1. Real Estate Principles, 11th Edition
By Charles F. Floyd
and Marcus T. Allen

2. Risk, Return, and the Time Value of Money
Chapter 17
Risk, Return, and the Time Value of Money

3. Relationship Between Risk and Return
Return – profit as a percentage of total investment
Risk – uncertainty about the actual rate of return an investment will provide over an anticipated investment period
Risk and return are directly related (investors require greater returns for greater risk)

4. Types of Risk
Business risk – uncertainty arising from changing economic conditions that affect an investment’s ability to generate returns
Financial risk – uncertainty associated with the possibility of defaulting on borrowed funds used to finance an investment

5. Types of Risk, cont.
Purchasing power risk – uncertainty arising from the possibility that the amount of goods and services that can be acquired with a given amount of money will decline over time (inflation)
Liquidity risk – possibility of loss resulting from not being able to convert an asset into cash quickly should the need arise

6. Time Value of Money Principle
Money in hand today is worth more than money to be received in the future

7. Future Value of a Lump Sum
Compound interest – during any given period, interest is earned not only on the original principal amount, but also on any interest previously earned by the principal amount
Compounding – the process of determining future value
Example: What is the future value of $70,000 compounded at 10% annual interest over 3 years?

8. Present Value of a Lump Sum
Discounting – the process of determining present value of a single amount (lump sum) to be received in the future
Example: What is the present value of $93,170 to be received in 3 years discounted at 10% annual interest?

9. Present Value of an Annuity
Annuity: a series of equal amounts received one per period for a specified number of periods
Example: What is the present value of a series of three payments of $1,000 received at the end of each year if the discount rate is 10%?

10. Future Value of an Annuity
Example: What is the future value of a series of five payments of $100 received at the end of each year if the compound interest rate is 10%?

11. Sinking Fund Payments
Sinking Fund Payments: equal amounts of money that are deposited into an account earning for a specific number of years to accumulate a specific amount.
Example: What is the amount of money that must be deposited into an account each year that earns 10% for five years in order to accumulate $20,000?

12. Mortgage Payments
Mortgage Payment: equal amount of money that must be paid to a lender each period to fully amortize a loan.
Example: What annual payment would be necessary to amortize a loan for $100,000 over ten years at 10% interest?

13. Financial Decision Rules
Net Present Value (NPV): difference between how much an investment costs and how much it is worth to an investor in present value dollars
NPV = present value of cash inflows minus present value of cash outflows
NPV Decision Rule: If the NPV is equal to or greater than zero, we choose to invest

14. Financial Decision Rules, cont.
Internal Rate of Return (IRR): the discount rate that makes the NPV equal to zero
IRR = the rate of return on the investment
IRR Decision Rule: If the IRR is greater than or equal to our required rate of return, we choose to invest