The Tools of Finance May 20101

 A dollar received in the future does not have the same purchasing power as a dollar today  Why? Inflation  Interest helps dollars grow to maintain their purchasing power May 20102

 Principle x Rate x Time  Principle is an amount borrowed or invested  Rate is the annual rate of interest paid or earned  Time is a function of one year  If you invest $10,000 for one year at 6%  10,000 x.06 x 1 = $600  10,000 x.06 x 4 = $2,400 for four years  At the end of four years you have $12,400 May 20103

 Interest earning interest  What if the interest earned each year is allowed to grow as part of the investment? Yr 1: 10,000 + (10,000 x.06 x 1) = 10,600 Yr 2: 10,600 + (10,600 x.06 x 1) = 11,236 Yr 3: 11,236 + (11,236 x.06 x 1) = 11,910 Yr 4: 11,910 + (11,910 x.06 x 1) = 12,625  You come out ahead by $225 May 20104

Compound interest is an exponential function: the bigger it gets the faster it grows Future value = Present value x (1 + r) n FV = $10,000 x (1 +.06) 4 FV = $12,625 May 20105

 Present Value (PV)  The value of an investment or amount borrowed today  Principle only, no time no interest  Future Value (FV)  Principle + interest at some time in the future  N is the number of compounding periods  R is the interest rate per compounding period May 20106

Compounding is the process of adding interest: take a present value or principle payments and add interest to arrive at a future value FV = PV x (1+r) n May 20107

Discounting moves in the opposite direction: take a future value with principle and interest and remove the interest PV = FV /(1+r) n May 20108

 Risk aversion  Diversification (firm-specific risk vs. market risk)  Risk vs. Return  Asset valuation  Value & Price  Capital gains & dividends  Random walk & index funds May 20109

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