Chapter 4 and Chapter 6 notes

Chapter 4 and Chapter 6 notes - In Chapter 4 reviews the...

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In Chapter 4 reviews the discounted cash flow valuation Two basic concepts, future value and present value, are introduced in the beginning of this chapter. With a 12 percent interest rate, an investor with \$1 today can generate a future value of \$1.12 in a year, \$1.25 (= \$1 x (1.12) 2 ) in two years, and so on. Conversely, present value analysis places a current value on a future cash flow. With the same 12 percent interest rate, a dollar to be received in one year has a present value of \$0.8929 (= \$1/1.12) in year 0. A dollar to be received in two years has a present value of \$0.7972 (= \$1/(1.12) 2 ). We are accustomed to annual percent rate (APR) quotation, say, 12 percent per year. However, APR does not take in consideration more than once per year compounding or discounting. For example, the same 12 percent interest may be paid on a quarterly basis. Therefore, APR = 12%, EAR = 12.55% = (1.03) 4 – 1). In other words, more frequent compounding produces higher interest rate. The limiting case is continuous compounding, where funds are assumed to be reinvested every infinitesimal instant. Now, it may be a good time to check EAR on your mortgage, car loan, or credit card! A basic quantitative technique for financial decision making is net present value analysis. The net present value formula for an investment that generates cash flows (C i ) in future periods is: A perpetuity is a never-ending constant stream of cash flows. The example used in the text is a British consol, which is a type of bond. The PV of an annuity is easily calculated as PV = C/r where C is amount received each period and r is interest rate. A growing perpetuity , is where cash flows are expected to increase over time. The formula is adjusted accordingly: PV = C/r-g where C is amount received each period and r is interest rate, and g is the expected growth per period. The book reminds us that these formulas should look familiar because they are used in stock problems. For

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Chapter 4 and Chapter 6 notes - In Chapter 4 reviews the...

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