FIN502 Chapter 2: FIN502 - Chapter 2 Notes

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3 Feb 2016
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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
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