# Chapter 5 - Introduction to Valuation The Time Value of...

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Introduction to Valuation: The Time Value of Money Chapter Five

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2 Chapter Outline Future Value and Compounding Present Value and Discounting More on Present and Future Values
3 Time Value Terminology Time value of money deals with equivalence relationships between cash flows with different dates Future value (FV) is the amount an investment is worth after one or more periods Present value (PV) is the current value of one or more future cash flows from an investment 0 1 2 3 4 PV FV

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4 Basic Definitions Interest rate the rate of return that reflects the relationship between differently dated cash flows “exchange rate” between earlier money and later money Discount rate Cost of capital Opportunity cost of capital Required return
5 From the investor’s perspective: Interest Rate Real risk-free interest rate is the single-period rate for a completely risk-free security if no inflation expected Inflation premium compensates investors for the expected inflation Default risk premium compensates investors for the possibility that the borrower will fail to make a payment Liquidity premium compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly Maturity premium compensates investors for the increased sensitivity of the market value of debt to a change in market interest rates as maturity is extended Nominal risk-free interest rate=real risk-free interest rate+inflation premium

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6 Future Values Suppose you invest \$1000 for one year at 5% per year. What is the future value in one year? Interest = 1000(.05) = 50 Value in one year = principal + interest Value in one year = 1000 + 1000(.05) = 1050 Future Value (FV) = 1000(1 + .05) = 1050
7 Future Values: Investing for More than One Period Suppose you leave the money in for another year. How much will you have two years from now? FV = 1050(1.05) = 1102.50 FV = 1000(1.05)(1.05) = 1102.50 FV = 1000(1.05) 2 = 1102.50

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8 Interest Rate Terminology Simple interest – interest earned only on the principal Compound interest – interest earned on both the principal and on the interest reinvested from prior periods Consider the previous example
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Chapter 5 - Introduction to Valuation The Time Value of...

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