Asset Pricing & Capital

Budgeting Summary by Akiel

 3. Time Value of Money: An Introduction

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3.3.2 The Interest Rate: Converting Cash Across Time
3.1 Cost Benefit Analysis
3.1.1 Role of the Financial Manager Interest Rate (r) : The rate at which money can be borrowed or
It is really simple, just make sure for every decision the lent over a given period.
benefits outweighs the costs. In order to quantify those costs’ and Interest Rate Factor: The rate of exchange between dollars today
benefits’, financial managers use skills from other management and dollars in the future. it has units of “$ in the future/$ today”
disciplines, such as:
(1+ r)

3.1.2 Quantifying Costs and Benefits

We must value all options using the same metric, which is Cash
Today. In Competitive Markets, a good can be bought and sold at
the same price, which determines the value of that good: This
means our own preference for the good doesn’t matter, we can
always sell it and receive the goods value.

3.2 Market Prices and the Valuation

Principle
3.2.1 The Valuation Principle
The Valuation Principle : the value of a commodity or an asset
to the firm or its investors is determined by its competitive
market price. The benefits and costs of a decision should be
evaluated using those market prices. When the value of the
benefits exceeds the value of the costs, the decision will
increase the market value of the firm.

Example: an airline having oil options but not needing oil. if the
market price of the oil still exceeds the the price of the option, it
should buy and sell the oil according to the valuation principle,
since its benefits exceeds its costs.

3.2.2 Why Can There be Only One Competitive Price for

a Good

The law of one price: in competitive markets, securities with the

same cash flows must have the same price.
Arbitrage: the practice of buying and selling equivalent goods to
take advantage of a price difference.
Arbitrage Opportunity: Any situation in which it is possible to
make a profit without taking any risk or making any investments.

3.3 The Time Value of Money and Interest

Rates
3.3.1 The Time Value of Money
Time Value of Money: the difference in value between money
received today and money received in the future; also, the
observation that two cash flows at two different points in time
have different values.
Remember: in general a dollar received today is worth more than
a dollar received in the future.
Present versus Future Value:
Present Value (PV):The Value of a cost or benefit computed in
terms of cash today.
Future Value(FV): The value of cash flow that is moved forwards
in time.
. ..
Discount Factors and Rates:
Discount Factor: the value today of a dollar received in the future.
Discount Rate: The appropriate rate to discount a cash flow to
determine its value at an earlier time; also referred to as the
interest rate for an investment.

It r
=
1.10=0.909 • Discount Factor

In other words for just under 91 cents you can “buy” $1 to be

delivered in one year.
 3. Time Value of Money: An Introduction

l
3.3.2 Timelines 3.4.3 Rule 3: Dicscounting
Timeline : a linear representation of the timing of (potential) cash This rule stipulates that to calculate the value of a future cash
flows. flow at an earlier point in time., we must discount it.
Discounting: finding the equivalent value today of a future cash
flow by multiplying by a discount factor, or equivalently, dividing
by 1 plus the discount rate.

3.4 Valuing Cash Flows at Different

Points in Time.
There are three rules.

3.4.1 Rule 1: Comparing and Combining Values

It is only possible to compare or combine values at the same
point in time, meaning all cash flows must be converted to same
units (time) using the following 2 rules:

3.4.2 Rule 2: Compounding

This rule stipulates that to calculate a cash flow’s
future value, you must compound it.
Compounding : computing the return on an investment over a
long horizon by multiplying the return factors associated with
each intervening period.
Compound Interest: the effect of earning “interest on interest’.

Simple Interest: Interest earned on the initial deposit

 4 Time Value of Money: Valuing Cash Flow Streams

1.
Math Part
FV
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4.2 Perpetuities
simplifies to if OCRCI & N Bos
Perpetuity: A stream of equal cash flows that occurs at regular
-

This

n intervals and lasts forever. Example: Bonds, Mortgages, and

I Retirement Funds.
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Calculating Using geometric Series :
4.1 Valuing a Stream of Cash Flows
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Most Investments have cash flows occurring in multiple periods,
and this needs to be converted to one point in time in order to
compare costs and benefits. We can this the Present Value (PV).
PVCC in Perpetuity ) =
C-
r

Perpetuity formulas work Assuming the first Payment is one

year from now.
 4 Time Value of Money: Valuing Cash Flow Streams

I
4.3 Annuities 4.4 Growing Cash Flows
Annuity: a stream of equal cash flows arriving at a regular 4.4.1 Growing Perpetuity
interval and ending after a specified time period. Growing Perpetuity: A stream of cash flows that occurs at
regular intervals and grows at a constant rate forever.

Example: Bonds, Mortgage, and Retirement Fund.

4.3.1 Present Value of an Annuity

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4.3.2 Future Value of Annuity

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if ( ( Itf /
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If 9 > r : PV
=÷
: as

Which means it is Impossible

rate of
to sustain a growth
g. that is
larger than r
4.4.2 Growing Annuity
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