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ch14(1)-1

ch14(1)-1 - THEBASICTOOLSOF THEBASICTOOLSOF FINANCE THE...

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THE BASIC TOOLS OF  THE BASIC TOOLS OF  FINANCE FINANCE THE BASIC TOOLS OF FINANCE 1

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In this chapter,  In this chapter,  look for the answers to these questions: look for the answers to these questions: What is “present value”? How can we use it to compare sums of money from different times? Why are people risk averse? How can risk-averse people use insurance and diversification to manage risk? 2
THE BASIC TOOLS OF FINANCE 3 Introduction Introduction We have learned that Investment is key for Economic Growth. The financial system coordinates saving and investment. As we have learned from the recent recession, having a well functioning financial system is key for GDP growth. Participants in the financial system make decisions regarding the allocation of resources over time and the handling of risk. Finance is the field that studies such decision making. We will talk about banks later.

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THE BASIC TOOLS OF FINANCE 4 Measuring the time value of money Measuring the time value of money Project evaluation usually requires comparing costs and benefits from different time periods. Dollars across time periods are not immediately comparable, because of inflation and also returns in the financial market. Key: the interest compounds over time , i.e. the interest is also earning interest.
THE BASIC TOOLS OF FINANCE 5 Measuring the time value of money Measuring the time value of money Compound interest is simply “interest on interest”. For example, if you put \$100 in a bank today with an interest rate of 10% compounded annually (once a year), then compounded interest increases to an amount greater than simple interest . Simple Interest Compound Interest Year 1 \$100 * 10% = \$10 \$100 * 10% = \$10.00 Year 2 \$100 * 10% = \$10 \$110 * 10% = \$11.00 Year 3 \$100 * 10% = \$10 \$121 * 10% = \$12.10 Total Interest \$30 \$33.10

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THE BASIC TOOLS OF FINANCE 6 Compounding Compounding : the accumulation of a sum of money where the interest earned on the sum earns additional interest Because of compounding, small differences in interest rates lead to big differences over time. Example: Buy \$1000 worth of Microsoft stock, hold for 30 years. If rate of return = 0.08, FV = \$10,063 If rate of return = 0.10, FV = \$17,450
THE BASIC TOOLS OF FINANCE 7 Present Value:  The Time Value of Money To compare a sums from different times, we use the concept of present value. The present value (PV) of a future sum: the amount that would be needed today to yield that future sum at prevailing interest rates The future value (FV) of a sum: the amount the sum will be worth at a given future date, when allowed to earn interest at the prevailing rate

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THE BASIC TOOLS OF FINANCE 8 Deposit today \$100 in the bank at 5% interest. What is the future value (FV) of this amount?
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