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When we start looking at corporations or businesses and the financial decisions that they make, very seldom do we have a simple "Pay out this much money, get that much money back." type of problem.  Instead, we have problems that involve laying out money, some up front and some as we go, and then cash flow coming back over some future period.  We had to understand how things worked with lump sums first to make analyzing cash flow understandable, since multiple cash flows present us with a series of present value or future values to be summed.   In later chapters, we will use the skills learned in Chapter 5 to determine the market value of bonds (Corporate or Government IOUs) and the appropriate valuation of a stock (a piece of ownership in a company, called a share).

Study Tip
At the end of this chapter, there are six Chapter Review and Self-Test problems.  Working these BEFORE you attempt the homework will actually cut the time you spend on homework in half.  Try it first on your own, then review the process using the explanation in the book.  It's like having someone show you how.  Now that our homework problems are getting a little harder, the Self-Test part of each chapter will be more important to your understanding.

Learning Objectives

When you finish this chapter, you should be able to:

  1. UNDERSTAND and CALCULATE present value and future value of investments with multiple cash flows.
  2. UNDERSTAND the difference between simple interest, compound interest, Annual Percentage rate (APR) and the Effective Annual rate (EAR) and be able to CALCULATE the EAR and APR on a loan.
  3. Be able to CALCULATE the payments on a loan.
  4. UNDERSTAND and CALCULATE an amortization schedule on a loan.
  5. CALCULATE the present value of a perpetuity.

You will also be able to wow your friends by showing them what buying on credit REALLY costs them!

Key Terminology
Amortization table
Amortized loans
Annual Percentage Rate
Annuity due
Annuity Factors
Compounding
Consol
Effective Annual Rate
Interest-only loans
Multiple Cash flows
Ordinary Annuity
Perpetuity
Pure Discount loans
Time Value

Cash flow is the name of the game!  As long as there is more coming in than going out, there is no problem.  Business owners worry about cash flow all the time.  It's usually the coming in part that's the problem.  Cutting costs can only go so far.

While this is not a consumer finance course, the skills you learn in this chapter will hold you in good stead when you go to buy a house or car.  Over a large amount of money over time, it is at first quite surprising what a small difference in interest rates can make.

Special Assignment:

Pick out a car that you would like to own, and get a price for it from the newspaper.  Using an Excel spreadsheet,  figure out what the payments would be at a 0% promotional rate over 3 years and 5 years. (You can use the Financial Function PMT to do this.)  Then, do the same calculation with interest rates of  5% and 8%.  Figure out the total cost of the car under each of the scenarios.  Write a couple of sentences telling me what you learned.
This is due with the rest of your Chapter 5 homework.
Either attach the spreadsheet to your e-mail (preferred) or paste the results into your e-mail.
This is a good assignment to work on with your study group.

Not required, but if you are into it you might want to try:

Produce amortization schedules (see page 133 in the text) using each of the six scenarios.