E con 122- Finance Brief Notes

1+i

CF t

1.

Present Value =
t=0

2. Real interest rate , r=i

3. Annuity vs . Pe rpetuity
t
1+i

1+r T
()
1 1

a.
r

CF t

Annuity=
t =0

b.

1+i t

1+r 2

CF t

Perpetuity :
t =1

4. Ne t pre se nt va lue
a. Firms inves t if N PV>0
b. NPV =C0 + PV
5. Bond value (annuity)
1+r T
Par value
()+
(1+ r)T
a.
1 1

r
CF
b. W hethe r to buy or not: NPV =P+ PV future returns
i. If PV > P, you expe ct a profi t and will move
money into the asse t, (ca using P to rise until N PV
= 0)
ii. If PV < P, you expe ct a loss and will move money
out to anothe r asset ( caus ing P to fa ll until N PV =
0)

iii. Beca use P repres ents the funds you ha ve

ava ilable to buy this asse t or any alte rna tive , it
repres ents the opportunity cost (sa me idea as
compa ring PV across diff e rent assets)
iv. Pe rfe ct marke ts will push expe cted yie lds towa rds
being e qua l via arbitra ge , driving NPV towa rds
zero
c . Holding period return
Coupon
discount
paid
Price sold Price

Price paid
i.

()+
T

t=0

6. Sum mary
a. Bond yields
i. Inverse yie ld-price re la tions hip
ii. Purchas e de cision: compa re PVs of alte rnatives or
ca lcula te net prese nt value
iii. If re troa ctive, use Holding Pe riod Re turns to
compa re assets
b. Stock yields
i. Simila r conce pt, but future pa yme nts not fi xe d,
resa le marke t more vola tile, and lower pa y- back
priority
ii. Pre miums
iii. Risk (defa ult) and te rm ( cha nging opportunity
cos ts) mean that ra tes diff er across asse ts even
in perfe ct ma rkets