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Chapter 11

Chapter 11. The Time Value of Money. Investing and Financing Activities. Investing activities concern Purchase Use Sale of long term assets Financing activities concern Raising cash by borrowing By issuing an ownership interest in the business

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Chapter 11

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  1. Chapter 11 The Time Value of Money

  2. Investing and Financing Activities • Investing activities concern • Purchase • Use • Sale of long term assets • Financing activities concern • Raising cash by borrowing • By issuing an ownership interest in the business • Paying cash to repay monies borrowed from creditors • To provide a return to owners

  3. Managements goal is to utilize the company’s resources effectively and efficiently so the operating activities generate an operating profit. • Companies use operating profits in three ways. • To pay the interest on borrowed funds and repay the borrowed funds when due • To reward the owners with dividends ( or in the form of withdrawals for sole proprietors or partnerships) • To reinvest funds in the firm to maintain the existing operational capacity and to finance additional long-term investments in the firm.

  4. What is the Difference between Return Of and Return On an Investment? • Return OF • Return of the initial amount invested • Return ON • Additional amount returned in excess (or less than) the amount invested

  5. Rate of return • Rate of Return– a percentage measures the performance of investments on a common-size basis and eliminates any distortion caused by the size of the initial investment. • Dollar amount of return on investment divided by Dollar amount of initial investment = rate of return • Illustration on page 309—exhibit 11.3

  6. Expected Rate of Return – Predicted Rate • Do not confuse the expected rate of return with the actual rate of return on an investment. An investor estimates the expected rate of return before making the investment, while the actual rate of return on an investment is calculated at some future date after the outcome of the investment is revealed. • Illustration on page 310 exhibit 11.4

  7. What is Risk? • Risk • The chance of an unfavorable outcome • Inflation risk • Risk of changing price levels • Business risk • Risk of a particular company going out of business • Liquidity risk • Risk that an investment cannot be converted into cash when needed

  8. How are Risk and Return Related? • Expected rate of return • Estimated rate of return on an investment • Risk premium • Expected rate of return adjusted for inflation, business, and liquidity risk • Note: The greater the risk, the higher the expected rate of return.

  9. What is the Difference between Simple and Compound Interest? • Simple • Interest is calculated on principal only • Interest (1) = Principal * Rate * Time • Interest (2) = Principal * Rate * Time • Compound • Interest is calculated on principal plus accumulated interest • Interest (1) = Principal * Rate * Time • Interest (2) = (Principal + Interest [1]) * Rate * Time

  10. What are the Time Value of Money Components? • FV = future value • PV = present value • c = compoundings/payments per year • r = annual interest rate • n = total number of compoundings/payments • ANN = annuity

  11. What is the Future Value of $1? • Answers the question: What amount will $1 grow to at some point in the future? • Example: • If we invest $2,000 today, what will it be worth in 5 years, if we earn 8 percent interest compounded quarterly? • PV = 2,000, r = 8, c = 4, n = 20, ANN = 0 • FV = $2,971.89

  12. Formula: FV of $1 PV * ($1 + r/c)n = FV $2,000 * ($1 + 0.08/4)20 = FV $2,000 * 1.4859 = FV $2,971.89 = FV

  13. What is the Present Value of $1? • Answers the question: What is $1 at some point in the future worth today? • Example: • If we receive $2,000 in 5 years, what is it worth today if we could invest it at 8 percent interest compounded quarterly? • FV = 2,000, r = 8, c = 4, n = 20, ANN = 0 • PV = $1,345.94

  14. Formula: PV of $1 FV * 1/($1 + r/c)n = PV $2,000 * 1/($1 + 0.08/4)20 = PV $2,000 * 0.6730 = PV $1,345.94 = PV

  15. What is an Annuity? • A series of EQUAL cash payments made at EQUAL intervals.

  16. What is the Future Value of an Annuity? • Answers the question: What is a series of payments going to be worth at some point in the future? • Example: • If we invest $100 every month for 10 years and earn 12 percent interest, how much money will we have in 10 years? • ANN = 100, PV = 0, r = 12, c = 12, n = 120 • FV = $23,003.87

  17. Formula: Future Value of an Annuity ANN * [($1 + r/c)n - $1]/(r/c) = FV $100 * [$1 + 0.12/12)120 - $1]/(0.12/12) = FV $100 * 230.0387 = FV $23,003.87 = FV

  18. What is the Present Value of an Annuity? • Answers the question: How much must be received today to generate a series of equal payments in the future? • Example: • We want to buy a car for $25,000. The dealer will finance us at 10 percent annual interest for 5 years, how much will the monthly payments be? • PV = 25,000, FV = 0, r = 10, c = 12, n = 60 • ANN = $531.18

  19. Formula: Present Value of an Annuity ANN * [$1 - $1/($1 + r/c)n]/(r/c) = PV ANN * [$1 - $1/($1 + 0.10/12)60]/(0.10/12) = $25,000 ANN * 47.0654 = $25,000 ANN = $531.18

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