Question

Which of the following is NOT correct?

Multiple Choice

A) Cash flows occurring in different periods should not be compared unless the flows have been discounted to a common date.

B) The argument that 700 dollars today worth more than 700 dollars one year from now is correct only when interest rate is positive.

C) Other things being equal, the more frequent the compounding period, the higher the EAR.

D) Other things being equal, the more frequent the compounding period, the higher the APR.

Answer 1

Answer is (D) Other things being equal, the more frequent the compounding period, the higher the APR

APR or Annual Percentage Rate is based on simple interest and does not take compounding into account. For e.g. if the monthly rate being charged is 1% then APR is calculated by multiplying it by 12 to get 12%

Others statements are correct –

(A) Cash flows occurring in different periods become comparable only when they are discounted to a common date. For e.g. $100 today can be compared with $100 received after one year by discounting it to today

(B) If the interest rates are negative like -10% then discounting 700 by 1 year to today would give us 778 (i.e. 700/ (1- 0.1) making 700 received after 1 year more valuable

(C) EAR (Effective Annual Rate) is calculated by following example –

      EAR = (1 + periodic rate) ^{(Number of periods)} - 1

     Implying that as the frequency of compounding increases so does the EAR

    For e.g. 12% annual rate gives

    EAR = 12.36% for half yearly compounding

    EAR = 12.68% for monthly compounding