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**Unformatted text preview: **Ch 6 – Time Value of Money • What determines interest rates? o The balance of time rate preferences of capital market participants – i.e. consumption preference adjusted for risk Who has the high rate of time preference? • Depends on endowments and health Who has low rate of time preference? • Nature of Interest o Payment for the use of money o Excess cash received or repaid over the amount (borrowed) principal. o Variables involved in financing transaction Principal: amount borrowed Interest Rate: a percentage Time: The number of years or portion of a year that the principal is outstanding • Simple Interest: Interest computed on the principal only o On 1/2/07, Tomalczyk borrows $20,000 for 3 years at a rate of 7% a year. Annual interest cost Full Year Partial Year • Compound Interest o Computes interest on… Principal On interest earned to date (assuming interest is left in deposit) o Compound interest is the typical interest computation applied in business situations • Annual Interest Rate = r = $10% on $1,000 investment • Basic Time Value Concepts o Compound Interest: • Single-Sum Problems • Valuation of Long-Term Bonds o Two Cash Flows: Periodic Interest Payments (Annuity) Principal paid at maturity (Single-sum) o Bonds current market value is the combined present values of both the cash flows • When the coupon rate is higher than the discount rate, the market value of the bond will be higher than the par value • Interest [only] yield = Interest Payment/ Market Value o Buy a bond at the market value, and get a return of X%. • Journal Entry to record the purchase of the bond as an “available for sale” investment in February 2010 • Lottery Prizes – Man taking home lump sum of 88.5 million after taxes o $232 million jackpot / 20 years = 11.6 million per year o After tax at 39% - 11.6 x [1-0.39] = 7.076m per year for 20 years o PV of income stream = PV of lump sum 7.076 x AF(20,r) = 88.5 AF(20,r) = 88.5/7.076 = 12.5 • Average Interest Rate = Interest Paid per Year / Average Amount Borrowed o =(Total Interest/Length of Loan)/Average Loan • Repayment = Amount Borrowed / AF • Dealing with Inflation o Time Preference of Money exists for several reasons: Consumption preference Risk preference Investment preference And additionally, changes in the purchasing power of money o M = money rate, i = inflation rate, r = real time preference rate of capital market (1+m) = (1+r)(1+i) • Discount Factor: PV=1/(1+r) n • Savings Plan = C /AF o AF = 1- (1/(1+i) t )/i Ch. 7 Cash and Receivables • Why hold cash – what is it? o Transactions motive o Precautionary motive Just in case, in expectation you won’t be able to pay for something in three months time o Speculative motive o Most liquid asset – Current o Basis for measuring and accounting for all items o Example: Coin, currency, available funds on deposit at the bank, money orders, certified checks, cashier’s checks, personal checks, bank drafts, and savings accounts...

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