Unit 5 Finance Concepts

Unit 5 Lesson 1: Calculating Economic Value and Core Concepts

• Opportunity Cost - Definition: The rate of return we should expect to earn on an investment given our alternatives. It is the best alternative not chosen when pursuing another course of action, often framed as a discount rate, hurdle rate, benchmark rate, or required rate of return.

  • This is influenced by the interest rate and signifies the time value of money.

  • As stated in the First Principle of Finance: - "The closer to the present an amount is, the higher its value to us."

• Time Value of Money - Concept: The present value of money is more than the same sum in the future due to its earning potential.

  • Core principle: - "A dollar received today is worth more than a dollar received in the future." (Investopedia)

  • Compounding: - Process of applying a rate of return to determine future value.

  • Discounting: - Process of applying a rate of return to determine present value.

• Interest Rate - Definition: Rate of return on an investment or cost of borrowing.

• Economic Value - Definition: Maximum dollar price one would pay for an economic asset.

  • Focuses on cash flows and involves comparing cash flows at different times.

  • Future cash flows are predicted, but not determined, introducing risk in decisions.

  • Combination of factors gives:- Economic Value of an Asset

• Economic Assets: - Definition: Entities that serve as stores of value, with enforced ownership rights, from which economic benefits arise over time.

  • Benefits include primary incomes from asset use and possible holding gains or losses.

• Cash Flow: - Definition: The flow of purchasing power used for valuing and transferring economic assets.

• Present Value: - The worth of a future cash flow as assessed today.

• Future Value: - The worth of a given amount of money projected to the future.

Unit 5 Lesson 2: Making Wealth-Increasing Decisions

• Decision Processes - Utilize opportunity cost in distinct ways while selecting a course of action:

  • Focusing on Rate of Return:

    • Internal Rate of Return (IRR): - Definition: The rate of return earned from investments, adjusted considering time value. It is the rate of return earned on an investment.

      • IRR Rule: Investment is accepted if its IRR exceeds the opportunity cost from equivalent investments.

      • Comparison with opportunity cost is crucial to assess investment desirability:

      • If {\text{IRR > Opportunity Cost}}, the investment is desirable.

  • Focusing on Wealth Increase:

    • Net Present Value (NPV): - Definition: A cost/benefit analysis comparing the present value of an investment's costs to its economic value (present value of cash inflows) using opportunity cost. It is a decision-making process employing time value and opportunity cost to compare benefits of decisions with their costs.

      • If benefits outpace costs, the decision generates wealth.

      • NPV Rule: Investment is accepted if its NPV is positive.

      • Positive NPV indicates an increase in wealth (cash flow) expressed in today's terms, confirming the project's desirability and signifying that benefits outweigh costs when adjusted for time value and opportunity cost.

• Both decision rules utilize opportunity cost as the discount rate for time value calculations.

• Risk in Decision-Making: - Decisions focus on future benefits, which are inherently uncertain.

• Wealth: - Control over economic assets.

• Economic Decision-Making: - Involves calculating economic values, comparing the economic value of assets to their acquisition costs.

• Creating Wealth: - Achieved when the purchase price for an economic asset is less than its economic value.

  • Fundamental to financial decisions and market actions.

• Decision Rule: - Quantitative guideline used to evaluate the undertaking of a course of action.

Unit 5 Lesson 3: Adjusting Economic Decisions for Risk

• Future Payoffs - The motivation for decision-making is based on future benefits, which are uncertain.

  • Example: Investing time and money in education for uncertain future payoffs.

• Risk - Definition: Variability in forecasts of future cash flows affects the opportunity cost in economic decisions. It is the likelihood of obtaining a lower rate of return than anticipated, and the uncertainty of future cash flows leading to fluctuating current economic values, a principal concern in financial decisions.

• Two Components of Opportunity Cost:

  • Risk-Free Rate of Return:

    • Represents assured returns from an investment. It is a certain return rate from an asset with guaranteed future cash flows.

  • Risk Premium:

    • The additional return expected above the risk-free rate, accounting for investment uncertainties. It is the additional return required above the risk-free rate due to future cash flow uncertainty.

• Higher risk leads to a higher discount rate, which results in a lower present value of future cash flows.

• NPV Assessment - Directly assesses an asset's ability to create wealth.

  • Cash flows and subsequently the project's NPV are influenced by the user of the asset.

• Expected Return: - Anticipated return from an investment, which remains uncertain mainly used in business decision-making.

• Realized Return: - The actual return received at the investment period's conclusion.