(L02)Present_Value(f)2new

(L02)Present_Value(f)2new - Lecture 2: Present Value and...

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Primbs/Investment Science 1 Lecture 2: Present Value and Internal Rate of Return Reading: Luenberger Chapter 2, Sections 2-7.
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Primbs/Investment Science 2 Present Value and Present Value and Internal Rate of Return Internal Rate of Return Present Value (PV) Internal Rate of Return (IRR) Cash Flow Evaluation Cycle Problems Taxes, Depreciation, and Inflation Cash Flow Streams
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Primbs/Investment Science 3 Modeling Framework Cash Flow Stream An investment can be characterized by its expenditures and receipts. When denominated in cash, these make up a cash flow stream. time x 0 x 1 x 2 x 3 x 4 x 5 x 6
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Primbs/Investment Science 4 Cash Flow Streams You put $100 in the bank for 1 year at 10% interest. What is the resulting cash flow stream? 0 1 -$100 $110 Goal of Investment: Find the best cash flow streams.
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Primbs/Investment Science 5 Present Value and Present Value and Internal Rate of Return Internal Rate of Return Present Value (PV) Internal Rate of Return (IRR) Cash Flow Evaluation Cycle Problems Taxes, Depreciation, and Inflation Cash Flow Streams
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Primbs/Investment Science 6 Present Value Big Picture We would like to compare cash flows that occur at different times. Interest rates tell us how to move cash flows in time. We can use interest rates to move all cash flows to the same time, then things are easy to compare. time x 0 x 1 x 2 x 3 x 4 x 5 x 6 time PV
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Primbs/Investment Science 7 The Ideal Bank Ideal Bank: An ideal bank applies the same rate of interest to deposits and loans, and has no transaction costs. Ideal Bank deposit loan
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Primbs/Investment Science 8 The Ideal Bank Ideal Bank: An ideal bank applies the same rate of interest to deposits and loans, and has no transaction costs. We use the ideal bank for 2 operations Moving a cash flow forward in time ( compounding ). i.e. deposit money in the ideal bank. Moving a cash flow backward in time ( discounting ). i.e. get a loan from the bank to be paid back later.
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Primbs/Investment Science 9 Compounding : Every time a cash flow is moved forward one period, it is multiplied by (1+r). A A(1+r) A(1+r) 2 0 1 2 Discounting : Every time a cash flow is moved backward one period, it is divided by (1+r). A/(1+r) 2 A/(1+r) A 0 1 2
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Primbs/Investment Science 10 The Comparison Principle The ideal bank allows us to compare different cash flow streams. We can just use it to move all cash flows to the current time. Ideal Bank We call this amount the bank will give us now the “ Present Value ”.
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Primbs/Investment Science 11 The Comparison Principle Cash Flow Stream Present Value Ideal Bank The Best!
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Primbs/Investment Science 12 Terminology When all cash flows are moved to the present time, that is known as the present value . time x 0 x 1 x 2 x 3 x 4 x 5 x 6 time PV If all cash flows are moved to the time of the final cash flow, that value is known as the future value .
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(L02)Present_Value(f)2new - Lecture 2: Present Value and...

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