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Understanding Interest Rates: Determination and Future Value Factors, Lecture notes of Finance

The concept of interest rates, their relationship with productivity and preference, and how to calculate the future value of a sum using future value factors. It also covers the time dimension in investment/financing decisions and provides examples of using future value factors to determine the future value of a sum.

Typology: Lecture notes

2010/2011

Uploaded on 09/10/2011

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M.Sc. Finance
M.Sc. Investment & Finance
M.Sc. International Banking & Finance
and
M.Sc. International Accounting & Finance
Time Value of Money – The Role of Interest
Rates in Decision Taking
30th September 2009
J R Davies
Finance I
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Download Understanding Interest Rates: Determination and Future Value Factors and more Lecture notes Finance in PDF only on Docsity!

M.Sc. Finance

M.Sc. Investment & Finance

M.Sc. International Banking & Finance

and

M.Sc. International Accounting & Finance

Time Value of Money – The Role of Interest

Rates in Decision Taking

30

th

September 2009

J R Davies

Finance I

Time Value of Money

A pound today is worth more than a pound to-morrow………even in the absence of

Risk and uncertainty

Inflation

The time value of money stems from the interest rate– effectively the price that balances the supply anddemand for loans.

The rate of interest in turn reflects

The productivity (at the margin) of realinvestments

The preference (at the margin) for consumptiontoday rather than some time later

As a result of the time value of money it is notpossible to sum costs and benefits anticipated atdifferent points in time

Interest Rates

The riskless real rate of interest (r

0

): the rate of

interest that can be expected in the absence of

Risk and uncertainty

Inflation

A premium is added to the real rate of interest for

Risk and uncertainty.

Inflation.

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Time Dimension – Investment/Financing Decisions

Capital Budgeting (RealInvestments)

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Adjusting Values to Allow for Interest (1)

Assume the interest rate is 10 % ie 0.10 What are the equivalent values at the end of one year, year two,

etc to a sum of £100 available today?

100

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Adjusting Values to Allow for Interest (2)

Given an interest rate of 10 % what is the equivalent value at the

end of one year of £100 that is available today?

100

(10)

110

?

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1

2

3

The original sum (£100) plus interest that can be earnedover one year (£10).

time

Adjusting Values to Allow for Interest (4)

Given an interest rate of 10 %

£100 today £110 next year^ £121 two years from now

all have the same value, and are equally acceptable (assume no risk and no inflation for simplicity).

Future Value Factors

To obtain the equivalent value at a point in time in thefuture of a sum available today we must multiply this sumby a future value factor – also referred to as a compoundinterest factor, or more simply as the interest factor – toallow for interest that can be earned on the sum availableto-day:

FVF

n/r

= (1 + r)

n

where

r

is the rate of interest

n

is the number of time periods in thefuture

Developing Future Value Factors

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Developing Future Value Factors

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