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# CFA Prep Level 1

Session 1

## Time Value of Money

A dollar tomorrow is worth less than a dollar today
Present consumption preferred to future consumption Monetary Inflation Uncertainty (risk)

## Time Value of Money

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)

## Discount rate = Risk-free rate + Risk Premium

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

## Effective Annual Rate (EAR)

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

EAR = (1 + PeriodicRate) -1
m

Annualized Rate
AnnualizedRate = PeriodicRate * CompoundingFrequency

## Annuity and Perpetuity

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

## Perpetuity is an annuity extending over an infinite period of time

PVperpetuity = Cash Flow / r

## Net Present Value (NPV)

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

## Internal Rate of Return (IRR)

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

## The NPV Rule

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

## Face Value : \$1000 Maturity : 4 years Coupon Rate : 5% Discount Rate : 8%

Loan Amortization
\$X \$X \$X \$X

## Amount Borrowed : \$1000 Maturity : 4 years Interest Rate : 8%

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

Thank You!