FIN502: CHAPTER 2

Time Value of Money

•the technique of comparing monetary amounts that you pay or receive at different

times is called the time value of money or interest rate mathematics

•we use the rate of return to compare different investments and loans

• discount rate: equates value of cash flows received or paid at different times;

assumes different forms of cash flow are pure substitutes if properly discounted

Rate of Return - Single Period

•a discount bond is an investment that pays no interest during its life; therefore, the

interest you receive on it is part of the final payment

Rate of Return - Multi period

•referred to as rate of return in book, when people refer to it in finance, generally

annual rate is almost always implied

•the geometric mean return is lower than or equal to the arithmetic mean return

•when the annual returns are exactly equal for every year in the sequence, the two

means are equal

•we use the arithmetic mean return in analyzing investments when we want to

estimate an average or expected return across different investments in the same

period

Compounding More Frequently Than Annually

•virtually every form of consumer loan, including residential mortgages, is

compounded more than once a year

•the annual percentage rate (APR) is a conventional method of quoting interest

rates that ignores the compounding effect completely

•this method is used for quoting rates for consumer loans, residential mortgages,

corporate/commercial mortgages and other loans, and bond yields

•the effective annual rate (EAR) is compounding the periodic rate the number of

times there are periods in the year

•we would use the EAR to compare different rates

Mechanics of Time Value

•when we invest money, the money we get back is both principal and interest

•when dealing with multi period investments, each year the interest earned increases

because of interest on interest; this method of calculation is called compound

interest