Lecture 2 - Lecture2:Announcements Assignment1...

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Lecture 2: Announcements • Assignment 1  – Due in class on  Thursday July15 th – Posted on web tomorrow – Work in groups of  up to 3 people – Individual work is OK as well – Must  show your work  to receive credit
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Lecture 1: Recap • Topic 1: Time value of money (Chapters 3, 4, 5) – Streams of cash flows can be replicated by lending/borrowing at  the risk free rate – Present Value / Future Value – Special cases: Simple and growing annuities/perpetuities – PV formulas give you the amount of money you need to have in  the bank 1 period before the first cash flow C • Be careful when discounting back to get the PV of a  forward starting annuity/perpetuity
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Lecture 2: Outline • Topic 1 continued (Chapters 3, 4, 5) – Interest rate quotations and adjustments • Effective annual rate • Annual percentage rate – Inflation and purchasing power – Nominal cash flows vs. real cash flows – Nominal interest rates vs. real interest rates • Topic 2: Investment decision rules (Chapter 6) – Net Present Value (NPV) – Opportunity cost / cost of capital – Internal Rate of Return (IRR) – Alternative decision rules
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So far we have been implicitly dealing with annual interest rates with an annual compounding frequency But rates are often quoted using different conventions The Effective Annual Rate (EAR) Indicates the total amount of interest that will be earned at the end of one year Example: Monthly interest rate is 1%. What is the EAR? Example: If the EAR is 12%, and interest is paid every month, what is the monthly interest rate? What is the general formula? Interest quotations: Effective Annual Rate
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Suppose an investment pays interest quarterly with the interest rate quoted as an effective annual rate (EAR) of 9% What amount of interest will you earn each quarter? If you have no money in the bank today, how much will you need to save at the end of each quarter to accumulate $25,000 in 5 years? Example 2
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The annual percentage rate (APR) , indicates the amount of simple interest earned in one year. Simple interest is the amount of interest earned without the effect of compounding The APR is less than the effective annual rate (EAR) if compounding frequency is more frequent than annual compounding If the compounding frequency is different than annual, then you cannot use the APR as a discount rate Interest quotations: Annual Percentage Rate
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