LOS 5

Real Risk-Free Rate

• A theoretical rate on a single-period loan that has no expectation of inflation in it.

LOS 5

Nominal Risk-Free Rate

= real risk-free rate + expected inflation rate

LOS 5

Types of Risk that Require
a Rate of Return

1. Default Risk
2. Liquidity Risk
3. Maturity Risk

LOS 5

Default Risk

The risk that a borrower will not make the promised payments in a timely manner.

LOS 5

Liquidity Risk

LOS 5

Maturity Risk

LOS 5

Required Rate of Return on a Security =

LOS 5.c

Effective Annual Rate
(EAR)

• The rate of interest that investors actually realize as a result of compounding.
• Represents the annual rate of return actually being eraned after adjustments have been made for different compounding periods.
  
• = (1 + periodic rate)^m - 1
  where:
  period rate = stated annual rate / m
  m = the number of compounding periods per year

LOS 5.c                                                                               Formula

EAR =

= (1 + Periodic Rate)^m - 1

where:

periodic rate = stated annual return / m

m = the number of compounding periods per year

LOS 5.e

Future Value of A Single Sum

• The amount to which a current deposit will grow over time when it is placed in an account paying compound interest
• Also called Compound Value

LOS 5.e                                                                               Formula

Future Value of Single Cash Flow =

= PV (1 + I/Y)^N

where:

PV = present value, amount of money invested today

I/Y= rate of return per compounding period

N = total number of compounding periods

LOS 5.e

Present Value of a Single Sum

• Today's value of a cash flow that is to be received at some point in the future
• The money that must be invested today, at a given rate of return over a period of time, in order to end up with a specified future value.

LOS 5.e

Discounting

• The process of calculating the present value.
  
  
• Future cash flows are 'discounted' back to the present.

LOS 5.e                                                                               Formula

Present Value =

LOS 5.f

Loan Ammortization

The process of paying off a loan with a series of periodic loan payments, a portion of the loan is ammortized with each payment.

LOS 5.f

Cash Flow Addivity Principle

LOS 5.a

Interest Rate

Can be interpreted as:

• The rate of return required in equillibrium for a particular investment.
• The discount rate for calculating the present value of future cash flows
• The opportunity cost of current consumption

LOS 6.a

Net Present Value

• The present value of expected cash flows associated with the investment project  less the present value of the project's expected cash outflows, discounted at the appropriate cost of capital.

LOS 6.a

Steps to Computing NPV

1. Identify all cost (outflows) and benfits (inflows) associated with an investment
2. Determine the appropriate discount rate or opportunity cost for the investment
3. using the appropriate discount rate, find the PV of each cash flow.
   Inflows are positive and increase NPV.
   Outflows are negative and decrease NPV
4. Compute the NPV, the sum of the discounted cash flows.