Time Value of Money Flashcards
What is corporate finance?
how corporations make financial decisions, main types of decisions include:
- investment appraisal
- what to do with retained profits
- buying more production lines
- how to finance investment and corporate finance (whether to pay excess cash dividends and how)
- giving up a certain loss - making product etc
What are interest rates?
if we tie up our money in savings, we get a reward called interest, return, yield etc - measured by interest rate.
If we invest in something else, we lose the chance to earn this interest (opportunity cost)
What is inflation?
is the erosion of money, over time the cost of things will go up e.g. inflation rates are 3.5% then £100 shoes now would cost £103.5 in a year times.
There are 2 elements of inflation - 1. compensation for inflation, 2. ‘real’ rate above inflation
What’s a cashflow?
a cashflow needs an amount and a time, cashflows at different times are not the same. To account for these time differences, we use equivalent of exchange rates
What is compounding?
Present to Future
What is discounting?
Future to Present
What is future value?
the amount to which an investment will grow after earning interest.
FV = CF x (1 + r)^t
You can use the present value of money with the interest rate and time to calculate the future value of that money
What is present value?
converts future cash flow to their current values via discounting:
DFt = 1/(1+r)^t
PV = discount factor t x Ct (future cash flow)
You can use the FV of money with interest rate and the time to work backwards to the present value of money
Where can you find discount factors?
In the present values tables, you use the number of periods and match it to the interest rate
What is Net Present Value?
Is the present value of sum of all future cash flows minus the required investment. If it is positive your getting more than what you are paying/initially invested so it makes more sense to invest more, if its negative your getting less for what you payed/initially invested, so it doesn’t make sense to continue to invest
Why does most investors dislike risky ventures?
They wont invest in them unless they see the prospect of a higher return. Riskier the venture the less they are prepared to pay and the higher the return that they will demand
Do PV and opportunity cost hold for risky investment?
Yes as you need to discount the payoff by the opportunity cost of capital. Now the cash flow that you discount is the expected cash flow and the opportunity cost of capital is now that rate of return available in financial markets on investment of similar risk.
What is rate of return?
Profit as a proportion of the initial outlay.
Return = profit/investment.
What is cost of capital?
the return foregone by not investing in financial markets for example, if an office building investment is as risky as investing in the stock market, the return foregone is 12% since the 14.3% return on the office building exceeds the 12% opportunity cost, they should go ahead with the project.
What are 2 rules used to justify investment?
1 - NPV rule - accepts investments that have positive NPV
2 - Rate of return rule - accepts investments that offer rates of return in excess of their opportunity cost of capital
What is a annuity?
a fixed sum paid each year for a specified number of year, starting one year from now (series of annual cash flows of same amount).
Formula used to calcuate the Annuity factor is found in the PV table.
PV = CF x AF(r,t)
What is a annuity due?
first payment is made immediately e.g. if discount rate is 16%, PV of £100 per annum for 4 years - the first payment is now plus a 3 year standard annuity
What is a deferred annuity?
first payment is made a few years from now e.g. if discount rate is 16%, PV of £100 per annum for 4 years as a 1 year deferred annuity i.e. first payment is 2 years from now
What is a bank loan annuity?
Pay back principle including interest pay back in equal instalments, present value of instalments must equal the value of the loan, present value of a annuity - amortising loans.
What is a perpetuity?
is an annuity that continues forever, government issued consoles - bonds which carry a fixed interest payment but on which there is no obligation to pay back the principal
What is the PV of a perpetuity?
when the first payment takes place one year from now. If first payment is not one year from now, the value will have to be discounted to calculate the PV - known as perpetuity due. To find PV of a perpetuity due we add on the first years cash flow to a regular perpetuity
E.g. if the CF starts in year t + 1 then the formula gives you a PV as of year t, giving you a perpetuity one year before first CF.
PV of perpetuity = CF/r
PV of growing perpetuity = CF/r-g
What is a investment decision
often referred to a capital expenditure or capital budgeting decision for tangible assets.
Todays investments generate future cash returns, sometimes the cash inflows last for decade such as investment to develop self-driving cars or reduce greenhouse gases also has long term payoffs.
Financial managers know that cash returns are not guaranteed and investment may not have such distant pay-offs.
