Chapter 27

1. The Tools of Finance Chapter 27

2. Time Value of Money • A dollar received in the future does not have the same purchasing power as a dollar today • Why? Inflation • Interest helps dollars grow to maintain their purchasing power

3. Simple Interest • Principle x Rate x Time • Principle is an amount borrowed or invested • Rate is the annual rate of interest paid or earned • Time is a function of one year • If you invest $10,000 for one year at 6% • 10,000 x .06 x 1 = $600 • 10,000 x .06 x 4 = $2,400 for four years • At the end of four years you have $12,400

4. Compound Interest • Interest earning interest • What if the interest earned each year is allowed to grow as part of the investment? Yr 1: 10,000 + (10,000 x .06 x 1) = 10,600 Yr 2: 10,600 + (10,600 x .06 x 1) = 11,236 Yr 3: 11,236 + (11,236 x .06 x 1) = 11,910 Yr 4: 11,910 + (11,910 x .06 x 1) = 12,625 • You come out ahead by $225

5. Compound Interest Compound interest is an exponential function: the bigger it gets the faster it grows Future value = Present value x (1 + r)n FV = $10,000 x (1 + .06)4 FV = $12,625

6. Variables • Present Value (PV) • The value of an investment or amount borrowed today • Principle only, no time no interest • Future Value (FV) • Principle + interest at some time in the future • N is the number of compounding periods • Ris the interest rate per compounding period

7. Compounding vs. Discounting Compounding is the process of adding interest: take a present value or principle payments and add interest to arrive at a future value FV = PV x (1+r)n

8. Compounding vs. Discounting Discounting moves in the opposite direction: take a future value with principle and interest and remove the interest PV = FV /(1+r)n

9. Other Considerations • Risk aversion • Diversification (firm-specific risk vs. market risk) • Risk vs. Return • Asset valuation • Value & Price • Capital gains & dividends • Random walk & index funds

10. Case Study: Enron