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Chapter 6 - time value of money

### compound interest

Interest that accrues on both the principal and the interest earned in past periods (interest not withdrawn or paid out).

### discounting

The process of reducing the amounts or values of cash flows from the future to the present, making the present value less than the future amount. (p. 271).

### effective yield

The rate of interest the bondholders actually earn on a bond (and which takes into account the frequency of compounding). If bonds sell at a discount, the effective yield exceeds the stated rate; if bonds sell at a premium, the effective yield is lower than the stated rate. (p. 269).

### effective-interest method

The preferred procedure for computing the amortization of a discount or premium. Under this method, companies compute bond interest expense (revenue) at the beginning of the period by the effective-interest rate) and then subtract bond interest paid (calculated as the face amount of the bonds times the stated interest rate); the result is the amortization amount. (p. 289).

### expected cash flow approach

Method of calculating present value that uses a range of cash flows and incorporates the probability of those cash flows to provide as accurate as possible measure of expected future cash flows. (p. 290).

### face rate

The annual interest rate stated on a financial instrument. Also called nominal or stated rate. (p. 269).

### future value of an annuity

The accumulated total that results from a series of equal deposits (rents) invested at compound interest. (p. 276).

### interest

Payment for the use of someone else's money. It is the excess cash received/repaid over and above the amount lent/borrowed. (p. 265).

### nominal rate

The annual interest rate stated on a financial instrument (a note or bond, for example). Also called face or stated rate. (p. 269).

### ordinary annuity

An annuity in which each rent is payable/receivable at the end of the period. (p. 276).

### present value

The value at an earlier date (usually now) of a given future sum discounted at compound interest. (p. 270).

### risk-free rate of return

The pure (real) rate of return plus the expected inflation rate. Typically measured by the return on a low-risk security (such as a 3-month U.S. Treasury bill.) (p. 291).

### simple interest

Interest on principal only, regardless of interest that may have accrued in past periods (compounded). (p. 266).

### stated rate

The annual interest rate stated on a financial instrument (a note or bond, for example). Also called face or nominal rate. (p. 269).

### time value of money

The relationship between time and money. A dollar received today is worth more than a dollar promised at some time in the future, because of the opportunity to invest today's dollar and receive interest on the investment. (p. 264).

### When computing the future value of an ordinary annuity, the number of compounding periods __

will always be one less than the number of rents.

### What are some topics where the the time value of money is relevant?

(1) notes, (2) leases, (3) pensions and other postretirement benefits, (4) long-term assets, (5) sinking funds, (6) business combinations, (7) disclosures, and (8) installment contracts