What is interest? (2)
- The cost for borrowing and the reward for saving
- AKA ‘cost of capital’ or ‘time value of money’
What is simple interest? (2)
- Interest over a single period of time e.g. 1 year
- Paid periodically
What is compound interest? (2)
- Interest is ‘rolled over’/accrued into subsequent periods e.g. yearly
- Assumes that interest is reinvested
What is reinvestment return? (1)
- Additional income generated through reinvesting income
How do you calculate reinvestment return? (1)
- Compound return - income return from shares
When is the highest future value obtained with interest payments? (1)
- If interest is COMPOUNDED CONTINUOUSLY
What is the compounding formula? (1)
- FV = PV x (1+r)^n
What is the formula for continuous compounding?
FV = PV x e^rn
- e = natural exponent [2nd] [In]
What is an annuity? (3)
- Equal cash payments
- Received or made at regular intervals
- Over a specified period of time
E.g mortgage payments, pension
What is a perpetuity and how do you calculate it? (3)
- Equal cash payments
- Received/paid at regular intervals
- Over an UNSPECIFIED period of time
What are annual percentage rates? (3)
- The annual cost of borrowing money
- APR is often charged monthly/quarterly
- Assumes no compounding
e.g credit cards
How do you calculate APR and monthly rate? (2)
- APR = (1+monthly rate)^12-1
- Monthly rate = 12 square route APR-1
What is discounting? (1)
- Calculates how much to invest today, given a rate of interest and frequency of payment, in order to achieve a required terminal value in the future
What are the 2 mains DCF techniques used for projects? (2)
- Net present value (NPV)
- Internal rate of return (IRR)
What is the NPV approach? (2)
- Measures the present value of cash inflows against cash outflows to determine viability of investments
- NPV = PVi - PVo
When is a project viable according to NPV?
- If NPV is equal to or greater than 0, it is viable. Inflows are greater than or equal to outflows
- If NPV is less than 0, it is not viable. Outflows are greater than PV inflows
What is the internal rate of return? (3)
- Measures the profitability of an investments
- PV of future cash flows = initial investment
- Assumes NPV = 0
What is the IRR decision rule? (4)
- The IRR must be compared to the company’s cost of capital (equity and debt) to see if the project is viable
- IRR > CoC (viable)
- IRR < CoC (not viable)
- IRR = COC (breakeven)
What are the problems with IRR? (4)
- Ignores quantity of earnings
- Discount cannot be variable
- Can be multiple IRRs with a number of inflows and outflows
- If there is a big difference between the IRR and discount rate - can cause conflicting decisions
What is better to measure the viability of a project IRR or NPV? (1)
- NPV
How do you calculate the IRR in an exam? (2)
- Trial and error / iterative process until NPV equals 0
- You use all the multiple choice answers
What is the difference between IRR and discount rate? (2)
- IRR is the actual return
- Discount rate is the required return
When might the difference between IRR and discount rate widen? (2)
- Time lags in cash inflows, requiring a larger discount rate
- Risky, long term projects
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