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03TimeValueOfMoney2-2013.pdf-Centre for Management of Technology andshowing page 1-7 out of 15

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Centre for Management of
Technology and Entrepreneurship
University of Toronto
Copyright:
Joseph C. Paradi, 1996-2007
Yuri Lawryshyn, 2008-2010
Course: CHE374
Centre for Management of Technology and Entrepreneurship
Time Value of Money
- Part B


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Interest Period
Interest rates are typically stated for some period,
almost always for a year, but the computation of
interest may be based on shorter compounding sub-
periods like months.
The base unit of time over which an interest rate is
calculated.
6% per year (if not stated otherwise it is compounded
ANNUALLY
)
6% per year, compounded semi-annually
6% per year, compounded monthly
6% per year, compounded daily
The longer the interest period, the higher the interest
rate must be to provide the same return (inflation).


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Example - Credit Cards
For a $1000 balance at the beginning of the
year, find the effective annual interest rate
and total owed at the end of the year with
18%/year, compounded monthly. Assume you
make no payments throughout the year.
Why do credit card companies charge such
high interest rates?


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Example - Market investment
Continuous Compounding
Nominal rate 18% compounded continuously
What is effective interest rate?
Continuously
Monthly


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Example – Continuous Compounding
A $100 T-bill with maturity of 3 months costs
$98
What is the short term “risk-free” continuously
compounded investment rate
What is the risk-free rate based on yearly
compounding?
What is the risk-free rate based on daily
compounding (assume 252 trading days per year)?
A stock currently sells for $12. What can we
say about investor expectations regarding the
price of the stock 3 months from now?


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Categories of Cash Flows
First/Capital Cost
– expense to build or to buy and
install
Operation and Maintenance (O&M) Cost
– annual
expense, e.g., electricity, labour, repairs
Salvage Value(s)
– receipt at project termination for
disposal of equipment (can be a cost)
Revenues
– annual receipts due to sale of products or
services
Overhauls
– major capital expenditure that occurs part
way through the life of an asset
Prepaid Expenses
– annual expenses, such as leases
and insurance payments that must be paid in advance


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Some key definitions
Time Horizon
- the time interval for the project
Interest
- rate of "rent" the lender offers money at or the required
return on an investment
Future/Terminal Cost/Value
- the value at the end of a period


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