- Relationship Between Risk and Return
- Return – profit as a percentage of total investment
- Risk – uncertainty about the actual rate of return an investment will provide over an anticipated investment period
- Risk and return are directly related (investors require greater returns for greater risk)

- Types of Risk
- Business risk – uncertainty arising from changing economic conditions that affect an investment’s ability to generate returns
- Financial risk – uncertainty associated with the possibility of defaulting on borrowed funds used to finance an investment
- Purchasing power risk – uncertainty arising from the possibility that the amount of goods and services that can be acquired with a given amount of money will decline over time (inflation)
- Liquidity risk – possibility of loss resulting from not being able to convert an asset into cash quickly should the need arise

- Time Value of Money Principle
- Money in hand today is worth more than money to be received in the future

- Future Value of a Lump Sum
- Compound interest – during any given period, interest is earned not only on the original principal amount, but also on any interest previously earned by the principal amount
- Compounding – the process of determining future value
- Example: What is the future value of $70,000 compounded at 10% annual interest over 3 years?

- Present Value of a Lump Sum
- Discounting – the process of determining present value of a single amount (lump sum) to be received in the future
- Example: What is the present value of $93,170 to be received in 3 years discounted at 10% annual interest?

- Present Value of an Annuity
- Annuity: a series of equal amounts received one per period for a specified number of periods
- Example: What is the present value of a series of three payments of $1,000 received at the end of each year if the discount rate is 10%?

- Future Value of an Annuity
- Example: What is the future value of a series of five payments of $100 received at the end of each year if the compound interest rate is 10%?

- Sinking Fund Payments
- Sinking Fund Payments: equal amounts of money that are deposited into an account earning for a specific number of years to accumulate a specific amount.
- Example: What is the amount of money that must be deposited into an account each year that earns 10% for five years in order to accumulate $20,000?

- Mortgage Payments
- Mortgage Payment: equal amount of money that must be paid to a lender each period to fully amortize a loan.
- Example: What annual payment would be necessary to amortize a loan for $100,000 over ten years at 10% interest?

- Financial Decision Rules
- Net Present Value (NPV) – difference between how much an investment costs and how much it is worth to an investor in present value dollars
- NPV = present value of cash inflows minus present value of cash outflows
- NPV Decision Rule: If the NPV is equal to or greater than zero, we choose to invest

- Internal Rate of Return (IRR) – the discount rate that makes the NPV equal to zero
- IRR = the rate of return on the investment
- IRR Decision Rule: If the IRR is greater than or equal to our required rate of return, we choose to invest

- Net Present Value (NPV) – difference between how much an investment costs and how much it is worth to an investor in present value dollars