PF Chapter 5 part 1

In financial decision-making, why is the past referred to as "sunk"?

The past can be known and analyzed, but it cannot be decided upon or changed through current decisions.

According to the text, financial decisions can only be made regarding what timeframe?

The future.

Evaluating alternatives for financial decisions involves speculation on what two aspects of a result?

The kind of result and the value of the result that will occur.

Concept: Time Value of Money

Definition: The impact of time on the value of money, based on the premise that separation from liquidity creates opportunity cost.

Why is liquidity considered valuable in financial planning?

It provides the owner with choice and the ability to use wealth without additional transaction costs.

What is the relationship between the liquidity of an asset and its value, all other things being equal?

The more liquid an asset is, the higher its value.

How does time create a "distance" between an individual and their wealth?

Time separates the individual from liquidity, preventing immediate use for consumption or investment.

In the context of currency exchange, what is a "transaction cost"?

The costs of achieving a trade or doing a deal that do not contribute to the value of the thing being traded.

What three factors take away from the value of wealth when transforming non-liquid wealth into liquid wealth?

Transaction costs, opportunity costs, and risk.

How does the distance of future cash flows affect their present value ($PV$)?

The further in the future the cash flows are, the lower their present value due to increased opportunity cost and risk.

Why will equivalent present values today always be less than the nominal or face values of the same amount in the future?

The separation from liquidity over time creates a cost that discounts the future value.

To relate a present value to a future value, what three specific factors must be known?

The amount of the cash flow, the timing of the cash flow, and the rate at which time affects value.

Term: Discount Rate

Definition: The rate at which time affects value, representing the opportunity cost of not having liquidity.

What is the primary source of an "opportunity cost" in finance?

Forgone choices or sacrificed alternatives resulting from a lack of liquidity.

How is the future value ($FV$) of wealth calculated using present value ($PV$), discount rate ($r$), and time ($t$)?

$FV = PV \times (1 + r)^t$

How is the present value ($PV$) of wealth calculated given a future value ($FV$), discount rate ($r$), and time ($t$)?

$PV = \frac{FV}{(1 + r)^t}$

What does the variable $r$ represent in the equation $PV \times (1 + r)^t = FV$?

The discount rate, which accounts for both opportunity costs and risk.

In financial equations, what does the variable $t$ represent?

The number of time periods between the present and the realization of liquidity.

As the time ($t$) separating you from liquidity increases, what happens to the present value ($PV$)?

The present value ($PV$) decreases.

If the discount rate ($r$) decreases, how is the present value ($PV$) of a future cash flow affected?

The present value ($PV$) increases.

What is the strategic implication for managing incoming cash flows to maximize value?

Accelerate incoming cash flows to obtain liquidity sooner.

What is the strategic implication for managing outgoing cash flows to maximize value?

Decelerate outgoing cash flows to retain liquidity longer.

Concept: Annuity

Definition: A series of cash flows where equal amounts occur at regular, periodic intervals.

List three examples of common financial products that are structured as annuities.

Mortgages, consumer loan repayments, and retirement plan payouts.

What four factors are required to calculate the present value of an annuity?

Amount of each cash flow ($CF$), frequency, number of cash flows ($t$), and the discount rate ($r$).