Chapter 4 Flashcards
(18 cards)
Stream of Cash flows
Series of cash flows lasting several periods
Timeline
Linear representation of the timing of the expected cash flows
Rule 1 of Time travel with money
Our first rule is that it is only possible to compare or combine values at the same point in time
This restates that only cash flows in the same units can be compared or combined
A dollar today and a dollar in one year aren’t equivalent
Rule 2 of Time travel with money
To move cash forward in time, you must compound it
Compounding: multiplying the value or cash flow by the interest rate factor → all becomes C * (1 + r) ^ n
Time value of money: change between PV and FV → reflects the fact that by having money sooner, you can invest it and have more money later as a result
Future value of a cash flow
Money x (1 + r) ^ t
Rule 3 of Time travel with money
To move back a cash flow in time, you must discount it
Discounting: dividing the value or cash flow by the interest rate factor → all becomes C / (1 + r) ^ n
Present value of a cash flow
PV = C / (1 + r)^n
Perpetuity
Stream of equal cash flows that occur at regular intervals and last forever
Present value of a perpetuity
C / r
Growing perpetuity
Stream of cash flows that occur at regular intervals, and grow at a constant rate forever
Present value of a growing perpetuity
C / r - g
Annuity
Stream of N equal cash flows paid at regular intervals
Growing annuity
Stream of N growing cash flows paid at regular intervals
Loan or Annuity Payment
C = P / 1/r (1 - 1/(1+r)^n)
IRR
Internal Rate of Return
The interest rate that sets the net present value of the cash flows equal to 0
IRR with 2 cash flows
(FV / P) ^ (1/n) - 1
If IRR > desired rate of return
Investment is attractive
If IRR < desired rate of return
Investment isn’t worth pursuing
