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Session 1

A dollar tomorrow is worth less than a dollar today

Present consumption preferred to future consumption Monetary Inflation Uncertainty (risk)

Money, when invested, grows with time

CF0 CF1 CF2 CF3 CFn

2

Compounding

n

Future Value

Present Value

Discounting

Discount Rate

The rate of return used to compound or discount the cash flows in order to find the future value or present value of money

CF1 CF2 CF3 CFn PV = CF0 + + + ........................ + 1 2 3 n (1 + r) (1 + r) (1 + r ) (1 + r)

Example 1

John has invested in an account that returns $500 at the end of every year for next 3 years. The discount rate in is 8% per annum. Find the present value of the cash flows and their future value after 3 years.

$500 $500 $500 CFn

t

$462.96

$428.66

$396.91

PV = $1288.54

FV = $1623.20

Annual rate of return actually being earned taking into account different compounding periods

EAR = (1 + PeriodicRate) -1

m

Annualized Rate

AnnualizedRate = PeriodicRate * CompoundingFrequency

Annuity is a stream of equal cash flows that occur at equal intervals over a given period

Ordinary Annuity : Payments are made at the end of each compounding period Annuity Due : Payments are made at the beginning of each compounding period

PVperpetuity = Cash Flow / r

The Net Present Value of an investment is the present value of its cash inflows minus the present value of the cash outflows

It indicates the net gain to the investor after accounting for the opportunity cost of capital Invest money in any project, only if its NPV value is positive

The Internal Rate of Return is the discount rate that makes the NPV of a project equal to zero Invest in a project only if its IRR is greater than the opportunity cost of capital

Mutually exclusive projects When NPV and IRR give conflicting results, always choose the project with higher NPV An inherent assumption in the calculation of IRR is that the reinvestment happens at the same rate. This may not be true.

Applications

Bond Valuation

$50 $50 $50 $1000 + 50

Loan Amortization

$X $X $X $X

x x x x P= + + ........................ + 1 2 3 (1 + r) (1 + r) (1 + r ) (1 + r)n

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