Main points of Lecture 1

Three formulae of calculating rate of return, future value and present value

1. Rate of return formula and the conversion between annual rate and periodic rate
2. From the rate of return formula, we derive the future value and present value
formulae.
1) Simple growth v compound growth
2) Present value v time and discount rate

Concept of time value of money

Today’s money is worth more than the same amount of money to be received in the
future, because of certainty, interest to be earned, consumption needs. Future money is
worth less because of predicted inflation additionally.

Cash flow to be received in the distant future must be more heavily discounted than that
to be received in the near future.

The following diagram connects all formulae we learnt in lecture 1.

Conversion between ka and kp

1+kp=(1+ka)P

Annual rate ka Periodic rate kp

when t-s> 1 year
when t-s=1 year
or t-s<1 year

Rate of return

Growth Discounting

Future value in 1 period Present value of 1-period project

Future value in period T Present value of T-period project

Future value in period
by compound growth PT
T by simple growth P 0=
T T
PT=P0(1+Tk) PT=P0(1+k) (1+ k )

PV is negatively correlated with k

PV is negatively correlated with time
Time value of money!