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Lecture02_student - Cash flow valuation over time Present...

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Unformatted text preview: Cash flow valuation over time Present value and future value Interest rates and discounting Compounding frequency Americans have been lured to the term “millionaire” Having a million dollars has caught the attention of Americans for decades However, inflation has decreased the value of $1,000,000 The lowered value of $1,000,000 has led to many game shows that offer a $1,000,000 prize Who Wants to Be a Millionaire? Price is Right Million Dollar Spectacular Million Dollar Password Million Dollar Money Drop The $1,000,000 Chance of a Lifetime One of the first shows to offer a Million Dollar prize Aired from 1986-1987 Initially, 3 wins each against another couple and a bonus round paid $1,000,000 as follows $40,000 per year for 25 years A winner in 1986 should have received final payment in 2010 Why not give $1,000,000 all at once? $1,000,000 in 1986 = $1,960,000 in 2011 (based on CPI) This is a lot of money What is a way to lower the obligation? Pay out over time Payments made in the future are worth less than those made today Does the government care? Of course! They use this scheme, too Example: Mega Millions $12,000,000 jackpot paid out… …$461,538/year for 26 years… …or a one-time lump sum of $7,042,000 Mega Million information as of March 3, 2011 How can we come up with $7,042,000? We will learn tools in the next two lectures that deal with figuring out how much a stream of payments is worth in today’s dollars Present value We can also find out how much a payment made today is worth in the future Future value What are our tools? Interest Simple Compound Discount rates How much less do we value future payments? Compounding frequency Frequency matters More frequent compounding can be more complicated to calculate Starting “simple” We will look at a simple case here Two time periods Today and one year from now No risk Assume that promised payments one year from now are paid with certainty We assume that for each $1 gained or lost today, it is worth $(1 + r ) one year from now What is r ? The letter r can be thought of in multiple ways Interest rate Rate of return Discount rate What is r ? Interest rate/Rate of return If I invest $1 today, I will have $(1 + r ) in the next time period Example: If r = 0.2 = 20% per year, then for every dollar I invest today, I will have $1.20 in one year Discount rate If I receive $1 in the next time period, it is worth $ today r + 1 1 A two-period example...
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This note was uploaded on 12/05/2011 for the course ECON 134a taught by Professor Lim during the Fall '08 term at UCSB.

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Lecture02_student - Cash flow valuation over time Present...

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