Citibank: basic of corporate finance
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2-18 FINANCIAL MARKETS AND INTEREST RATES
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ANSWER KEY
1. Match each market player with a description of his/her role. Write the letter of the
role next to the title of the market player.
Market Players Roles
b Investor
c Issuer
a) Financial intermediary that buys and sells
securities
d Broker
b) Entity with more money than it needs
a Dealer c) Entity in need of money
d) Financial intermediary that facilitates the
buying and selling of securities
2. The most liquid, lower-risk securities are traded in the:
c) money market.
3. QRS Manufacturing Company decides to "take the company public." This means it
will:
b) issue stock in the primary equity market.
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FINANCIAL MARKETS AND INTEREST RATES 2-19
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PROGRESS CHECK 2
(Continued)
4. Select two basic market characteristics that influence the level of interest rates.
_____a) Investors' expected rate of return
_____b) Fees charged by brokers and dealers
_____c) Government intervention and regulation
_____d) Preference of potential investors for consumption versus savings
_____e) Efficiency of the capital allocation price system
5. The offered rate of interest reflects the pure interest rate plus:
_____a) an investment premium (IP) to account for opportunity cost.
_____b) a premium for investment costs plus a rate premium (RP) for profit.
_____c) a premium for the expected future rate of inflation plus a premium for
counterparty, liquidity, and interest rate risk.
_____d) compensation for assuming risk plus a premium based on the current
rate of inflation.
6. When planning their investment / borrowing strategies, investors and issuers look at
the yield curve representing the term structure of interest rates to:
_____a) determine their preference for long-or short-term securities.
_____b) predict future rate fluctuations.
_____c) view the historical movement of interest rates over a given period of
time.
_____d) determine the shape of future market movements.
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2-20 FINANCIAL MARKETS AND INTEREST RATES
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ANSWER KEY
4. Select two basic market characteristics that influence the level of interest rates.
a) Investors' expected rate of return
d) Preference of potential investors for consumption versus savings
5. The offered rate of interest reflects the pure interest rate plus:
c) a premium for the expected future rate of inflation plus a premium for
counterparty, liquidity, and interest rate risk.
6. When planning their investment / borrowing strategies, investors and issuers look at
the yield curve representing the term structure of interest rates to:
a) determine their preference for long-or short-term securities.
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Unit 3
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UNIT 3: TIME VALUE OF MONEY
INTRODUCTION
We know that money has two general purposes: it serves as a store of value and as a
medium of exchange. The term time value of money refers to all aspects of converting
the value of cash flows at one point of time to their equivalent values at another time. It is
important that we know the value of current and future cash flows to facilitate the
financial planning process.
In Unit Two, we discussed the factors that are used to calculate interest rates and the
market conditions that influence the level of interest rates. In this unit, we focus on the
application of interest rates to specific debt instruments. You will learn how to calculate
the future value of cash in hand, given different interest rates and payment schedules. You
will also learn how to calculate the present value of future cash flows.
UNIT OBJECTIVES
When you complete this unit, you will be able to:
• Explain how and why the value of money changes over time
• Calculate simple and compound interest to determine the future value of
debt instruments
• Discount future cash flows to present value for comparison with other cash
flows
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3-2 TIME VALUE OF MONEY
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FUTURE VALUE
Cash flow
worth more
today
The term future value (FV) refers to the value of a cash flow at a
specified rate of interest at the end of a stated length of time. A cash
flow that is received today is worth more than the same amount
received in the future. Cash in hand today may be invested to earn a
return over a period of time.
Example
For example, an investor receiving $100 today may have the
opportunity to invest the $100 for one year at 10% per annum (p.a.).
With a risk-free investment in an environment free from inflation,
the investor will have $110 value at the end of the one year. If the
receipt of the $100 is delayed for one year, the investor will have
only $100 at that time; the opportunity to earn the 10% will have
been lost. The principal plus the return on the investment over time
represents the future value of the investment.
Calculating Interest Payments
Simple /
compound
interest
There are two methods for calculating interest payments on debt
instruments: simple interest and compound interest. In this
section we will look at the formulas for deriving a simple interest
payment and a simple interest rate. We also will see how interest is
compounded discretely at regular intervals or continuously over a
defined period of time.
In our discussions, we show formulas and calculations so that you may
understand the process and become familiar with the terminology.
However, a financial calculator is the most efficient and accurate tool
for solving the types of problems in this course. We recommend that
you become familiar with the functions on your financial calculator.
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TIME VALUE OF MONEY 3-3
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Simple Interest
Calculating
simple interest
payment
Simple interest refers to the payment of interest on the principal
amount of an investment. Interest payments are made at a constant
absolute rate. The equation for computing simple interest earned or
paid is:
I = P x R x T
Where:
I = Interest payment
P = Principal
R = Rate of interest
T = Number of interest paying periods
Annual interest
Let's look at an example to illustrate the use of the formula. Suppose
that you borrow $160,000 for one year at a 12% annual rate. How
much is the interest payment at the end of the one year period? (The
interest rate is represented in decimal form for all of our calculations.
For example, twelve percent is 0.12.)
I = P x R x T
I = ($160,000) x (0.12) x (1)
I = $19,200
Interest for
periods of less
than one year
For periods of less than one year, the annual interest is adjusted with
this formula:
I = P x R x (days/360)
This formula converts the time period to a fractional yearly
equivalent. For example, suppose that you borrow $100,000 for 90
days at a 10% annual rate. The calculation for interest is:
I = P x R x (days/360)
I = ($100,000) x (0.10) x (90/360)
I = $2,500
The interest for 90 days based on an annual rate of 10% is $2,500.
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3-4 TIME VALUE OF MONEY
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Calculating
simple interest
rates
Using simple algebra, the formula can be rearranged to calculate the
rate. For example, suppose that you borrow $120,000 for one year
and you know that your interest payment is $9,600. What is the
simple interest rate on the loan?
R = I / (P x T)
R = $9,600 / ($120,000 x 1)
R = 0.08 or 8%
You have completed the section on simple interest. Please take a moment to complete
the following practice exercise on calculating simple interest.
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TIME VALUE OF MONEY 3-5
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PRACTICE EXERCISE 3.1
Directions: Calculate the answer to each question and write the correct answer.
Check your solution with the Answer Key on the next page.
1. If you borrow $300,000 for two years at a 9% simple annual interest rate, how
much interest will you pay?
$_____________________
2. If you invest $270,000 for one-half year at a 9.5% simple annual interest rate, how
much will you earn on the investment?
$_____________________
3. If you borrow $500,000 for one year and have to pay back $540,000 at the end of
the year ($500,000 is the return of the principal; $40,000 is the interest), what is
the simple interest rate you are being charged for the loan?
________%
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