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Principles of Finance Notes

This document provides an overview of key principles of finance from Chapter 3, including: 1) The risk-free rate is the rate at which money can be borrowed or lent without risk over time, where the supply of savings equals the demand for borrowing. 2) Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return. 3) Net present value is the present value of the net cash flows from a project, investment, or financial asset. The NPV rule states you should accept projects with positive NPV. 4) In competitive markets without arbitrage opportunities, the price of a financial security will equal the present value of its expected

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127 views2 pages

Principles of Finance Notes

This document provides an overview of key principles of finance from Chapter 3, including: 1) The risk-free rate is the rate at which money can be borrowed or lent without risk over time, where the supply of savings equals the demand for borrowing. 2) Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return. 3) Net present value is the present value of the net cash flows from a project, investment, or financial asset. The NPV rule states you should accept projects with positive NPV. 4) In competitive markets without arbitrage opportunities, the price of a financial security will equal the present value of its expected

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Amarachi Udoye
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PRINCIPLES OF FINANCE NOTES – WEEK 1 ( Chapter 3)

1) Risk free rate (rf) – rate at which money can be borrowed or lent without risk over a
period of time. This rate depends on supply and demand. At this rate the supply of
savings is equal to the demand of borrowing. Also known as discount rate.
2) £1 today is equal to (£1 + rf) in the future
3) To find the value of today’s money in the future (calculating future value) multiply
amount by (£1 + rf), to find value of future’s money today (calculating present value)
divide amount by (£1 + rf).
4) Present value (PV) – money today
5) PVAF= 1-1
(1+r )n
r
6) Future value (FV) – money in the future
7) FVAF= 1-1
(1+r )n
r
8) Net Present Value (NPV) = PV (benefits) – PV (costs)
9) NPV = PV (all project cashflows)
10) NPV rule – choose the option with the highest NPV. Choosing this alternative is
equivalent to receiving its NPV in cash today.
11) Arbitrage – making profit without taking any risk or making any investment. Like
buying and selling goods to make a profit on price difference.
12) Normal market – a competitive market with no arbitrage opportunity.
13) Competitive market – a market where buying and selling can happen at the same
price
14) Financial security- an investment opportunity that trades in a financial market.
15) Short sale - In finance, a short sale is the sale of an asset that the seller does not
own. The seller effects such a sale by borrowing the asset in order to deliver it to the
buyer
16) No arbitrage price of security - Price (Security) = PV (All cashflow paid by security)
17) Return = (Gain at the end of the year)/ initial cost
18) Return = risk free rate
19) In a normal market buying a security has an NPV of zero, because there is no
arbitrage.
20) Financial transactions are not sources of value they help to adjust the timing and risk
of cashflow.
21) A company can increase value by real investment projects such introducing new
product lines or developing new stores.
22) Separation principle – separate a company’s investment decision from its financing
choice. Because, they will get the same result for any choice of financing in a normal
market.
23) Value additivity – Price(C) = Price (A+B) = Price (A) + Price (B) (value of a portfolio is
equal of its parts)
24) NTV (Net terminal value) = C0(1+r)n + C1(1+r)n-1 + C2(1+r)n-2 ….
25) NTV (USING ANNUITY FACTOR) =
26) PV of NTV is EQUAL to NPV.
27) IRR – rate that results in 0 NPV

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