273: M1 - Time Value of Money Flashcards
Why is money to be received in the future worth less than money in my pocket today?
- Inflation
- Payment in the future is not guaranteed
- Lost opportunity
Describe inflation
The end result is $1 today will buy more than a $1 in the future, this is referred to as loss of purchasing power. Expected inflation is measured using historical averages and projected growth rates in the economy.
Describe how payment in the future is not guaranteed
A company may experience issues with production or distribution and there may be quality issues with the technology requiring a massive recall or they may have not accurately assessed consumer demand
What is default risk
Default is the risk that the future payment will not be received. Default risk is the risk that the lender takes on in the chance that a borrower will be unable to make the required payments on their debt obligation
Describe lost opportunity
Given that there is limited money to invest, investors must choose between multiple investment opportunities. Choosing one comes at the cost of having to forego another investment opportunity referred to as opportunity cost
Opportunity cost
Opportunity cost is the relative difference between the outcome of the investment and what could have been if a different investment was made. Financial markets are subject to supply and demand. When there are lots of investors with money to lend/invest, opportunity costs are typically low as average returns are pushed down by investor supply. However, during periods of contraction in the economy when there are fewer investors with money available to invest, opportunity costs increase as average returns increase
Discount rate
The discount rate is the rate of interest used to calculate the present value of money to be received in the future. It collectively takes into account inflation, default risk and opportunity cost. Said differently, we can think of the discount rate as a hurdle rate, the minimum return you would require on an investment for it to be financially viable.
Risk Free Rate
Risk Free Rate = Inflation + Opportunity Cost
The interest rate that reflects inflation and opportunity costs collectively is referred to as the risk-free rate of return as such an investment has zero default risk.
Default risk
Default Risk: the rate of interest must adequately compensate the investor for bearing the risk that the borrowing company or government will be unable to repay the loan and default on the contract. The more likely default becomes, the higher the interest rate demanded by investors as compensation for bearing default risk.
Calculation for Discount Rate
Discount Rate = risk free rate + default risk
Discount Rate = inflation + opportunity cost + default risk
Annuity
an annuity is a series of identical cash flows for a set period of time (payments start and stop).
The annuity formula above calculates the present value (value at time zero) only if the first cash flow is received _______________.
The annuity formula above calculates the present value (value at time zero) only if the first cash flow is received in one year.
The annuity formula assumes that …
The annuity formula assumes that the first cash flow is received in one period from time zero (the present)
Growing annuity
An annuity that grows by the same amount in each period, each payment increases by the same percentage in each period
Perpetuities
Perpetuities are a series of repetitive cash flows that never end. So unlike annuities that start and stop, once a perpetuity begins, the cash flows never end. There are regular perpetuities that have the same payment every period and there are growing perpetuities, where the payment increases by the same percentage each period.
Just like annuities, the perpetuity present value formulas assume the first payment is received in one period from the present, if not, adjustments are necessary.
