• simply the cost of "renting" money for a specific purpose
• determined by the interaction of the deman for loanable funds and the supply of loanable funds

• lenders should rationally expect compensation for inflation when lending since inflation reduces the purchasing power of money
• can explain the impact of higher inflationary expectations in the loanable funds context
• Demand for loanable funds increase while supply for loanable funds seem to fall

1 +Nominal rate= (1+ Real Rate)*(1+Expected Inflation)

A key point to remember is that a lender has to form an expectation about future inflation when lending money

• Foreign Exchange Rates (FX)
• An exchange rate is the rate at which one currency can be converted into another currency
• Four Lessons about FX Rates

1. FX Rates can vary substantially
2. A strong currency is not necessarily a good thing, nor is a weak currency necessarily a bad thing
3. Not all countries allow their currencies to float freely in the FX market
4. Trade flows impact FX

the value of a cash flow at the beginning of a period

P=F_t/(1+i)^t

the value of a cash flow at the end of a period

F_t= P (1+i)^t

P- present value

F- future value

t- number of periods

i- rate of interest

A- annuity

1. Ordinary Annuity- one where cash flows occur at the end of periods
2. Annuity Due- cash flows occur at the beginning of each period

most annuities have a finite number of cash flows, but a few go on perpetually

P=A/i

Future: F_t= A [(1+i)^t-1/i]

Present: P= A [1/i - 1/i(1+i)^t]

Future: F_t= A [(1+i)^t+1-1/i - 1]

Present: P=A+A[1/i - 1/i(1+i)^t-1]

• Unfortunately, in the real world the standard is uneven cash flows
• This requires that you discount or compound each cash flow individually

1. The opportunity cost associated with investing or saving
2. Inflationary expectations
3. Risk

• because a bond's price is a present value, if interest rates rise (fall), the price of a bond will fall (rise)
• since the yield to maturity is market interest rate, bond prices can rise and/or fall from now until maturity
• the investor always receives face value at maturity
• The sensitivity of a bond's price to changes in market interest rates is called interest rate risk

• credit risk varies widely from bond to bond
• reinvestment risk : If the reinvestment rate < y, the actual return < y. If the reinvestment rate > y, the actual return > y.
• Bonds with higher coupons have more reinvestment risk; zero coupon bonds have no reinvestment risk and thus the actual return always equals y, if the bond is held to maturity
  

valuation of common stocks follows the same basic principles

• unlike bonds they never mature
• harder to find appropriate discount rate
• future cash flows are far less certain

• can be used to value any growing perpetuity

• assumes: stock pays a dividend, dividends grow at a constant rate, discount rate exceeds growth rate
• tells us that stock prices are a function of more variables than bond prices

• Assessment Methods: NPV, IRR, Payback Period, Discounted Payback Period
• Cash flow estimation
• Cost of Capital

• Replacement: needed to continue current operations
• Replacement: cost reduction
• Expansion of existing products or markets
• Expansion into new products or markets
• Safety and/or environmental projects
• Mergers

• Cash flows
• Discount Rates

What should the decision rule for asset investment projects be when using NPV?

-Independent Projects:

if NPV > 0 then make the asset investment

if NPV < 0 then reject the asset investment

-Mutually Exclusive

choose whichever project has the higher NPV

Adv: considers time value of money/ risk

DisAdv: tough predicting cash flows and discount rates

Decision Rule for IRR

-Independent projects: if IRR > discount rate (WACC) then make the asset investment

-Mutually Exclusive: accept the project with the highest IRR assuming IRR > WACC

the time it takes to recover the initial cash outlay

Adv: easy to compute and nice rough guide

DisAdv: does not consider TVM/risk and ignore cash flows after the payback period

• Care about the cash generated by the projetc not the accounting income
• Factors: Timing and Incremental
• Essential to understand the cost associated with a project
• Opportunity costs: other options must the firm forego in order to pursure a given project
• Externalities: the effects of a project on other parts of the firm or the environment (ex. Negative within-firm, Positive within-firm, and Environmental)

• Long-term sources of funds only
• Most firms finance all of their long-term assets, and even some of their short-term assets, with long-term sources of funds
• Use current market values and rates

• should be higher than both the cost of debt and the cost of preferred stock
• Two types

Old Equity: retained earnings

New Equity: sale of new shares