1.

Make up of interest, Risk and Time Value of money

The risks in financial management are any actions that contribute to the reduction in value or loss
of any of the organization's financial assets. The decrease can be from the actions of an internal
source such as an employee or volunteer, or someone outside of the organization can perpetrate
the loss—a burglar, "con man," or client defrauding the organization. Every organization should
be aware of the possibility of a financial loss and take the appropriate protective actions.

The time value of money is one of the basic theories of financial management. The theory of
states that the value of money you have now is greater than a reliable promise to receive the
same amount of money at a future date. This may sound simple, but it underpins the concept of
interest, and can be used to compare investments, such as loans, bonds, mortgages, leases and
savings.

2. Simple Interest and Compound Interest

Comparison
While both types of interest will grow your money over time, there is a big difference between
the two. Specifically, simple interest is only paid on principal, while compound interest is paid
on the principal plus all of the interest that has previously been earned.
As an investor or depositor, you definitely want to earn compound interest, as it adds up greater
over time. In the example of the $1,000 five-year CD at 4%, a simple interest calculation would
produce $200, $21 less than the monthly compounding.

3. Determination of Future Value

Annual Compounding
- A method of calculating and adding interest to an investment or loan once a year, rather
than for a period
- If interest is compounded yearly, then n = 1; if semi-annually, then n = 2; quarterly,
then n = 4; monthly, then n = 12; weekly, then n = 52; daily, then n = 365; and so forth,
regardless of the number of years involved. Also, "t" must be expressed in years, because
interest rates are expressed that way. If an exercise states that the principal was invested
for six months, you would need to convert this to 6/12 = 0.5 years; if it was invested
for 15 months, then t = 15/12 = 1.25 years; if it was invested for 90 days, then t = 90/365 of a
year; and so on.
Intra Year Compounding
- Compounding interest more than once a year is called "intra-year compounding". Interest
may be compounded on a semi-annual, quarterly, monthly, daily, or even continuous
basis. When interest is compounded more than once a year, this affects both future and
present-value calculations.
- With intra-year compounding, the periodic interest rate, instead of being the stated annual
rate, becomes the stated annual rate divided by the number of compounding periods per
 year. The number of periods, instead of being the number of years, becomes the number
of compounding periods per year multiplied by the number of years.
- As shown in the following table:

-
-
With monthly compounding, for example, the stated annual interest rate is divided by 12
to find the periodic (monthly) rate, and the number of years is multiplied by 12 to
determine the number of (monthly) periods.

Stream Of Payments
- . A payment stream is a payment that occurs continuously, just like the stream of water
out of a tap. We model this as the limit of the following sequence: annual payments,
monthly payments, weekly payments, daily payments, hourly payments, payments every
minute, payments every second, et cetera. Mathematically speaking, we are taking the
limit p → ∞.

- Equal amount/annuity

- Annuity is a series of period payments (usually equal) made at regular intervals of time.
Installment payments, monthly rentals, and life insurance premiums are familiar example
of annuities.
- Annuities paid continuously
- The concept of a continuous payment stream can also be applied to annuities. An annuity
paid continuously is a payment stream with a constant rate that lasts for a specified period
of time. As with the other annuities, we are interested in the present and accumulated
value of annuties paid continuously.
- Unequal Payments/ Cash flow
- Consider an investment that pays $200 one year from now, with cash flows increasing by
$200 per year through year 4. If the interest rate is 12%, what is the present value of this
stream of cash flows?
- If the issuer offers this investment for $1,500, should you purchase it?
- We can solve this problem by separately calculating the present value of each of the
future cash flows. The present value of $200.00 received one year from now with the
discount rate of 12% is $178.57. Repeating this exercise for the subsequent payments
 produces a total present value of $1,432.93. Since we're being asked to invest $1,500
today in order to receive this payment flow and the present value of the payment flow is
less than the amount they were being asked to invest, this is a bad investment and we
would choose not to enter into it.

- The present value is a keystone in the time value of money concept because this
technique is developed to evaluate any assets from financial instruments (e.g., stocks and
bonds) with respect to the value of the entire corporation. A large proportion of assets
generate uneven or irregular cash flow, making the process of their valuation
cumbersome. Common examples of an uneven cash flow stream are dividends on
common stock, coupon payments on a floating-rate bond, or the free cash flow of a
business. Since the value of each cash flow in the stream can vary and occur at irregular
intervals, the present value of uneven cash flows is calculated as the sum of the present
values of each cash flow in the stream.

Determination of Present Value

Present value (PV) is the current worth of a future sum of money or stream of cash flows given a
specified rate of return. Future cash flows are discounted at the discount rate, and the higher
the discount rate, the lower the present value of the future cash flows. Determining the
appropriate discount rate is the key to properly valuing future cash flows, whether they be
earnings or obligations.

Perpetuity
Perpetuity refers to an infinite amount of time. In finance, it is a constant stream of identical cash
flows with no end, such as with the British-issued bonds known as consols. The concept of a
perpetuity is also used in financial theory, such as in the dividend discount model (DDM).
An annuity is a stream of cash flows. A perpetuity is a type of annuity that lasts forever, into
perpetuity. The stream of cash flows continues for an infinite amount of time. In finance, a
person uses the perpetuity calculation in valuation methodologies to find the present value of a
company's cash flows when discounted back at a certain rate. Specifically, the perpetuity formula
determines the amount of cash flows in the terminal year of operation. In valuation, a company is
said to be a going concern, meaning that it goes on forever. For this reason, the terminal year is a
perpetuity, and analysts use the perpetuity formula to find its value.
Perpetuity Formula
The basic formula used to calculate a perpetuity is cash flows divided by some discount rate. The
formula used to calculate the terminal year in stream of cash flows for valuation purposes is bit
more complicated. It is the estimate of cash flows in year 10 of the company, multiplied by one
plus the company’s long-term growth rate, and then divided by the difference between the cost of
capital and the growth rate. Simplified, the terminal year is some amount of cash flows divided
by some discount rate, which is the basic formula for a perpetuity.

Perpetuity Example
For example, if a company is projected to make $100,000 in year 10, and the company’s cost of
capital is 8%, with a long-term growth rate of 3%, the value of the perpetuity is $100,000,
multiplied by 1.03%, and then divided by or 5%. The answer is $2.06 million. This is saying that
$100,000 paid into perpetuity, and assuming a 3% rate of growth, with an 8% cost of capital, is
worth $2.06 million in 10 years. Now, a person must find the value of that $2.06 million today.
To do this, analysts use another formula referred to as the present value of a perpetuity.

Determination of Annual Growth Rate

he compound annual growth rate (CAGR) is the mean annual growth rate of an investment over
a specified period of time longer than one year.

To calculate compound annual growth rate, divide the value of an investment at the end of the
period in question by its value at the beginning of that period, raise the result to the power of one
divided by the period length, and subtract one from the subsequent result.

This can be written as follows:

The compound annual growth rate isn't a true return rate, but rather a representational figure. It is
essentially a number that describes the rate at which an investment would have grown if it had
grown at a steady rate, which virtually never happens in reality. You can think of CAGR as a
way to smooth out an investment’s returns so that they may be more easily understood.

CAGR Example
Don't worry if this concept is still fuzzy to you – CAGR is one of those terms best explained
through an example. Suppose you invested $10,000 in a portfolio on Jan 1, 2014. Unsurprisingly,
your portfolio would likely grow at an inconsistent rate. Let us assume that by Jan 1, 2015, your
portfolio had grown to $13,000. Let us also assume that it then grew to $14,000 at the same time
in 2016, and spiked during that year, ending up at $19,500 by Jan 1, 2017.

To calculate the CAGR of your portfolio from the period from Jan 1, 2014 to Jan 1, 2017, you
would divide the final value of your portfolio by the portfolio’s initial value ($19,500 / $10,000
= 1.95). Next, you would raise the result to the power of 1 divided by the number of years (1/3
or 0.3333). Finally, you would subtract 1 from the resulting value.

Doing the math, you would calculate:

(19,500 / 10,000)1/3 – 1

= 1.950.3333 – 1

= 1.2493 – 1

= 0.2493, or 24.93%.

Thus, the compound annual growth rate of your three-year investment is equal to 24.93%,
representing the smoothed annualized gain you earned over your investment time horizon,
assuming your investment was compounding over the three-year time period.