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**Unformatted text preview: **1-1LECTURE 3 – Semester 1, 2009CORPORATE FINANCE7211AFE1-2Concepts Covered Today•Understand Time Value of Money•Simple Interest and Compound Interest•Calculation of Present and Future Values•Effective Annual Rates•Calculation of PV and FV of Ordinary Annuity and Annuity due•Calculation of PV of a Perpetuity1-3Fundamental principles of Finance•There is a time value of money•Risk expects an appropriate returnEverything in finance builds upon these two principles1-4Fundamental principles of FinanceWhy is there a time value of money?1-5Fundamental principles of FinanceWhy is there a time value of money?•Money can earn interest (tautological)•Rather consume now than later•Inflation can erode value of money1-6Fundamental principles of FinanceWhy does risk expect an appropriate return?1-7Fundamental principles of FinanceWhy does risk expect an appropriate return?•We are risk averse•More risk, we want more return1-8Some warm-up questionsYou deposit $100 in a savings account that pays 5%. How much will you have the end of one year?1-9Some warm-up questionsYou deposit $100 in a savings account that pays 5%. How much will you have the end of one year?You invested $1,000 in a stock a year ago. The stock is now worth $1,200. What was your return over the past year?1-10Some warm-up questionsYou put money in a high-yield deposit that pays 10%. You now have $600. How much did you deposit a year ago?1-11Some warm-up questionsYou put money in a high-yield deposit that pays 10%. You now have $600. How much did you deposit a year ago?You deposit $200 in a savings account that pays 10%. How much will you have the end of two years?1-12Terminology of Financial Mathematics•Cash Flows ($ Inflows and Outflows)•Rate of Return (earned by an investor) (use symbol r ork)•Interest Rate (used when the agreement is in the form of debt) (use symbol ror i )1-13Simple v Compound Interest: the basics•Compounding interest is earning (or paying) interest on interest. •Simple Interest is used when there is only a single time period involved.1-14Simple Interest Example 1Suppose you borrow $1000 and agree to repay at 12% p.a. (per annum) interest in 1 year. Calculate the interest and principal component?Interest owed = 1000 * 0.12 = $120 = PrTotal repayment = $1000 + $120 = $1120In general: FV= P+ Pr=P(1+r)1-15Simple Interest Example 2Calculate the repayment of a loan of $10,000 after 6 months, interest @ 8% p.a.interest rate r= 0.08*(6/12) = 0.04FV= P(1 + r) = $10,000 x 1.04= $10,400Thus you would repay $10,400 at the end of 6 months.1-16Future ValueFuture Value (FV) is the value of an investment or loan at some point in the future....

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