25-08-2012, 11:28 AM
Concepts of Value and Return
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LEARNING OBJECTIVES
Understand what gives money its time value.
Explain the methods of calculating present and future values.
Highlight the use of present value technique (discounting) in financial decisions.
Introduce the concept of internal rate of return.
Time Preference for Money
Time preference for money is an individual’s preference for possession of a given amount of money now, rather than the same amount at some future time.
Three reasons may be attributed to the individual’s time preference for money:
risk
preference for consumption
investment opportunities
Required Rate of Return
The time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It may be therefore called the risk-free rate.
An investor requires compensation for assuming risk, which is called risk premium.
The investor’s required rate of return is:
Risk-free rate + Risk premium.
Would an investor want Rs. 100 today or after one year?
Cash flows occurring in different time periods are not comparable.
It is necessary to adjust cash flows for their differences in timing and risk.
Example : If preference rate =10 percent
An investor can invest if Rs. 100 if he is offered Rs 110 after one year.
Rs 110 is the future value of Rs 100 today at 10% interest rate.
Also, Rs 100 today is the present value of Rs 110 after a year at 10% interest rate.
If the investor gets less than Rs. 110 then he will not invest. Anything above Rs. 110 is favourable.
Future Value
Compounding is the process of finding the future values of cash flows by applying the concept of compound interest.
Compound interest is the interest that is received on the original amount (principal) as well as on any interest earned but not withdrawn during earlier periods.
Simple interest is the interest that is calculated only on the original amount (principal), and thus, no compounding of interest takes place.