annual rate and m is the number of compounding periods per year.
How does inflation impact the value of money over time?
Inflation decreases the purchasing power of money over time, meaning a given sum of money will buy fewer goods and services in the future compared to today.
Define opportunity cost in the context of interest rates.
Opportunity cost is the value of the best alternative forgone when a particular investment is chosen. In the context of interest rates, it is the return from the next best investment option available.
What is an annuity due and how does it differ from an ordinary annuity?
An annuity due involves payments at the beginning of each period, while an ordinary annuity involves payments at the end of each period.
Describe how compounding interest affects the future value of an investment.
Compounding interest means earning interest not just on the initial principal but also on the accumulated interest over previous periods, leading to exponential growth of the investment.
Explain the formula for calculating Future Value (FV) and its components.
The formula for Future Value (FV) is FV = PV × (1 + r)^n where PV is the present value, r is the interest rate per period, and n is the number of periods.
What does TVM stand for and why is it important in financial decision-making?
TVM stands for Time Value of Money, which is a fundamental financial concept that states money available now is worth more than the same amount in the future due to its potential earning capacity.
In scenario problem 5 for Bruce: $9000 today with annual payments for 7 years at 3%, calculate the PMT (annual payment).
The annual payment (PMT) can be calculated using a financial calculator or formula for annuities. In this scenario, PMT = $1444.55.
If you invest $500 at a 7% interest rate for 5 years, what will be the future value using the compounding interest formula?
Using the compounding interest formula FV = PV × (1 + r)^n, the future value will be $500 × (1 + 0.07)^5 = $701.29.
Differentiate between the real risk-free rate and the nominal risk-free rate.
The real risk-free rate is the rate of return on a risk-free asset without accounting for inflation, while the nominal risk-free rate includes the inflation premium.
Explain the difference between present value (PV) and future value (FV).
Present value (PV) is the current worth of a sum of money, while future value (FV) is the value of that sum at a future date based on specific interest or growth rates.
Using a financial calculator, how would you set up a problem to calculate the future value of an annuity?
To calculate the future value of an annuity on a financial calculator, input the periodic payment (PMT), interest rate, number of periods, and set the calculator to 'end' mode for an ordinary annuity or 'begin' mode for an annuity due.
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