Chapter 2 Interest Rates and Rates of Return Interest the cost of money It compensates for o Opportunity cost o Default risk o Inflation It varies with o Economic changes Inflation Money supply Economic and political stability versus uncertainty Potential returns from other investments opportunity cost Economic environment Time Value of Money Money received today is worth more than money received in the future Compounding Most financial tax involves the future flow of cash The future value FV o The value of an investment made today is expected to increase in the future as a result of The interest earned on the investment Interest rates link the financial present and future Compounding occurs when interest is earned on interest o ex invest 1000 paying 8 for two years Compounding annually o Shorter compounding periods result in higher yields o The longer the time money compounds the larger its future values o The more frequently money compounds the larger its future value o The higher the interest rate at which money compounds the larger its future value o Money compounds exponentially o The more time before a payment in the future is received the smaller its present o The higher the interest rate used to discount a future payment the smaller its o The PV of a series of future payments is the sum of the discounted value of each of value present value the individual payments Discounting Consider since money received today is worth more than if it were received in the future then o The same sum of money received in the future must be worth less This smaller value is its present value PV Why discounting is important o When someone buys an investment they expect it to be worth more in the future The amount they ll pay for it today depends on their expectations of the future amount they think they ll receive and when they think they ll get it o Investors can discount these future expected amounts based on their assumptions of the future These expected returns are used to calculate the investment s PV This amount they should be willing to pay for the investment today o If the investment s price is its PV they should be willing to buy it If its price is greater than its PV they should consider the investment overpriced and not buy it
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