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I am so confused with them. Can you please define these terms to me…
1) Interest rate is the amount of interest due based on the amount borrowed, invested and lent?
2) Discount rate is the interest rate that company pays on borrowings that is used in present value to discount the future money by removing the interest from future value to arrive at present value to help us decide how much we should pay today?
3) Rate of return is the profit return that company received from the money invested into investments projects?
4) Discount factor can be calculated with this formula: 1 / (1+r)^n
5) Discount Factors table given at the start of the book is calculated based on the discount factor formula using different interest rates based on different number of years (correct?)
6) Is it true that interest rate diminishes over time because of the effect of inflation in the economy. For eg discount factor of 10% after one-year would be equal to 0.909~ which has significantly reduced due to inflation?
7) Is inflation the only factor that influence and reduce the interest value over time. Or there are many?
8) Similarly we can also calculate the compound interest using the same formula used for discounting. For eg the formula for compound interest would be 1 x (1+r)^n
Are they ALL correct?
1 to 5: correct
6: Discounting is purely to account for the cost of money (i.e. the interest). Inflation may certainly affect the cash flows but has nothing to do with discounting.
7. I presume you are referring to the interest rate (not value). Many factors affect the rate of interest being charged.
8. You have not typed the formula completely correct. However it is given on the tables in the exam and is explained also in my lectures.
Thanks to you for answers…
6) What i wanted to know that what causes the interest rate to diminishes every year, for example, discount factor of 10% after one-year would be equal to 0.909~ and diminish each year, and as you said it didn’t not happen due to inflation but cost of money which i presume caused by losing value of money where money potentially loses its value if not used to earn interest (please explain?)
Interest rates to not diminish every year – that would be ridiculous.
If currently interest rates are (for example) 10% per year, then next year the interest rate might be higher or might be lower (due to factors such as the governments monetary policy). When discounting in Paper MA, we assume that the annual interest rate will stay constant.
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