Chapter 4 - Part B. Cash flow skills EXPANDED POSTED

# Chapter 4 - Part B. Cash flow skills EXPANDED POSTED - Cash...

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Cash Flow Skills Chapter 4 - Part B Finance 357

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Compounding The process of leaving money in an investment and allowing it to grow over multiple periods is called compounding . We invest \$1000 in a bank account that has an interest rate of 5% per year. At the end of year 1, it is worth \$1050. This is called simple interest. Leaving the money in the account for the second year allows it to grow by 5% again. However, this time we are starting year two with \$1050. We are earning interest on our previously earned interest.
Another View of Compounding then Another way to accomplish this is to combine the steps. By combining the process into one step, we are calculating compound interest. Which equals the formula for a cash flow that is compounded over multiple time periods. T = the number of time periods over which the money is invested.

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Compounding Example A stock you own currently pays a dividend of \$1.50 per share. The dividend is expected to grow by 20% per year for the next 5 years. How much will the dividend be 5 years from now?
Compounding Example A stock you own currently pays a dividend of \$1.50 per share. The dividend is expected to grow by 20% per year for the next 5 years. How much will the dividend be 5 years from now? Method 1 - Formula FV = \$1.5 * (1 + .2) 5 = \$3.73 Method 2 – Future Value Table 20% for 5 periods yields a 2.4883 FV factor (p 666) 2.4883 * \$1.50 = \$3.73 Method 3 – Financial Calculator PV = 1.5 N = 5 I/Y = 20 FV = ? FV = \$3.73

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Is it true? "Compound interest is the greatest force in the universe" Attributed to Albert Einstein
Model T The original price of the first car, the Model T, was \$1000 in 1909. How much would the \$1000 be worth if it has been invested at 10% interest per year?

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Model T Solution The original price of the first car, the Model T, was \$1000 in 1909. How much would the \$1000 be worth at the end of 2008, if it has been invested at 10% interest per year? PV = \$1,000 I/Y = 10 N = 99 FV = ?

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Discounting With a little simple algebra, the compounding formula turns into the discounting formula A lottery winner will receive \$1,000,000 4 years from today. How much is the prize worth today using a 5% discount rate?
Lottery Value Today A lottery winner will receive \$1,000,000 4 years from today. How much is the prize worth today using a 5% discount rate? Method 1 PV = 1,000,000 / (1.05) 4 = 1,000,000 / 1.215 = \$823,045 Method 2 FV = 1,000,000 I/Y = 5 N = 4 PV = ?

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Another Discounting Example We have a savings bond that will be worth \$100 in 3 years. If current interest rates are 4%, how much is the bond currently worth? FV = \$100 I/Y = 4 N = 3 PV = ?
Using PV Tables Present Values can also be calculated using tables. In your textbook, Appendix A – Table A1 is a Present Value Table. Using our last example, we know FV = \$100.

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Chapter 4 - Part B. Cash flow skills EXPANDED POSTED - Cash...

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