Chapter 2 The Two Key Concepts in Finance. It’s what we learn after we think we know it all that counts. - Kin Hubbard. Outline. Introduction Time value of money Safe dollars and risky dollars Relationship between risk and return. Introduction.
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- Kin Hubbard
You just invested $2,000 in a three-year bank certificate of deposit (CD) with a 9 percent interest rate.
How much will you receive at maturity?
Solution: Solve for the future value:
You have just won the lottery! You will receive $1 million in ten installments of $100,000 each. You think you can invest the $1 million at an 8 percent interest rate.
What is the present value of the $1 million if the first $100,000 payment occurs one year from today? What is the present value if the first payment occurs today?
Solution: These questions treat the cash flows as an ordinary annuity and an annuity due, respectively:
Your bank pays you 3 percent per year on your savings account. You just deposited $100.00 in your savings account.
What is the future value of the $100.00 in one year if interest is compounded quarterly? If interest is compounded continuously?
Solution: For quarterly compounding:
Solution (cont’d): For continuous compounding:
You have won the right to spin a lottery wheel one time. The wheel contains numbers 1 through 100, and a pointer selects one number when the wheel stops. The payoff alternatives are on the next slide.
Which alternative would you choose?