Chapter 4 (come back to 4.6) Flashcards
Excl. 4.7 - 4.10
What does a stream of cash flow mean?
Its when we refer to and value a series of cash flows lasting several periods.
How can we show how a stream of cash flows look like graphically?
On a timeline
What is a timeline?
Its a linear representation of the ‘timing’ of the expected cash flows
Timelines are an important first step in organizing and solving a financial problem.
Its useful in tracking cash flows if you interpret each point on the timeline as a specific date.
Example:
Suppose a friend owes you money (today) and he has agreed to repay the loan by making two payments of $10,000 at the end of each of the next two years. We represent this information on a timeline how?
There are three places
Date 0 (refer to as today)
Date 1 (1 yrs from today) - You will recieve payment 1 at the end of the first year.
Date 2 (2 yrs from today) - You will recieve payment 2 at the end of the second year
Example:
Suppose a friend owes you money (today) and he has agreed to repay the loan by making two payments of $10,000 at the end of each of the next two years.
What does date 0 / date 1 / date 2 mean?
Date 0 is the beginning of the first year
Date 1 is the end of the first year and also the beginning of the second year.
Date 2 - Is the end of the second year
In many financial decisions we often see what two things about cash flow?
Cash inflow
Cash outflow
What sign do we assign a cash inflow?
A positive symbol to represent a cash inflow
What sign do we assign a cash outflow
A negative symbol to represent a cash outflow
Example:
To illustrate, suppose you’re still feeling generous and have agreed to lend your brother $10,000 today. Your brother has agreed to repay this loan in two instalments of $6000 at the end of each of the next two years. The timeline is what?
Date 0 - -10,000
Date 1 - +6,000
Date 2 - +6,000
So far you have learnt and seen on timelines that cash flows occur at the end of the year. Is that true in all cases and give me an example.
No,
we can use timelines to represent cash flows that take place at the end of any time period
For example, if you pay rent each month, you could use a timeline like the one in our first example to represent two rental payments, but you would replace the “year” label with “month.”
What do they recommend to do for every problem?
Draw a timeline!
example: Suppose you must pay tuition and residence fees of $10,000 per year for the next two years. Assume your tuition and residence fees must be paid in equal instalments at the start of each semester (assume July 1 and January 1 as the semester-payment due dates). What is the timeline of your tuition and residence fee payments
Go to the end of 4.1 : Chapter 4
What do we have to do a lot for financial decisions?
It requires us often to compare or combine cash flows that occur at different points in time.
What are the three important rules that central financial decisions that allow us to compare on combine values (cash flows)?
Rule 1: Only Cash Flow Values at the Same Point in Time Can Be Compared or Combined
Rule 2: To Move a Cash Flow Forward in Time, You Must Compound It
Rule 3: To Move a Cash Flow Backward in Time, You Must Discount It.
Explain the first rule of comparing or combing cash flows that occur at different points in time?
The first rule states that its only possible to compare or ‘combine cash flows’ or values at the same point in time.
Meaning only cash flows in the same units (either PV or Fv both) can be compared or combined.
To compare or combine cash flows that occur at different points in time, you first need to convert the cash flows into the same units (either PV or FV) or move them to the same point in time.
What does the second rule of financial decisions when we want to compare or combine cash flows mean what?
To move a cash flow forward in time, you must compound it.
How do we move the cash flow forward in time? (Calculation wise)
We multiply the interest rate factor (1+ r) to the cash flow to move the cash flow.
What is compounding?
Its the process of moving a value or cash flow forward time.
To move a cash flow forward in time, we must compound it
Example: Suppose we have $1000 today, and we wish to determine the equivalent amount in one year’s time. If the current market interest rate is 10%, we can use that rate as an exchange rate to move the cash flow forward in time. That is,
1000*(1.10) = 1100
Example:
Example: Suppose we have $1000 today, and we wish to determine the equivalent amount in one year’s time. If the current market interest rate is 10%, we can use that rate as an exchange rate to move the cash flow forward in time.
how can we show this on a timeline (for two years)
date 0 - present would have 1000
Date 1 - would have 1100
Date 2- would have1210
Due to the 10% interest rate they are all equivalent in terms of value but expressed in different units (different points in time)
What does the future value mean?
its the value of a cash flow that is moved forward in time.
Ex: 1210 is the FV of 1000 (10% interest rate)
What happens when we move the cash flow further into the future?
the value grows as we move the cash flow further into the future
What is the time value of money
its the ability to show two equivalent cash flows at different points in time.
two different units basically mean they are equivalent however they are at expressed at different points in time
What is simple interest?
Its when an investment only earns interest on principle payment you made and no interest on accrued interest
