fins5514week2 - FINS5514:WEEK02 1 MarkHumpheryJenner...

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FINS 5514: WEEK 02 Mark Humphery-Jenner 1
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THE TIME VALUE OF MONEY Future Value and Compounding Present Value and Discounting Future and Present Values of Multiple Cash  Flows Valuing Level Cash Flows: Annuities and  Perpetuities Comparing Rates: The Effect of Compounding 5-2
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BASIC DEFINITIONS Present Value – earlier money on a time line (ie  value today) Future Value – later money on a time line (ie  value at some time in the future) Interest rate – “exchange rate” between earlier  money and later money Discount rate Cost of capital Opportunity cost of capital Required return 5-3
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FUTURE VALUES: GENERAL  FORMULA FV = PV(1 + r) t FV = future value PV = present value r = period interest rate, expressed as a decimal T = number of periods Future value interest factor = (1 + r) t 5-4
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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 = 1000 + 50 = 1050 Future Value (FV) = 1000(1 + .05) = 1050 Suppose you leave the money in for another  year.  How much will you have two years from  now? FV = 1050 (1.05) = 1102.50 ie 1000(1.05)(1.05) = 1000(1.05) 2  = 1102.50 5-5
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EFFECTS OF COMPOUNDING Simple interest  assumes that interest rate paid is a flat  percentage of the principal (P) each period Compound interest interest is earned/paid on the principal plus  any accumulated interest determined since the  start of the deposit/loan. Consider the previous example FV with simple interest = 1000 + 50 + 50 =  1100 FV with compound interest = 1102.50 The extra 2.50 comes from the interest of . 05(50) = 2.50 earned on the first interest  payment 5-6
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FUTURE VALUES – EXAMPLE 2 Suppose you invest the $1000 from the previous  example for 5 years. How much would you have? FV = 1000(1.05) 5  = 1276.28 The effect of compounding is small for a small  number of periods, but increases as the number  of periods increases. (Simple interest would have  a future value of $1250, for a difference of  $26.28.) 5-7
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Suppose you had a relative deposit $10 at 5.5%  interest 200 years ago. How much would the  investment be worth today? FV = 10(1.055) 200  = 447,189.84 What is the effect of compounding? Simple interest = 10 + 200(10)(.055) = 120.00
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This note was uploaded on 04/14/2011 for the course FINS 5514 taught by Professor No during the Three '11 term at University of New South Wales.

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fins5514week2 - FINS5514:WEEK02 1 MarkHumpheryJenner...

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