Textbook Notes (368,425)
Finance (362)
FIN 502 (69)
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Chapter 2

# CFIN502- Chapter 2- Time Value of Money.docx

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School
Department
Finance
Course
FIN 502
Professor
Joan Lobo
Semester
Summer

Description
CFIN502- Chapter 2- Time Value of Money LEARNING OBJECTIVES  How to compare monetary amounts that you pay or receive at different times  Arithmetic of personal financial management  Time value of money—concept of rate of return  Understanding rate of return is an essential preparation for debt and credit management and investment management RATE OF RETURN—SINGLE PERIOD  Discount bond- investment that pays no interest during its life time o Interest you receive on it is part of the final payment  k= CF -CF /CF 1 0 0 o Only holds for a single period with cash flows at the beginning and end of the period  Discount rate- interest rate or rate of return that we use to equate amounts of money paid or received in different periods  Opportunity costs- what you can earn if you don’t spend the money today o Discount rate simply tells you in monetary value the amount you are giving up o You can look at it as the discount rate what makes us indifferent between present and future amounts  Best alternative available o In order to compare alternative investments—must keep everything equal (risk, income tax, time of length) RATE OF RETURN—MULTIPERIOD ∑  Arithmetic mean return= o Used in analyzing investments when we want to estimate an average or expected return across different investments in the same period ∏ [ ]  Geometric mean return= o Rate of return compounded to the same final answer as the individual rates multiplied together o Lower than or equal to the arithmetic mean return COMPOUNDING MORE FREQUENTLY THAN ANNUALLY  Annual percentage rate- conventional method of quoting interest rates that ignores the compounding effect completely o Used for quoting rates for consumers, residential mortgages, corporate/ commercial mortgages and other loans, and bond yields o APR=  Effective annual rate- compound the periodic rate the number of times there are periods in the year o EAR= MECHANICS OF TIME VALUE  Discount rate- opportunity cost of spending your money now instead of investing it in the best available investment  Future and present value—single period o FV= PV (1+k) o PV=FV/(1+k) o Important mathematical fact most interest rate mathematics deals with (1+discount rate)—preserve this relationship  Future and present value—multiperiod o Compound interest- each year the interest earned increases—interest on interest o FV= PV(1+k)t o PV= FV/(1+k)t o Future value interest factor- 1/(1+k)  Annuities (IFA) - any payment that is the same amount for many consecutive periods o End of the period—ordinary or deferred annuity o Beginning of the period—annuity due o FVIFA=(1+k) -1/k o PVIFA=[1-[1/(1+k) ]]/1  Constant growth annuity (CGA)- stream of payments that grows at a constant rate 1 CFIN502- Chapter 2- Time Value of Money [ ] o PVCGA= { } [ ] o FVCGA= { } o If the first payment is paid at the beginning of the year—constant growth annuity due (CGAD)  FVCGAD=(1+k)(FVCGA)  PVCGAD= (1+k)(PVCGA) FACTORS AFFECTING DISCOUNT RATES  Pure time premium- the price that we demand for waiting before we consume o Rate of return that would theoretically exist if there were no risk of any kind that the rate will change or not be paid—no inflation and no income taxes o Economist estimate that it is 2-4% per annum  Risk o May take in a form of a probability that we wont be paid a
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