Financial Management, Exercises of Financial Management

Download Financial Management and more Exercises Financial Management in PDF only on Docsity! Chapter 02 - How to Calculate Present Values Chapter 02 How to Calculate Present Values Multiple Choice Questions 1. The present value of $100 expected in two years from today at a discount rate of 6% is: A. $116.64 B. $108.00 C. $100.00 D. $89.00 2. Present Value is defined as: A. Future cash flows discounted to the present at an appropriate discount rate B. Inverse of future cash flows C. Present cash flow compounded into the future D. None of the above 3. If the interest rate is 12%, what is the 2-year discount factor? A. 0.7972 B. 0.8929 C. 1.2544 D. None of the above 4. If the present value of the cash flow X is $240, and the present value cash flow Y $160, then the present value of the combined cash flow is: A. $240 B. $160 C. $80 D. $400 Chapter 02 - How to Calculate Present Values 5. The rate of return is also called: I) discount rate; IT) hurdle rate; IIT) opportunity cost of capital A. Tonly B. Land II only C. 1, I, and II D. None of the given ones 6. Present value of $121,000 expected to be received one year from today at an interest rate (discount rate) of 10% per year is: A. $121,000 B. $100,000 C. $110,000 D. None of the above 7. One year discount factor at a discount rate of 25% per year is: A. 1.25 B. 1.0 C.0.8 D. None of the above 8. The one-year discount factor at an interest rate of 100% per year is: A. 15 B. 0.5 C.0.25 D. None of the above 9. Present Value of $100,000 that is, expected, to be received at the end of one year at a discount rate of 25% per year is: A. $80,000 B. $125,000 C. $100,000 D. None of the above Chapter 02 - How to Calculate Present Values 19. What is the present value of the following cash flow at a discount rate of 9%? Year 1 Year 2 Year 3 $100,000 $150,000 $200,000 A. $372,431.81 B. $450,000 C. $405,950.68 D. None of the above 20. At an interest rate of 10%, which of the following cash flows should you prefer? Year 1 Year 2 Year 3 A) S00 300 loo B) 100 300 500 Cc) 300 300 300 D)_ Any of the above as they all add up to $900 A. Option A B. Option B C. Option C D. Option D 21. What is the net present value of the following cash flow at a discount rate of 11%? 300,000 A. $69,108.03 B. $231,432.51 C. $80,000 D. None of the above 22. What is the present value of the following cash flow at a discount rate of 16% APR? ul 2 - 100,000 300,000 A. $136,741.97 B. $122,948.87 C. $158,620.69 D. None of the above Chapter 02 - How to Calculate Present Values 23. What is the net present value (NPV) of the following cash flows at a discount rate of 9%? Lo td L2 3 250,000 100,000 150,000 200,000 A. $122,431.81 B. $200,000 C. $155,950.68 D. None of the above 24. The following statements regarding the NPV rule and the rate of return rule are true except: A. Accept a project if its NPV >0 B. Reject a project if the NPV <0 C. Accept a project if its rate of return > 0 D. Accept a project if its rate of return > opportunity cost of capital 25. An initial investment of $500 produces a cash flow $550 one year from today. Calculate the rate of return on the project A. 10% B. 15% C. 25% D. none of the above 26. According to the net present value rule, an investment in a project should be made if the: A. Net present value is greater than the cost of investment B. Net present value is greater than the present value of cash flows C. Net present value is positive D. Net present value is negative Chapter 02 - How to Calculate Present Values 27. Which of the following statements regarding the net present value rule and the rate of return rule is not true? A. Accept a project if NPV > cost of investment B. Accept a project if NPV is positive C. Accept a project if return on investment exceeds the rate of return on an equivalent investment in the financial market D. Reject a project if NPV is negative 28. The opportunity cost of capital for a risky project is A. The expected rate of return on a government security having the same maturity as the project B. The expected rate of return on a well-diversified portfolio of common stocks C. The expected rate of return on a portfolio of securities of similar risks as the project D. None of the above 29. A perpetuity is defined as: A. Equal cash flows at equal intervals of time for a specific number of periods B. Equal cash flows at equal intervals of time forever C. Unequal cash flows at equal intervals of time forever D. None of the above 30. Which of the following is generally considered an example of a perpetuity: A. Interest payments on a 10-year bond B. Interest payments on a 30-year bond C. Consols D. None of the above Chapter 02 - How to Calculate Present Values 39. If the five-year present value annuity factor is 3.60478 and four-year present value annuity factor is 3.03735, what is the present value at the $1 received at the end of five years? A. $0.63552 B. $1.76233 C. $0.56743 D. None of the above 40. What is the present value annuity factor at a discount rate of 11% for 8 years? A. 5.7122 B. 11.8594 C. 5.1461 D. None of the above 41. What is the present value annuity factor at an interest rate of 9% for 6 years? A. 7.5233 B. 4.4859 C. 1.6771 D. None of the above 42. What is the present value of $1000 per year annuity for five years at an interest rate of 12%? A. $6,352.85 B. $3,604.78 C. $567.43 D. None of the above 43. What is the present value of $5000 per year annuity at a discount rate of 10% for 6 years? A. $21,776.30 B. $3,371.91 C. $16,760.78 D. None of the above Chapter 02 - How to Calculate Present Values 44. After retirement, you expect to live for 25 years. You would like to have $75,000 income each year. How much should you have saved in the retirement to receive this income, if the interest is 9% per year (assume that the payments start on the day of retirement)? A. $736,693.47 B. $802,995.88 C. $2,043,750 D. None of the above 45. After retirement, you expect to live for 25 years. You would like to have $75,000 income each year. How much should you have saved in the retirement to receive this income, if the interest is 9% per year (assume that the payments start one year after the retirement)? A. $736,693.47 B. $6,352,567.22 C. $1,875,000 D. None of the above 46. For $10,000 you can purchase a 5-year annuity that will pay $2504.57 per year for five years. The payments are made at the end of each year. Calculate the effective annual interest rate implied by this arrangement: (approximately) A. 8% B. 9% C. 10% D. None of the above 47. If the present value annuity factor for 10 years at 10% interest rate is 6.1446, what is the present value annuity factor for an equivalent annuity due? A. 6.1446 B. 7.38 C. 6.759 D. None of the above Chapter 02 - How to Calculate Present Values 48. If the present annuity factor is 3.8896, what is the present value annuity factor for an equivalent annuity due if the interest rate is 9%? A. 3.5684 B. 4.2397 C. 3.8896 D. None of the above. 49. For $10,000 you can purchase a 5-year annuity that will pay $2358.65 per year for five years. The payments are made at the beginning of each year. Calculate the effective annual interest rate implied by this arrangement: (approximately) A. 8% B. 9% C. 10% D. none of the above 50. John House has taken a $250,000 mortgage on his house at an interest rate of 6% per year. If the mortgage calls for twenty equal annual payments, what is the amount of each payment? A. $21,796.14 B. $10,500.00 C. $16,882.43 D. None of the above 51. John House has taken a 20-year, $250,000 mortgage on his house at an interest rate of 6% per year. What is the value of the mortgage after the payment of the fifth annual installment? A. $128,958.41 B. $211,689.53 C. $141,019.50 D. None of the above iN) Nv Chapter 02 - How to Calculate Present Values 61. Mr. Hopper is expected to retire in 30 years and he wishes accumulate $1,000,000 in his retirement fund by that time. If the interest rate is 12% per year, how much should Mr. Hopper put into the retirement fund each year in order to achieve this goal? A. $4,143.66 B. $8,287.32 C. $4,000 D. None of the above 62. You would like to have enough money saved to receive a growing annuity for 20 years, growing at a rate of 5% per year, the first payment being $50,000 after retirement. That way, you hope that you and your family can lead a good life after retirement. How much would you need to save in your retirement fund to achieve this goal.(assume that the growing annuity payments start one year from the date of your retirement. The interest rate is 10%)? A. $1,000,000 B. $425,678.19 C. $605,604.20 D. None of the above 63. You would like to have enough money saved to receive a growing annuity for 25 years, growing at a rate of 4% per year, the first payment being $60,000 after retirement, so that you and your family can lead a good life. How much would you need to save in your retirement fund to achieve this goal? (assume that the growing perpetuity payments start one year from the date of your retirement. The interest rate is 12%)? A. $1,500,000 B. $632,390 C. $452,165 D. None of the above 64. The discount rate is used for calculating the NPV is: A. Determined by the financial markets B. Found by the government C. Found by the CEO D. None of the above Chapter 02 - How to Calculate Present Values 65. The managers of a firm can maximize stockholder wealth by: A. Taking all projects with positive NPVs B. Taking all projects with NPVs greater than the cost of investment C. Taking all projects with NPVs greater than present value of cash flow D. All of the above 66. If you invest $100 at 12% APR for three years, how much would you have at the end of 3 years using simple interest? A. $136 B. $140.49 C. $240.18 D. None of the above 67. If you invest $100 at 12% APR for three years, how much would you have at the end of 3 years using compound interest? A. $136 B. $140.49 C. $240.18 D. None of the above 68. Which of the following statements is true? A. The process of discounting is the inverse of the process of compounding. B. Ending balances using simple interest is always greater than the ending balance using compound interest at positive interest rates. C. Present value of an annuity due is always less than the present value of an equivalent annuity at positive interest rates. D. All of the above are true. 69. The concept of compound interest is most appropriately described as: A. Interest earned on an investment B. The total amount of interest earned over the life of an investment C. Interest earned on interest D. None of the above Chapter 02 - How to Calculate Present Values 70. Ms. Colonial has just taken out a $150,000 mortgage at an interest rate of 6% per year. If the mortgage calls for equal monthly payments for twenty years, what is the amount of each payment? (Assume monthly compounding or discounting.) A. $1254.70 B. $1625.00 C. $1263.06 D. None of the above are true 71. An investment at 10.47% effective rate compounded monthly is equal to a nominal (annual) rate of: A. 10.99% B. 9.57% C. 10% D. None of the above 72. An investment at 12% nominal rate compounded monthly is equal to an annual rate of: A. 12.68% B. 12.36% C. 12% D. None of the above 73. Mr. William expects to retire in 30 years and would like to accumulate $1 million in the pension fund. If the annual interest rate is 12% per year, how much should Mr. Williams put into the pension fund each month in order to achieve his goal? Assume that Mr. Williams will deposit the same amount each month into his pension fund and also use monthly compounding. A. $286.13 B. $771.60 C. $345.30 D. None of the above Chapter 02 - How to Calculate Present Values 88. In the amortization of a mortgage loan with equal payments, the fraction of each payment devoted to interest steadily increases over time and the fraction devoted to reducing the loan decreases steadily. True False 89. In the case of a growing perpetuity, the present value of the cash flow is given by: [Cir - g)] where r > g. True False 90. Compound interest assumes that you are reinvesting the interest payments at the rate of return. True False Short Answer Questions 91. Briefly explain the term "discount rate." 92. Intuitively explain the concept of the present value. Chapter 02 - How to Calculate Present Values 93. State the "net present value rule." 94. Briefly explain the concept of risk. 95. State the "rate of return rule." 96. Discuss why a dollar tomorrow cannot be worth less than a dollar the day after tomorrow. Chapter 02 - How to Calculate Present Values 97. Define the term "perpetuity." 98. Describe how you would go about finding the present value of any annuity given the formula for the present value of a perpetuity. 99. What is the difference between simple interest and compound interest? 100. Briefly explain, "continuous compounding." i) v v Chapter 02 - How to Calculate Present Values 7. One year discount factor at a discount rate of 25% per year is: A. 1.25 B. 1.0 C.0.8 D. None of the above Discount Factor = 1/1.25 = 0.8 Type: Easy 8. The one-year discount factor at an interest rate of 100% per year is: ALLS B.0.5 C.0.25 D. None of the above Discount factor = 1/(1 + 1) =0.5 Type: Easy 9. Present Value of $100,000 that is, expected, to be received at the end of one year at a discount rate of 25% per year is: A. $80,000 B. $125,000 C. $100,000 D. None of the above PV =(100,000)/(1 + 0.25) = 80,000 Type: Easy 2-25 Chapter 02 - How to Calculate Present Values 10. If the one-year discount factor is 0.8333, what is the discount rate (interest rate) per year? A. 10% B. 20% C. 30% D. None of the above 1 +r = 1/(0.8333) = 1.20; r = 20% Type: Medium 11. If the present value of $480 to be paid at the end of one year is $400, what is the one-year discount factor? A. 0.8333 B. 1.20 C.0.20 D. None of the above Discount factor is = 400/480 = 0.8333 Type: Medium 12. If the present value of $250 expected to be received one year from today is $200, what is the discount rate? A. 10% B. 20% C. 25% D. None of the above 1 +r= 250/200 = 1.25; r= 25% Type: Medium 2-26 Chapter 02 - How to Calculate Present Values 13. If the one-year discount factor is 0.90, what is the present value of $120 to be received one year from today? A. $100 B. $96 C. $108 D. None of the above PV = (120)(0.90) = 108 Type: Medium 14. If the present value of $600 expected to be received one year from today is $400, what is the one-year discount rate? A. 15% B. 20% C. 25% D. 50% 1 + r= (600)/(400) = 1.5; r= 50% Type: Medium 15. The present value formula for one period cash flow is: A. PV =Ci(1 +1) B.PV=C/(1 +14) C.PV=C\/r D. None of the above Type: Medium 2-27 Chapter 02 - How to Calculate Present Values 21. What is the net present value of the following cash flow at a discount rate of 11%? t=0 t=l t=2 -120.000 300,000 -100,000 A. $69,108.03 B. $231,432.51 C. $80,000 D. None of the above NPV = - 120,000 + (300,000/1.11) -(100,000/(1.1142)) = 69,108.03 Type: Medium 22. What is the present value of the following cash flow at a discount rate of 16% APR? tL -100,000 30 A. $136,741.97 B. $122,948.87 C. $158,620.69 D. None of the above PV = (-100,000/1.16) + (300,000/(1.16%2)) = 136,741.97 Type: Medium 23. What is the net present value (NPV) of the following cash flows at a discount rate of 9%? t=0 tel t ts -250.000 100,000 150, 200,000) A. $122,431.81 B. $200,000 C. $155,950.68 D. None of the above NPV = -250,000 + (100,000/1.09) + (150,000/(1.09%2)) + (200,000/(1.0943)) NPV = 122,431.81 Type: Medium 2-30 Chapter 02 - How to Calculate Present Values 24. The following statements regarding the NPV rule and the rate of return rule are true except: A. Accept a project if its NPV >0 B. Reject a project if the NPV <0 C. Accept a project if its rate of return > 0 D. Accept a project if its rate of return > opportunity cost of capital Type: Difficult 25. An initial investment of $500 produces a cash flow $550 one year from today. Calculate the rate of return on the project A. 10% B. 15% C. 25% D. none of the above Rate of return = (550 - 500)/500 = 10% Type: Easy 26. According to the net present value rule, an investment in a project should be made if the: A. Net present value is greater than the cost of investment B. Net present value is greater than the present value of cash flows C. Net present value is positive D. Net present value is negative Type: Difficult Chapter 02 - How to Calculate Present Values 27. Which of the following statements regarding the net present value rule and the rate of return rule is not true? A. Accept a project if NPV > cost of investment B. Accept a project if NPV is positive C. Accept a project if return on investment exceeds the rate of return on an equivalent investment in the financial market D. Reject a project if NPV is negative Type: Difficult 28. The opportunity cost of capital for a risky project is A. The expected rate of return on a government security having the same maturity as the project B. The expected rate of return on a well-diversified portfolio of common stocks C. The expected rate of return on a portfolio of securities of similar risks as the project D. None of the above Type: Difficult 29. A perpetuity is defined as: A. Equal cash flows at equal intervals of time for a specific number of periods B. Equal cash flows at equal intervals of time forever C. Unequal cash flows at equal intervals of time forever D. None of the above Type: Easy 30. Which of the following is generally considered an example of a perpetuity: A. Interest payments on a 10-year bond B. Interest payments on a 30-year bond C. Consols D. None of the above Type: Easy Chapter 02 - How to Calculate Present Values 37. If you receive $1,000 payment at the end each year for the next five years, what type of cash flow do you have? A. Uneven cash flow stream B. An annuity C. An annuity due D. None of the above Type: Easy 38. If the three-year present value annuity factor is 2.673 and two-year present value annuity factor is 1.833, what is the present value of $1 received at the end of the 3 years? A. $1.1905 B. $0.84 C. $0.89 D. None of the above PV = (2.673 - 1.833) * (1) =0.84 Type: Difficult 39. If the five-year present value annuity factor is 3.60478 and four-year present value annuity factor is 3.03735, what is the present value at the $1 received at the end of five years? A. $0.63552 B. $1.76233 C. $0.56743 D. None of the above PV = (3.60478 - 3.03735) * (1) = 0.56743 Type: Difficult 2-35 Chapter 02 - How to Calculate Present Values 40. What is the present value annuity factor at a discount rate of 11% for 8 years? A. 5.7122 B. 11.8594 C.5.1461 D. None of the above PV annuity factor = (1/0.11) - (1/((0.11)(1.1148))) = 5.1461 Type: Medium 41. What is the present value annuity factor at an interest rate of 9% for 6 years? A. 7.5233 B. 4.4859 C. 1.6771 D. None of the above PV annuity factor = (1/0.09) - (1/((0.09)(1.09%6))) = 4.4859 Type: Medium 42. What is the present value of $1000 per year annuity for five years at an interest rate of 12%? A. $6,352.85 B. $3,604.78 C. $567.43 D. None of the above PV annuity factor = [(1/0.12) - (1/(0.12)(1.124 5)))] * 1000 = 3,604.78 Type: Medium 2-36 Chapter 02 - How to Calculate Present Values 43. What is the present value of $5000 per year annuity at a discount rate of 10% for 6 years? A. $21,776.30 B. $3,371.91 C. $16,760.78 D. None of the above PV =[(1/0.10) - (1/((0.10)(1.10%6)))] * 5000 = 16,760.78 Type: Medium 44. After retirement, you expect to live for 25 years. You would like to have $75,000 income each year. How much should you have saved in the retirement to receive this income, if the interest is 9% per year (assume that the payments start on the day of retirement)? A. $736,693.47 B. $802,995.88 C. $2,043,750 D. None of the above PV = [[(1/0.09) - (1/((0.09)(1.09425)))] * 75,000] * (1.09) = 802,995.88 Type: Difficult 45. After retirement, you expect to live for 25 years. You would like to have $75,000 income each year. How much should you have saved in the retirement to receive this income, if the interest is 9% per year (assume that the payments start one year after the retirement)? A. $736,693.47 B. $6,352,567.22 C. $1,875,000 D. None of the above PV = [(1/0.09) - (1/((0.09)(1.09%25)))] * 75,000 = 736,693.47 Type: Difficult 2-37 Chapter 02 - How to Calculate Present Values 52. If the present value of $1.00 received n years from today at an interest rate of r is 0.3855, then what is the future value of $1.00 invested today at an interest rate of r% for n years? A. $1.3855 B. $2.594 C. $1.70 D. Not enough information to solve the problem FV = 1/(0.3855) = 2.594 Type: Difficult 53. If the present value of $1.00 received n years from today at an interest rate of r is 0.621, then what is the future value of $1.00 invested today at an interest rate of r% for n years? A. $1.00 B.$1.61 C.$1.621 D. Not enough information to solve the problem FV =1/(0.621) = 1.61 Type: Difficult 54. If the future value of $1 invested today at an interest rate of r% for n years is 9.6463, what is the present value of $1 to be received in n years at r% interest rate? A. $9.6463 B. $1.00 C. $0.1037 D. None of the above PV = 1/9.6463 = 0.1037 Type: Difficult 240 Chapter 02 - How to Calculate Present Values 55. If the future value annuity factor at 10% and 5 years is 6.1051, calculate the equivalent present value annuity factor A. 6.1051 B. 3.7908 C. 6.7156 D. None of the given ones PV =6.1051/(1.1)*5 = 3.7908 Type: Difficult 56. If the present value annuity factor at 10% APR for 10 years is 6.1446, what is the equivalent future value annuity factor? A. 3.108 B. 15.9374 C. 2.5937 D. None of the above FV annuity factor = 6.1446 * (1.1410) = 15.9374 Type: Difficult 57. If the present value annuity factor at 12% APR for 5 years is 3.6048, what is the equivalent future value annuity factor? A. 2.0455 B. 6.3529 C. 1.7623 D. None of the above FV annuity factor = 3.6048 * (1.1245) = 6.3529 Type: Difficult 241 Chapter 02 - How to Calculate Present Values 58. If the present value annuity factor at 8% APR for 10 years is 6.71, what is the equivalent future value annuity factor? A. 3.108 B. 14.487 C. 2.159 D. None of the above FV annuity factor = 6.71 * (1.08410) = 14.487 Type: Difficult 59. You are considering investing in a retirement fund that requires you to deposit $5,000 per year, and you want to know how much the fund will be worth when you retire. What financial technique should you use to calculate this value? A. Future value of a single payment B. Future value of an annuity C. Present value of an annuity D. None of the above Type: Easy 60. Mr. Hopper is expected to retire in 25 years and he wishes accumulate $750,000 in his retirement fund by that time. If the interest rate is 10% per year, how much should Mr. Hopper put into the retirement fund each year in order to achieve this goal? [Assume that the payments are made at the end of each year] A. $4,559.44 B. $2,500 C. $7,626.05 D. None of the above Future value annuity factor = [(1.1425) - 1]/(0.1) = 98.347; payment = 750,000/98.347 = 7626.05 Type: Difficult Chapter 02 - How to Calculate Present Values 66. If you invest $100 at 12% APR for three years, how much would you have at the end of 3 years using simple interest? A. $136 B. $140.49 C. $240.18 D. None of the above FV = 100 + (100 * 0.12 * 3) = $136 Type: Medium 67. If you invest $100 at 12% APR for three years, how much would you have at the end of 3 years using compound interest? A. $136 B. $140.49 C. $240.18 D. None of the above FV = 100 * (1.1243) = $140.49 Type: Medium 68. Which of the following statements is true? A. The process of discounting is the inverse of the process of compounding. B. Ending balances using simple interest is always greater than the ending balance using compound interest at positive interest rates. C. Present value of an annuity due is always less than the present value of an equivalent annuity at positive interest rates. D. All of the above are true. Type: Difficult 245 Chapter 02 - How to Calculate Present Values 69. The concept of compound interest is most appropriately described as: A, Interest earned on an investment B. The total amount of interest earned over the life of an investment C. Interest earned on interest D. None of the above Type: Medium 70. Ms. Colonial has just taken out a $150,000 mortgage at an interest rate of 6% per year. If the mortgage calls for equal monthly payments for twenty years, what is the amount of each payment? (Assume monthly compounding or discounting.) A. $1254.70 B. $1625.00 C. $1263.06 D. None of the above are true PMT = 150,000/[(1/0.005) - 1/((0.005 * ((1 + 0.005)4240)))] = $1254.70 Type: Difficult 71. An investment at 10.47% effective rate compounded monthly is equal to a nominal (annual) rate of: A. 10.99% B. 9.57% C. 10% D. None of the above NOM = [(1.1047)4(1/12) - 1] * 12 = 0.1 = 10.00% Type: Medium 246 Chapter 02 - How to Calculate Present Values 72. An investment at 12% nominal rate compounded monthly is equal to an annual rate of: A. 12.68% B. 12.36% C. 12% D. None of the above EAR = ((1.01)*12) - 1 = 0.12681 = 12.68% Type: Medium 73. Mr. William expects to retire in 30 years and would like to accumulate $1 million in the pension fund. If the annual interest rate is 12% per year, how much should Mr. Williams put into the pension fund each month in order to achieve his goal? Assume that Mr. Williams will deposit the same amount each month into his pension fund and also use monthly compounding. A. $286.13 B. $771.60 C. $345.30 D. None of the above PMT = 1,000,000/{[(1/0.01) - (1/(0.01 * (1.014360)))] * (1.014360)} = $286.13 Type: Difficult 74. An investment at 10% nominal rate compounded continuously is equal to an equivalent annual rate of: A. 10.250% B. 10.517% C. 10.381% D. None of the above (eX(0.1)) - 1 = 0.10517 = 10.517% Type: Difficult 247 Chapter 02 - How to Calculate Present Values 85. An annuity is an asset that pays a fixed sum each year for a specified number of years. TRUE Type: Easy 86. The value of a five-year annuity is equal to the sum of two perpetuities. One makes its first payment in year 1, and the other makes its first payment in year 6. SE Type: Difficult 87. An equal-payment home mortgage is an example of an annuity. TRUE Type: Medium 88. In the amortization of a mortgage loan with equal payments, the fraction of each payment devoted to interest steadily increases over time and the fraction devoted to reducing the loan decreases steadily. TRUE Type: Difficult 89. In the case of a growing perpetuity, the present value of the cash flow is given by: [Cir - g)] where r > g. TRUE Type: Difficult Chapter 02 - How to Calculate Present Values 90. Compound interest assumes that you are reinvesting the interest payments at the rate of return. TRUE Type: Medium Short Answer Questions 91. Briefly explain the term "discount rate." Discount rate is the rate of return used for discounting future cash flows to obtain the present value. The discount rate can be obtained by looking at the rate of return, an equivalent investment opportunity in the capital market. Type: Difficult 92. Intuitively explain the concept of the present value. If you have $100 today, you can invest it and start earning interest on it. On the other hand, if you have to make a payment of $100 one year from today, you do not need to invest $100 today but a lesser amount. The lesser amount invested today plus the interest earned on it should add up to $100. The present value of $100 one year from today at an interest rate of 10% is $90.91. [PV = 100/1.1 = 90.91] Type: Difficult 93. State the "net present value rule." Invest in projects with positive net present values. Net present value is the difference between the present value of future cash flows from the project and the initial investment. Type: Medium Chapter 02 - How to Calculate Present Values 94. Briefly explain the concept of risk. If the future cash flows from an investment are not certain then we call it a risky cash flow. That means there is an uncertainty about the future cash flows or future cash flows could be different from expected cash flows. The degree of uncertainty varies from investment to investment. Generally, uncertain cash flows are discounted using a higher discount rate than certain cash flows. This is only one method of dealing with risk. There are many ways to take risk into consideration while making financial decisions. Type: Difficult 95. State the "rate of return rule." Invest as long as the rate of return on the investment exceeds the rate of return on equivalent investments in the capital market. Type: Medium 96. Discuss why a dollar tomorrow cannot be worth less than a dollar the day after tomorrow. If a dollar tomorrow is worth less than a dollar a day after tomorrow, it would be possible to earn a very large amount of money through "money machine" effect. This is only possible, if someone else is losing a very large amount of money. These conditions can only exist for a short period of time, and cannot exist in equilibrium as the source of money is quickly exhausted. Thus a dollar tomorrow cannot be worth less than a dollar the day after tomorrow. Type: Difficult 97. Define the term "perpetuity." A perpetuity is defined as the same cash flow occurring each year forever. Type: Medium i) nr Nv