Fin 390 Chapt 5

# Fin 390 Chapt 5 - Chapter 5 Introduction to Valuation The...

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Chapter 5 Introduction to Valuation: The Time Value of Money

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Chapter Outline Future Value and Compounding Present Value and Discounting Interest Rate and return of invesment How long will the amunt of money today be doubled? Rule of 72 Number of years * interest rate = 72 5C-2
Key Concepts and Skills Be able to compute the future value of an investment made today Be able to compute the present value of cash to be received at some future date Be able to compute the return on an investment Be able to compute the number of periods that equates a present value and a future value given an interest rate Be able to use a spreadsheet to solve time value of money problems 5C-3

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Basic Definitions Present Value – earlier money on a time line Future Value – later money on a time line Interest rate – “exchange rate” between earlier money and later money Discount rate Cost of capital Opportunity cost of capital Required return 5C-4
Future Values Suppose you invest \$1,000 for one year at 5% per year. What is the future value in one year? Interest = 1,000(.05) = 50 Value in one year = principal + interest = 1,000 + 50 = 1,050 Future Value (FV) = 1,000(1 + .05) = 1,050 Suppose you leave the money in for another year. How much will you have two years from now? FV = 1,000(1.05)(1.05) = 1,000(1.05) 2 = 1,102.50 5C-5

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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 5C-6
Effects of Compounding Simple interest: the interest earned by principle Compound interest: the interest earned by interest. Consider the previous example FV with simple interest = 1,000 + 50 + 50 = 1,100 FV with compound interest = 1,102.50 The extra 2.50 comes from the interest of .05(50) = 2.50 earned on the first interest payment 5C-7

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Quick Quiz – Part I What is the difference between simple interest and compound interest? Suppose you have \$500 to invest and you
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Fin 390 Chapt 5 - Chapter 5 Introduction to Valuation The...

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