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Session 1
2
Compounding
n
Future Value
Present Value
Discounting
Discount Rate
The rate of return used to compound or discount the cash flows in order to find the future value or present value of money
CF1 CF2 CF3 CFn PV = CF0 + + + ........................ + 1 2 3 n (1 + r) (1 + r) (1 + r ) (1 + r)
Example 1
John has invested in an account that returns $500 at the end of every year for next 3 years. The discount rate in is 8% per annum. Find the present value of the cash flows and their future value after 3 years.
$500 $500 $500 CFn
t
$462.96
$428.66
$396.91
PV = $1288.54
FV = $1623.20
EAR = (1 + PeriodicRate) -1
m
Annualized Rate
AnnualizedRate = PeriodicRate * CompoundingFrequency
It indicates the net gain to the investor after accounting for the opportunity cost of capital Invest money in any project, only if its NPV value is positive
Applications
Bond Valuation
$50 $50 $50 $1000 + 50
Loan Amortization
$X $X $X $X
x x x x P= + + ........................ + 1 2 3 (1 + r) (1 + r) (1 + r ) (1 + r)n
Thank You!