Topic 1:

Introduction

Interest Rate
Interest rate (r) is rate of return that reflects the
relationship between differently dated cash flows.
Real risk-free interest rate is the single-period rate for a
completely risk-free security if no inflation were
expected.
Inflation premium compensates investors for the
expected inflation.
Nominal risk-free interest rate is the sum of the real risk-
free interest rate and the inflation premium.
Default risk premium compensates investors for the
possibility that the borrower will fail to make a promised
payment.
Liquidity premium compensates investors for the risk of
loss relative to an investments fair value if the
investment needs to be converted to cash quickly.
Maturity premium compensates investors for the
increased sensitivity of the market value of debt to a
change in market interest rates as maturity is extended.


Frequency of Compounding
monthly for 12 quarterly, for 4 ex.
year a in periods g compoundin of number m
rate annual stated r
m
r
1 PV FV
s
mN
s
N
=
=
|
.
|

\
|
+ =
Example: Future Value with Quarterly
Compounding
Find the FV of $10,000 invested today at
8% if the interest is compounded quarterly.
$11,716.59
02) $10,000(1.
m
r
1 PV FV
2 N
4 m
8% r
$10,000 PV
8
nM
s
N
s
=
=
|
.
|

\
|
+ =
=
=
=
=
Continuous Compounding
Interest can be compounded in discrete
intervals such as daily, monthly or
quarterly, or it can compound
continuously. For continuous
compounding we use,
7182818 . 2 e
PVe FV
N r
N
s
~
=
Example: Future Value with Continuous
Compounding
Use the same information before to find
the FV with continuous compounding.
$11,735.11
$10,000e
PVe FV
2 N
8% r
$10,000 PV
.08(2)
N r
N
s
s
=
=
=
=
=
=
Stated and Effective Rates
Stated rates do not account for the
number of compounding periods and so
we need to compute the effective annual
rate (EAR)
1 rate) interest Periodic 1 ( EAR
m
+ =
Example
Find the EAR if the stated interest rate is
8% and semiannual compounding is used.

0816 .
1
2
08 .
1
1
m
r
1 EAR
2
m
s
=

|
.
|

\
|
+ =

|
.
|

\
|
+ =
Stated and Effective Rates
The effective annual rate with continuous
compounding is
1 e EAR
s
r
=
Discounted Cash Flow Applications
Discounted cash flow has numerous
applications including:
determining if an investment is desirable
(capital budgeting).
valuing securities
Net Present Value
Net present value (NPV) compares the
cash outlay to the present value of the
cash flows from the project. If NPV 0 we
accept the project. If NPV < 0, we reject
the project.

=
+
=
N
0 t
t
t
) r 1 (
CF
NPV
Example: Using NPV
RAD Corporation intends to invest $1
million in R&D and expects incremental
cash flows of $150,000 in perpetuity from
this investment. If the opportunity cost of
capital is 10%, compute NPV

accept , 0 000 , 500 $
10 .
000 , 150 $
000 , 000 , 1 $
r
CF
CF NPV
0
> = + =
+ =
Internal Rate of Return
The internal rate of return on a project is
the interest rate that makes the NPV = 0.
If IRR discount rate, we accept the
project.
0
) IRR 1 (
CF
...
) IRR 1 (
CF
) IRR 1 (
CF
CF NPV
N
N
2
2
1
1
0
=
+
+ +
+
+
+
+ =
Example: Using IRR
Use IRR rule to determine the desirability
of the R&D given in the example before
15 .
000 , 000 , 1 $
000 , 150 $
Investment
CF
IRR
0
IRR
CF
Investment NPV
= = =
= + =
Problems with IRR
IRR has several problems that make it
less desirable than NPV:
If we are comparing different size projects, the
one with the highest IRR may not add the
greatest value to the firm.
If the sign of the cash flows changes more
than once, we may get more than one IRR.

Portfolio Return Measurement
Suppose you want to assess the success
of your investments.
Need to consider two related but distinct
tasks:
The first is performance measurement, which
involves calculating returns in a logical and
consistent manner.
The second is performance appraisal which
is, the evaluation of risk adjusted
performance.
Portfolio Return Measurement
We will use the fundamental concept of
holding period return (HPR), the return
that an investor earns over a specified
holding period in our discussion of portfolio
return.
0
1 0 1
P
D P P
HPR
+
=
Money-Weighted Rate of Return
In investment management applications,
the internal rate of return is called the
money-weighted rate of return because it
accounts for the timing and amount of all
dollar flows into and out of the portfolio.
One drawback is that it is affected by the
amount of money given in by investors.
not under the control of the money manager.
Time-Weighted Rate of Return
The time-weighted rate of return, is not
sensitive to additions and withdrawals.
preferred performance measure in the
industry.
it measures the compound rate of growth of
$1 initially invested in the portfolio over a
stated measurement period.
Time-Weighted Rate of Return
To compute an exact time-weighted rate of return on a
portfolio, take the following three steps:
1. Price the portfolio immediately prior to any significant addition
or withdrawal of funds. Break the overall evaluation period into
subperiods based on the dates of cash inflows and outflows.
2. Calculate the holding period return on the portfolio for each
subperiod.
3. Link or compound holding period returns to obtain an annual
rate of return for the year (the time-weighted rate of return for the
year). If the investment is for more than one year, take the
geometric mean of the annual returns to obtain the time-weighted
rate of return over that measurement period.
Example Time-Weighted Rate of
Return
Suppose that the portfolio earned returns of 15
percent during the first year and 6.67 percent
during the second year, what is the portfolios
time-weighted rate of return over an evaluation
period of two years?
% 76 . 10
1 ) 0667 . 1 )( 15 . 1 ( return weighted -
) 0667 . 1 )( 15 . 1 ( return) weighted - 1 (
2
=
=
= +
Time
Time
Time-Weighted Rate of Return
We can often obtain a reasonable approximation of the time-
weighted rate of return by valuing the portfolio at frequent,
regular intervals.
The more frequent the valuation, the more accurate the
approximation.
To compute the time-weighted return for the year, we first
compute each days holding period return:


where,
MVB
t
is the market value at the beginning of the period.
MVE
t
is the market value at the end of the period.
We calculate an annualized time-weighted return as the
geometric mean of N annual returns, as follows:

t
t t
t
MVB
MVB MVE
r

=
| | 1 ) r 1 ( ) r 1 ( ) r 1 ( r
N / 1
N 2 1 TW
+ + + =