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FIN111 Lecture 6: fin111 lecture w6

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School
UOW
Department
Finance
Course
FIN111
Professor
Freda Hui

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Week 6
Fin111 Lecture Notes
Discounted Cash Flows And Valuation!
Valuing Level Cash Flows - Annuities & Perpetuities!
-Annuity - finite series of equal payments that occur at regular intervals!
•If the first payment occurs at the end of the period it is called an ordinary
annuity!
•If the first payment occurs at the beginning of the period it is called an annuity
due!
-Perpetuity - infinite series of equal payments (cash flows continue forever)!
-Growing perpetuities - in addition to constant cash flow streams one may have to
deal with cash flows that grow at constant rate over time!
Effective Annual Rate (EAR)!
-This is the actual rate paid (or received) after accounting for compounding that
occurs during the year!
-If you want to compare two alternative investments with different compounding
periods you need to compute the EAR and use that for comparison!
Annual Percentage Rate (APR)!
-This is the annual rate that is quoted by law!
-By definition APR = period rate times the number of periods per year / quoted
interest rate!
-So to get the period rate we rearrange the APR equation to… period rate = APR
over number of periods per year!
-You should never divide the effective rate by the number of periods per year as it
will not give you the period rate!
Things To Remember!
-You always need to make sure that the interest rate and time period match!
•If you are looking at annual periods you need an annual rate!
•If you are looking at monthly periods you need a monthly rate!
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Document Summary

Valuing level cash flows - annuities & perpetuities. Perpetuity - in nite series of equal payments (cash ows continue forever) Growing perpetuities - in addition to constant cash ow streams one may have to deal with cash ows that grow at constant rate over time. This is the actual rate paid (or received) after accounting for compounding that occurs during the year. If you want to compare two alternative investments with di erent compounding periods you need to compute the ear and use that for comparison. This is the annual rate that is quoted by law. By de nition apr = period rate times the number of periods per year / quoted interest rate. So to get the period rate we rearrange the apr equation to period rate = apr over number of periods per year. You should never divide the e ective rate by the number of periods per year as it will not give you the period rate.

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Related Questions

QUESTION 1 The time value of money refers to the issue of: A. what the value of the stream of future cash flows is today. B. why a dollar received tomorrow is worth more than a dollar received today. C. what the time required to double an amount of money. D. why people prefer to consume things at some time in the future rather than today.

QUESTION 2 The process of converting an amount given at the present time into a future value is called: A. annualizing. B. discounting. C. compounding. D. capital budgeting. 2 points

QUESTION 3 Juan Vinson is planning to buy a house in five years. He is looking to invest $25,000 today in an index mutual fund that will provide him a return of 12 percent annually. How much will he have at the end of five years? (Round to the nearest dollar.) A. $45,000 B. $28,000 C. $44,059 D. $28,530 2 points

QUESTION 4 Which of the following statements is true with respect to the present value of a future amount? A. The higher the discount rate, the higher the present value of a single sum for a given time period. B. The relation between present value and time is exponential. C. The greater the time period, the higher the present value of a single sum for a given interest rate. D. The lower the discount rate, the lower the present value of a single sum for a given time period. 2 points

QUESTION 5 Which of the following statements is true of the rule of 72? A. It can be used to determine the amount of time it takes to double an investment. B. It is fairly accurate for interest rates between 25 and 50 percent. C. It states that the time to double your money (TDM) approximately equals 72/i, where i represents the years it takes to double your investment. D. It can be used to estimate approximate compound interest earned for a period of 72 days. 2 points

QUESTION 6 The present value of future cash flows are computed by multiplying future value with the: A. discounting factor. B. compound factor. C. interest rate. D. number of periods. 2 points

QUESTION 7 The present value of multiple cash flows is: A. greater than the sum of the cash flows. B. equal to the sum of all the cash flows. C. less than the sum of the cash flows. D. higher or lower than the cash flows depending on the interest rate. 2 points

QUESTION 8 Cash flows associated with annuities are considered to be: A. an uneven cash flow stream. B. a constant cash flow stream. C. a mix of constant and uneven cash flow streams. D. a cash flow stream with decreasing trend. 2 points

QUESTION 9 The annuity transformation method is used to transform: A. a present value annuity to a future value annuity. B. a present value annuity to an annuity due. C. an ordinary annuity to an annuity due. D. a perpetuity to an annuity. 2 points

QUESTION 10 The true cost of borrowing is the: A. annual percentage rate. B. effective annual rate. C. quoted interest rate. D. periodic rate.

Question 1 5 pts

0 multiple_choice_question 22046808

The internal rate of return (IRR) is the interest rate that sets the net present value of the future cash flows equal to ________.

The internal rate of return (IRR) is the interest rate that sets the net present value of the future cash flows equal to ________.

zero
one
one hundred
none of the above

Question 2 5 pts

On a timeline, the space between date 0 and date 1 represents the _______ between dates. Let’s assume it is the first year of the loan. Date 0 is the beginning of the first year, and date 1 is the end of the first year.

On a timeline, the space between date 0 and date 1 represents the _______ between dates. Let’s assume it is the first year of the loan. Date 0 is the beginning of the first year, and date 1 is the end of the first year.

dollar amount
present value
time period
future value

Question 3 5 pts

As the interest rate __________, present value decreases.

As the interest rate __________, present value decreases.

decreases
increases
remains unchanged
is unrelated

Question 4 5 pts

The present value (PV) of a stream of cash flows is the _______ the present values of each individual cash flow

The present value (PV) of a stream of cash flows is the _______ the present values of each individual cash flow

difference between
product of
sum of
same as

Question 5 5 pts

When a constant cash flow will occur at regular intervals for a finite number of periods of time, it is called a(n) __________.

When a constant cash flow will occur at regular intervals for a finite number of periods of time, it is called a(n) __________.

annuity
perpetuity
interest payment
principle payment

Question 6 5 pts

Edit this Question Delete this Question

0 multiple_choice_question 22047052

There are two basic types of annuities:

There are two basic types of annuities:

Discounted and compounded annuities
Ordinary annuities and annuities due.
Future value and present value annuities
None of the above

Question 7 5 pts

The NPV measures the ______ change in shareholder wealth that arises from undertaking a project.

The NPV measures the ______ change in shareholder wealth that arises from undertaking a project.

consistent
dollar
annual
semi-annual

Question 8 5 pts

The Net Present Value rule implies that we should compare a project’s net present value (NPV) to ________

The Net Present Value rule implies that we should compare a project’s net present value (NPV) to ________

zero
one
100
none of the above

Question 9 5 pts

To endow a perpetuity is the same as calculating the present value (PV) of a perpetuity. Say you want to endow an annual graduation party at your alma mater. You want the event to be a memorable one, so you budget $30,000 per year forever for the party. If the university earns 8% per year on its investments, and if the first party is in one year’s time, how much will you need to donate to endow the party?

The formula for PV of a perpetuity = C\r; = $30,000 \ 0.08; =

To endow a perpetuity is the same as calculating the present value (PV) of a perpetuity. Say you want to endow an annual graduation party at your alma mater. You want the event to be a memorable one, so you budget $30,000 per year forever for the party. If the university earns 8% per year on its investments, and if the first party is in one year’s time, how much will you need to donate to endow the party?

The formula for PV of a perpetuity = C\r; = $30,000 \ 0.08; =

$3,750
$37,500
$375,000
$3,750,000

Question 10 5 pts

With an Ordinary Annuity, payments are required at the ________ of each period. An example of this is bonds which usually pay coupon payments at the end of every six months until the bond's maturity date.

With an Ordinary Annuity, payments are required at the ________ of each period. An example of this is bonds which usually pay coupon payments at the end of every six months until the bond's maturity date.

beginning
middle
end
payments are not required

I. Fill in the blank using a number of terms listed below (@1 point). Annuity due, Asset Mgmt ratio, Call, Comparisons, Comparative ratio analysis, Corporation, Covered, Current Ratio, DSO, Du Pont Equation , Equal, Future performance, Greater, Higher, In-the-money, Less, Liquidity, Lower, Option, Ordinary Annuity, Out-of-the-money, Percentage, Perpetuity, Put, PV, Quick, Reduced, TIE, TATO, Trend Analysis, Writer 11. The payment or receipt of equal amounts, at the end of a series of equal periods, for a specified amount of time is called a(n) _______________. 12. When a loan is amortized over a five year term, the amount of interest paid is ________________ each year. 13. You have just won a $5 million lottery to be received in twenty annual equal payments of $250,000. What will happen to the present value of your winnings if the interest rate increases? It will be worth _________________. 14. The more frequent the compounding the _________________ the effective interest rate. 15. More frequent compounding results in _______________ future values and _______________ present values than less frequent compounding at the same nominal interest rate. 16. A(n) _______________ is a financial instrument that agrees to pay an equal amount of money per period into the indefinite future (i.e. forever). 17. A(n) _________________ is a contract which gives its holder the right to buy(or sell) an asset at some predetermined price within a specified period of time. 18. The seller of an option is called the option __________________. 19. An investor who writes call options against stock held in his or her portfolio is said to be selling _______________ options. 20. When the exercise price exceeds the current stock price, a call option is said to be _____________________; however, when the exercise price is less than the current price of the underlying stock, a call option is _________________. 21. An option which gives you the right to sell a stock at a specified price within some future period is called a(n) ______________ option.