FINANCE CHAPTER 5

BASIC DEFINITIONS Present Value

earlier money on a time line, value today

BASIC DEFINITIONS Interest Rate

"exchange rate" between earlier money and later money -Discount rate -Cost of capital -Opportunity cost of capital -Required return

Present Value and Discounting

-Present Value- current value of future cash flows discounted at the appropriate discount rate -Discount- Calculate the present value of some future amount

Discount

Calculate the present value of some future amount

Discounted cash flow (DCF) valuation

Calculating the present value of a future cash flow to determine its value today

[Compounding] What is compounding? What is discounting?

Compounding refers to the growth of a dollar amount through time via reinvestment of interest earned. It is also the process of determining the future value of an investment. Discounting is the process of determining the value today of an amount to be received in the future.

[Compounding and Period] As you increase the length of time involved, what happens to future values? What happens to present values?

Future values grow (assuming a positive rate of return); present values shrink.

Compound Interest

Interest earned on both the initial principal and the interest reinvested from prior periods

Interest on interest

Interest earned on the reinvestment of previous interest payments

Simple Interest

Interest earned only on the original principal amount invested

Doubling/Quadrupling Money

Quadrupling takes twice as long as doubling, important concept of time value of money

Future Value (FV)

The amount an investment is worth after one or more periods

Present Value (PV)

The current value of future cash flows discounted at the appropriate discount rate

[Present Value] The basic present value equation had four parts. What are they?

The four parts are: - the present value (PV) -the future value (FV) -the discount rate (r) -the life of the investment (t)

[Compounding and Interest Rates] What happens to a future value if you increase the rate r? What happens to present value?

The future value rises (assuming it's positive); the present value falls.

[Time Value of Money] Would you be willing to pay $24,099 today in exchange for $100,000 in 30 years? What would be the key considerations in answering yes or no? Would your answer depend on who is making the promise to pay?

The key considerations would be: -(1) Is the rate of return implicit in the offer attractive relative to other, similar risk investments? -(2) How risky is the investment; i.e., how certain are we that we will actually get the $100,000? -Thus, our answer does depend on who is making the promise to repay.

Compounding

The process of accumulating interest on an investment over time to earn more interest

Discount Rate

The rate used to calculate the present value of future cash flows

BASIC DEFINITIONS Future Value

later money on a time line, value at some point looking forward