Finance 3060 Chapter 4
As the length of time until payment grows.... What happens to PV?
Declines PV tends to become small as the time horizon grows
Calculating the present value of a future cash flow to determine its worth today is commonly called...
Discounted Cash Flow (DCF) Valuation
Prevent Value is the reverse of ...
Future Value Instead of compounding the money forward, we discount it back to the present
What we called the PV factor is just the reciprocal of (that is, 1 divided by) the future value factor
Future Value Factor: (1+r)^t Present Value Factor: 1/ (1+r)^t
If you invest for one period at an interest rate of r, your investment will grow to (1+r) per dollar invested
If r is 10 % then your investment will grow to (1+.10) =1.1 dollars per dollar invested
Simple Interest Vs Compound Interest
If you Invest $325 at 14% interest for 2 years how much of the interest is simple how much is compound? After the first year, you will have $325 * (1+0.14) = $370.50 If you reinvest this entire amount thereby compound the interest, you will have $370.50 * 1.14 = $422.37 at the end of the second year The total interest you earn is thus $422.37 - 325 = $97.37 You $325 original principal earns $325 * .14 = $45.50 in interest each year, for a two year total of $91 in simple interest. The remaining $97.37 - $91 = $6.37 results from compounding
Future values depend critically on assumed interest rate, particularly for long lived investments
In a particular case, doubling the interest rate more than doubles the future value
Compounding the interest means earning...
Interest on interested, called compound interested
Future Value (FV)
Refers to the amount of money an investment will grow to over some period of time at some given interest rate - is the cash value of an investment at some time in the future
Compound interest
gets bigger each year because more and more interest builds up and there is thus more to compound
With Simple Interest...
the interest is not reinvested, so interest is earned each period only on the original principal
Rule of 72
the time it takes to double your money is given approximately by 72/r%
Future Value Interest Factor
(1+r)^t
PV and Discount Rates are inversely related. Increasing the discount rate decreases the PV and vise verse
...
The discount rate is called the rate of return, or sometimes just return, on the investment
...
Compounding
This process of leaving your money and any accumulated interest in an investment for more than one period, thereby reinvesting the interest
Simple interest is
constant each year