Chapter 3
The Time Value of Money

Solutions to Questions 1. A rate of return is the ratio of net cash inflows to net cash outflows produced by a financial contract. It is often expressed as a percentage. The ‘financial contract’ involved may be, for example, an investment in shares, land or bonds. An interest rate is a rate of return produced by debt of one form or another. Thus, an interest rate is one type of rate of return. Simple interest is a method of calculating interest in which the interest is computed on the basis of the original sum borrowed. Compound interest is a method of calculating interest in which interest is computed on the basis of the original sum borrowed plus interest owing but unpaid at the date of computation. The statement is true. The three different terms—‘present value’, ‘price’ and ‘principal’—all refer to the value of a financial contract at a given date (typically, today). ‘Present value’ tends to be used when the valuation is the result of a discounting procedure; ‘price’ tends to be used when the valuation is the result of a market transaction for a security and ‘principal’ tends to be used when the valuation refers to an amount lent by way of a standard loan. However, these circumstances are not independent; for example, a price may be offered and agreed to because a discounting procedure indicates to market participants that the price is the correct valuation. The term ‘nominal interest rate’ can mean an interest rate where interest is charged more frequently than the quoted period. For example, ‘6 per cent per annum payable quarterly’ is a nominal interest rate because interest is charged quarterly—that is, four times each year—but the quoted period is a year. The term ‘nominal interest rate’ can also mean an interest rate before taking out the effects of inflation. For example, if a lender receives interest at the rate of 5