Chapters 9, 14
9.1) A. What is the opportunity cost rate? B. How is it used in time value analysis? C. Is this a single number that is used in all situations?
A - Opportunity Cost = the cost associated with alternative uses of the same funds. Example, if monies are used for one investment, it is no longer available for other uses, so an opportunity cost arises. Because on investment decision automatically negates all other possible investments with the same funds, Cash flows expected to be earned from any investment must be discounted at a rate of return that reflects the return that could be earned on forgone investment opportunities
B - The opportunity cost is involved in time value analysis directly (Time value analysis = the use of time value of money techniques to future cash flows. Sometimes called Discounted Cash Flow Analysis). – The opportunity cost rate to be applied in time value analysis is the rate that could be earned on alternative investments of similar risk.
This concept is one of the cornerstones of healthcare finance. The opportunity costs
(discount) rate applied to investment cash flows is the rate that could be earned on alternative investment of similar risk.
C – No- It is important to note that the opportunity costs rate does not depend on the source of the funds invested. Rather the primary determinant of this rate is the riskiness of cash flows being discounted. Also important to recognize the discounting process itself accounts for opportunity costs of capital (i.e. the loss of use of funds for other purposes)
9.7) - Explain the difference between the stated rate, periodic rate, and effective annual rate?
Nominal (state interest) rate - is the interest rate stated in debt contract. It does not reflect the effect of any compounding that occurs more frequently than annually.
Effective annual rate (EAR) – the interest rate that under annual compounding, produces that same future value as was produced by more frequent compounding.
Equation –the effective annual rate (EAR) is used to compare rates of return on investments that have different compounding periods. If compounding occurs more frequently than once a year, it is often necessary to calculate the effective annual rate, which is the rate that produces the same results under annual compounding as obtained with more frequent compounding
Suppose that a bank C pays 8%
Interest compounded quarterly. Its EAR is 8.24 percent:
EAR - Formula M EAR = (1 + 1stated/M) - 1
4 4 = (1 + 0.08/4) -1 = (1.02) - 1
= 1.0824 -1 = 0.0824
here , I (stated) is the interest rate stated in the contract and M is the number of compounding periods per year.
Period rate – in time value of money analysis, the interest rate period. For example, 2 percent quarterly interest equals an 8 percent stated (annual) rate. Also the periodic rate equals the stated rate divided by the number of compounding periods per year.
9.9) explain the concept of return on investment (ROI) and two different approaches to measuring ROI.
ROI – (return on investment or just return) – a business spends cash today with the expectation of receiving cash in the future. There are two basic ways of expressing ROI:
In terms of dollars and percentages.
Net Present Value (NPV) – A project’s return on investment (ROI) metric that measures time value adjusted expected dollar return. $$$$$
Rate of Return , or percentage return. This measures the interest rate that must be earned on the investment outlay to generate the expected cash in flows. In other words, this measures provides the expected periodic rate of return on the investment.%%%%
Internal rate of return (IRR)- a return –on investment (ROI) metric that measures expected rate of return. NOTE – that the rate of return on an investment, particularly an investment in plant or equipment, typically called internal rate of