Interest on Interest

Compound interest means you earn interest on interest. However, the benefits of compound
interest only apply if you leave your interest in your account and do not spend these earnings.
Compound interest can turn a modest original investment into a larger dollar balance if you let it
do what it does best: multiply your dollars.

Future Value of Dollars

Money historically loses value over time. The future value of a dollar is typically less than the
current value. Compound interest can reverse the historical devaluation of each dollar. Increasing
inflation can drive the future value of money down faster than time alone. Compound interest
rarely compensates for the typical decline in the value of dollars in the short-term. However, it
can counteract that decline over longer periods.

Reinvesting Effects
Pouring your interest earnings into a different investment typically reduces or eliminates the
benefits of compound interest. However, depending on the quality of your new investment, it
may generate more earnings than compound interest. Bonds and real estate investments often
provide interest at regular intervals, allowing you to increase your account or use these earnings
to make new investments.

Compounding Periods
The number of compounding periods in a year and over the life of the investment directly affect
the compound interest benefits you receive. The more compounding periods, the stronger the
affect on future investment value. The more interest-posting dates, the more compounding
increases your account balance, regardless of your interest rate.

Formula
The formula for compound interest is "P" multiplied by the following: (1 plus "r") to the power
of "n," minus 1. "P" equals principal or original balance, "r" equals the rate of interest each
compounding period and "n" is the number of compounding periods. For example, if you open a
$1,000 account with monthly compounding at 12 percent interest a year, your calculation is
$1,000 multiplied by the following: 1 plus .01 -- which is 12 percent divided by 12 months -- to
the 12th power, minus 1. This works out to $1,000 times 0.12683, or $126.83 in the first year --
more than the $120 you would earn without compounding. You can use online financial
calculators to estimated the future value of your investments that earn interest.

In the context of compound interest, effective annual interest rate (EAR) is an annual interest rate
when compounding period differs from one year. In other words, effective interest rate is the actual
interest when interest is compounded more than once a year. In this case, interest is compounded on
both the principal (initial investment) and the interest that has already accrued. As the result, effective
interest rate differs from the nominal (stated) interest rate when compounding occurs more than once a
year, and it depends on the frequency of compounding.

4How are total risk, non-diversifiable risk, and diversifiable risk related? Why is non-diversifiable risk
the
only relevant risk? What risk does beta measure? How can you find the beta of a portfolio?

Diversifiable risk can be minimized by diversification of portfolios consisting of securities from different
risk industries. ... The non-diversifiable risk cannot be eliminated by holding a diversified portfolio,
therefore the non-diversifiable risk is considered to be the only relevant risk.

Beta and Systematic Risk

Beta is a measure of a stock's volatility in relation to the market. It essentially measures the
relative risk exposure of holding a particular stock or sector in relation to the market.

If you want to know the systematic risk of your portfolio, you can calculate its beta. Beta
effectively describes the activity of a security's returns as it responds to swings in the market. A
security's beta is computed by dividing the product of the covariance of the security's returns and
the market's returns by the variance of the market's returns over a specified period, using this
formula:

5 The bonds will sell at a discount when the required return exceeds the coupon rate, a premium when
the required return is less than the coupon rate, and at par value when the required return equals the
coupon rate.

6 Cost of Capital vs WACC

 

Weighted average cost of capital and cost of capital are both concepts of finance that represent
the cost of money invested in a firm either as a form of debt or equity or both. Cost of equity
refers to the cost of selling shares to shareholders to obtain equity capital and cost of debt refers
to the cost or the interest that must be paid to lenders for borrowing money. These two terms cost
of capital and WACC are easily confused as they are quite similar to each other in concept. The
following article will explain each providing formulas on how they are calculated.

What is Cost of Capital?

Cost of capital is the total cost in obtaining debt or equity capital. In order for an investment to
be worthwhile, the rate of return on the investment must be higher than the cost of capital.
Taking an example, the risk levels of two investments, Investment A and Investment B, are the
same. For investment A, the cost of capital is 7%, and the rate of return is 10%. This provides an
excess return of 3%, which is why investment A should go through. Investment B, on the other
hand, has cost of capital of 8% and rate of return of 6%. Here, there is no return for the cost
incurred and investment B should not be taken into consideration.

However, assuming that the treasury bills have the lowest level of risk, and have a return of 5%,
this may be more attractive than both options since risk levels are very low, and return on 5% is
guaranteed since the T bills are government issued.

What is WACC?

WACC is a bit more complex than the cost of capital. WACC is calculated by giving weights to
the company’s debt and capital in proportion to the amount in which each is held. WACC is
usually calculated for various decision making purposes and allows the business to determine
their levels of debt in comparison to levels of capital.

The formula for calculation is; WACC = (E / V) x R e + (D / V) x Rd x (1 – Tc). Here, E is the

market value of equity and D is the market value of debt and V is the total of E and D. R e is the
total cost of equity and Rd is the cost of debt. Tc is the tax rate applied to the company.

What is the difference between Cost of Capital and WACC?

Cost of capital is the total of cost of debt and cost of equity, whereas WACC is the weighted
average of these costs derived as a proportion of debt and equity held in the firm.

Both, Cost of capital and WACC, are made use in important financial decisions, which include
merger and acquisition decisions, investment decisions, capital budgeting, and for evaluating a
company’s financial performance and stability.

Summary:

Cost of Capital vs WACC

• Weighted average cost of capital and cost of capital are both concepts of finance that represent
the cost of money invested in a firm either as a form of debt or equity or both.

• In order for an investment to be worthwhile, the rate of return on the investment must be higher
than the cost of capital.

• WACC is calculated by giving weights to the company’s debt and capital in proportion to the
amount in which each is held.

6a Projects are independent if the cash flows of one are not affected by the acceptance of the other.
Conversely, two projects are mutually exclusive if acceptance of one impacts adversely the cash flows
of the other; that is, at most one of two or more such projects may be accepted.

What is the difference between independent and mutually exclusive projects? Between projects
with normal and non-normal cash flows? Projects are independent if the cash flows of one are
not affected by the acceptance of the other. Conversely, two projects are mutually exclusive if
acceptance of one impacts adversely the cash flows of the other; that is, at most one of two or
more such projects may be accepted. Put another way, when projects are mutually exclusive it
means that they do the same job. Projects with normal cash flows have outflows, or costs, in the
first year (or years) followed by a series of inflows. Projects with non-normal cash flows have
one or more outflows after the inflow stream has begun.

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Independent and Mutually Exclusive Projects

Independent and Mutually Exclusive Projects2016-10-09T08:19:35+00:00 Annuity, NPV 7 Comments

Independent and Mutually Exclusive Projects

Understanding of classification of capital budgeting projects plays a crucial role while analyzing
viability of projects.

What is mutually Independent Projects?

A Project whose cash flows have no impact on the acceptance or rejection of other projects is
termed as Independent Project (not mutually exclusive). Thus, all such Projects which meet
this criterion should be accepted.

What is mutually exclusive Projects?

A set of projects from which at most one will be accepted is termed as Mutually Exclusive
Projects. In mutually exclusive projects, cash flows of one project can be adversely affected by
the acceptance of the other project. In mutually exclusive projects, all projects are to accomplish
the same task. Therefore, such projects cannot be undertaken simultaneously. Hence, while
choosing among Mutually Exclusive Projects, more than one project may satisfy the Capital
Budgeting criterion. However, only one project can be accepted.

Which project should be accepted depends on different factors like initial investment, time
period required for completion, strategic importance of the project, etc. usually the project which
adds more value to the business in the long run will be selected.
Capital budgeting techniques give same acceptance or rejection decisions regarding independent
projects but conflict may arise in case of mutually exclusive projects. If conflicts arise while
making decision regarding mutually exclusive projects, the Net Present Value method should be
given priority due to its more conservative or realistic reinvestment rate assumption. The Net
Present Value and Internal Rate of Return, both methods are superior to the payback period, but
Net present Value is superior to even Internal Rate of Return.