Week 1 - Time value of money I

Question 1

How to convert stated annual interest rate (SAIR) -> effective rate?

Question 2

How to convert effective monthly rate -> effective rate for eg. 2 months?

Answer 2

= (1+r)^n -1

Question 3

How to convert effective rate to SAIR?

Answer 3

= r(k)
where k is the no. of periods in a year

Question 4

Discount factor

Answer 4

Present value of £1. Not the same as discount rate!

d = 1/(1+r)^T

Question 5

Growth in purchasing power formula

Approximation for real interest rate

Answer 5

Growth in purchasing power = Growth of money / Growth of prices
(1+i) = (1+r)/(1+π)
where i is real interest rate, r is nominal interest rate, π is inflation rate

r wavy= i + π

Question 6

Continuous compounding formula

Answer 6

(1+EAR)^T = (e^ρ)^T = e^(ρT)

where ρ is the annual continuously compounded rate

Question 7

Inflation rate, π

Answer 7

the rate (usually annual) at which the PRICES level in the economy increases

Question 8

Nominal interest rate, r

Answer 8

the rate at which the balance of a deposit grows in CASH TERMS; to discount nominal cash flow

Question 9

Real interest rate, i

Answer 9

the rate at which the balance of a deposit grows in PURCHASING POWER TERMS; to discount real cash flow

Question 10

“Net present value is just a theory. It has no practical relevance. We maximize profits. That’s what shareholders really want.”

Respond to this comment.

Answer 10

1. An asset’s NPV is the NET GAIN to investors who acquire the asset
2. concept of “maximising profits” is fuzzy here:
   - Not clear whether means sacrificing profits tmr
   - In contrast, NPV criterion correctly accounts for the TIMING of returns from an investment
3. “maximising profits” also does not take RISK into account. Not possible to determine if worth trying to increase (avg) profits if risk is also increased
4. Unclear which acct. figure should be maximised b/c profit figure depends on acct. method chosen
5. CASH FLOW is important & can be spent/invested
   - not profit, which is just a no. of a piece of paper that changes w/ acct. methods