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FIN 502 (69)
Chapter 2

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FIN 502
Steve Joyce

Chapter 2 Time Value of MoneyJanuary 17 2012Time value of money or interest rate mathematics comparing monetary amounts that you pay or receive at different times arithmetic with which we convert money between periods or calculate what rate of return is implied by a given set of cash flowsRate of return used to compare different investments and loans o Different ways in which one can calculate it which often leads to misleading adsHolding period returns and multiple period rates of returnGIC guaranteed investment certificateRate of Return k Single PeriodDiscount bond an investment that pays no interest during its lifetime therefore the interest you receive on it is part of the final paymentDiscount Rate interest rate or rate of return that we use to equate amounts of money paid or received in different periods Opportunity Cost is what you earn if you dont spend the money todayThe discount rate simply tells you in monetary value the amount that you are giving up the opportunity forgone in order to consume now the rate that makes us indifferent between present and future amountsEx if you spend 90909 on clothes today you have the clothes and can start wearing them now What do you give up by spending the money nowo Answer you give up 1000 in one years time or 10Best Alternative Available In order to compare alternative investments we must keep everything equal risk income taxes and the time length of the investment The rate of return or discount rates give us a convenient way to compare the three choices even if the amounts to invest happened to be different Ex choosing between investing money in a GIC for one year from a bank trust company or credit union must look at the different risks involved in different investments as well Rate of Return k Multiperiod Annual Rates convert discount rates rate of return from monthly interest on a credit card debt etc to annual rates Arithmetic and Geometric Rates of Return Arithmetic Mean Return sum the rate of returns and take the meano 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 periodo Geometric Mean Return multiply together all the factors 1for the years and take theroot multiply all the individual rates
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