Lecture 1 - Return of Investment Time Value of Money

Question 1

What are the two types of assets one can invest in?

Answer 1

Real assets like machinery and property that exist physically and can generate income, and financial assets like bonds and shares which are contracts that can yield incomes such as interest or dividends and/or capital gains.

Question 2

How is return on an investment defined in finance?

Answer 2

It is the proportional change in value of an investment over a period of time, typically expressed as a percentage.

Question 3

How do you calculate the return on investment for a stock that increases in value from 10 pounds to 12 pounds within a year?

Answer 3

The return is calculated as (12-10)/10 = 20 percent.

Question 4

What is the formula for converting periodic returns to an annualized return?

Answer 4

Question 5

What is the present value concept?

Answer 5

Present value is a financial principle that calculates the current worth of a future cash flow or amount of money, taking into account a specific rate of return or discount rate.

Question 6

How does compound interest differ from simple interest?

Answer 6

Simple interest is applied only to the principal amount (P0), whereas compound interest is applied to both the principal and the interest earned in previous periods.

Question 7

Why are future cash flows discounted in financial analysis?

Answer 7

Future cash flows are discounted to account for the time value of money, reflecting the premise that money available now is worth more than the same amount in the future due to its potential earning capacity. Factors such as risk, inflation, and consumer preference also play a role.

Question 8

How does the present value of a future cash flow change with the discount rate?

Answer 8

The present value of a future cash flow decreases as the discount rate increases. This is because a higher discount rate reflects a higher opportunity cost of capital or a higher rate of return required, making future cash flows less valuable in present terms.

Question 9

Why is the interest rate often used as a discount rate in financial analysis?

Answer 9

The interest rate for savings is widely available and serves as a benchmark rate of return for investors. A project’s return must be at least as high as this rate for the investment to be considered worthwhile.

Question 10

What is the formula for calculating the rate of return (k)?

Answer 10

Question 11

How can the rate of return formula be reaaranged to find the future value of an investment?

Answer 11

Question 12

How can the rate of return formula be rearranged to find the present value of a future investment?

Answer 12

Question 13

What does this formula represent?

Answer 13

It represents the rate of return as the change in the investment value over its initial value.

Question 14

Answer 14

Question 15

Answer 15

Question 16

What are the three key insights from the given rate of return
𝑘?

Answer 16

Question 17

How do you calculate the future value of an investment?

Answer 17

Question 18

How do you calculate the present value needed to achieve a desired future value?

Answer 18

Question 19

What is the formula for calculating future value using simple interest?

Answer 19

T = number of years
P0 = Original investment (principal amount)
k = annual interest rate

Question 20

What is the formula for calculating future value using compound interest?

Answer 20

T = number of years
P0 = Original investment (principal amount)
k = annual interest rate

Question 21

What does “heavily discounted” mean in finance?

Answer 21

“Heavily discounted” refers to applying a higher discount factor to future cash flows expected further in the future, reducing their present value more significantly compared to near-term cash flows.

Question 22

Why is money to be received in the distant future worth less than money to be received in the near future?

Answer 22

Due to the time value of money, money today can be invested to earn returns, making it more valuable than the same amount in the future.

Question 23

What factors cause future cash flows to be more heavily discounted?

Answer 23

Risk: The future is uncertain.
Inflation: Prices usually increase over time.
Consumer Preference: People prefer to receive money sooner rather than later.

Question 23

How does risk affect the discounting of future cash flows?

Answer 23

The longer the time horizon, the greater the uncertainty and risk that expected cash flows may not be realized, leading to a higher discount rate and heavier discounting.

Question 24

How does inflation impact the discounting of future cash flows?

Answer 24

Inflation erodes the purchasing power of money over time, making future cash flows worth less in real terms and resulting in heavier discounting.

Question 25

What is the discount rate?

Answer 25

The discount rate is the rate of return used to convert future cash flows into their present value, reflecting the time value of money, risk, inflation, and opportunity cost.

Question 26

How does consumer preference influence the discounting of future cash flows?

Answer 26

People generally prefer to receive money sooner rather than later due to the opportunity to use or invest it, leading to higher discounting of future cash flows.

Question 27

Formula for Annualized Return (Ka)

Answer 27

Question 28

Formula for Monthly Return (Kp)

Answer 28

Question 29

What is the return formula when dividends is involved?

Answer 29

Question 30

How do you calculate the amount of Periods in a year for calculating both annualized return and monthly returns?

Answer 30