Risk future money is oftentimes uncertain o depending

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Risk: Future money is oftentimes uncertain. O Depending on how you invest your money or who promises it to you, there is almost always counterparty risk. Opportunity Cost: If you have a dollar today, you can invest it to earn a return on that dollar and end up with more money in the future. O The promised return on your investment has to compensate you for expected inflation and the risk of the investment (see above). O Or you can spend it. You don’t know how much your dollar will be worth one year from now. 11
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‘Interest’ and ‘Interest Rates’ O Interest I is the price someone who borrows money (borrower, debtor) pays the lender (creditor) for the use of the borrowed money. Also, money earned on deposited funds (e.g. a savings account). O Usually expressed as an annual percentage of the outstanding balance (‘principal outstanding’): => Interest rate r O Interest rate charged depends on: Credit risk of borrower (likelihood of not being paid back either principal or interest plus principal). Duration of loan. Inflation rate. We distinguish between simple and compound interest. 12 r = $ I $ P ! $ I = r *$ P
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Visual Aid: The Timeline O A timeline is a linear representation of the timing of potential cash flows. O Drawing a timeline of the cash flows lets you visualize a financial problem that involves cash outflows and inflows at different points in time. -1 0 1 2 Periods O ----|--------------------|--------------------------|-------------------------|--------- Cash Flows One period ago Today End of Period 1 = Beginning of Period 2 13 Year 1 Year 2 Period 1 Period 2
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Different Time Lines 0 1 2 3 4 Periods |----------|----------|----------|---------|---- Cash Flows (CFs) -1 0 1 2 3 4 Periods -|---------|----------|----------|----------|---------|--- CFs T S R Q K P Periods -|---------|----------|----------|----------|---------|-- CFs Interest rate you use has to be the effective interest rate for the length of a period. 14
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Cash Flows and The Timeline O One can differentiate between two types of cash flows: Inflows are positive cash flows. Outflows are negative cash flows, which are indicated with a – (minus) sign.
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