Calculating Economic Value Essentials

Economic Value: Calculating Economic Value

• Economic assets are entities that hold value and are legally owned. They generate economic benefits for their owners.
• Economic value is the highest price someone is willing to pay for an asset. It's calculated by finding the present value of future cash flows, discounted by the opportunity cost.
• Opportunity cost is what you give up by choosing one option over another. It's often expressed as a rate of return, representing the potential earnings from alternative investments.
• Cash is a crucial element of economic value, acting as a medium of exchange and a way to settle obligations.
• The First Principle of Finance states that a dollar today is worth more than a dollar tomorrow. This is due to the time value of money, where the value of money decreases over time.
• Interest rates represent the cost of borrowing or the return on lending. They bridge the gap between consumption and investment, allowing market participants to use excess capital or acquire funds.
• Compounding calculates the future value of an investment by adding earned interest to the principal, allowing the value to grow exponentially.
• Discounting calculates the present value of a future cash flow by factoring in the time value of money and the opportunity cost.

Making Wealth-Increasing Decisions

• Wealth is the control over economic assets.
• Wealth increase happens when an asset is acquired at a price lower than its opportunity cost, effectively securing a bargain.
• Internal Rate of Return (IRR) is a percentage measuring the return earned on an investment. It's used to compare the project's return against the opportunity cost.
  • If the IRR is greater than the opportunity cost, the investment is underpriced, leading to wealth increase.
  • If the IRR is less than the opportunity cost, the investment is overpriced, leading to wealth loss.
• Net Present Value (NPV) measures the dollar change in wealth resulting from an investment. It considers cash flows, time value, and opportunity cost.
  • A positive NPV indicates an increase in wealth and a desirable investment.
  • A negative NPV indicates a decrease in wealth and an undesirable investment.

Adjusting Economic Decisions for Risk

• Expected return is the anticipated return based on available information.
• Realized return is the actual return obtained after the investment period.
• Uncertainty is the possibility that realized return may deviate from expected return, leading to a difference in outcomes.
• Risk is quantifiable uncertainty, often measured by the potential for the realized return to differ from the expected return.
• Opportunity cost for risky investments consists of two elements:
  • Risk-free rate of return: The return earned on an asset with no risk.
  • Risk premium: A premium added to the risk-free rate to compensate for uncertainty.
• Investors adjust the price they're willing to pay for an asset based on the perceived risk and required risk-adjusted opportunity cost.

Key Concepts: Risk and Economic Value

• Risk in Finance is defined as receiving a lower return than expected.
• Expected return is the future return, often uncertain, anticipated from an investment.
• Realized return is the actual return received at the end of the investment period.
• Risk-free rate of return is the return earned on an asset with certain future cash flows.
• Risk premium is the additional return required to compensate for the uncertainty associated with the future cash flows of an investment.

### Economic Value: Applying Time Value Techniques: Single Cash Flows in Multiple Periods

• Future Value is directly proportional to the interest rate. A higher interest rate leads to a higher future value and vice-versa.
• Monetary Policy is the actions taken by central banks to influence economic conditions, such as price stability and employment.
• Present Value is inversely proportional to the interest rate.

This quiz covers the key concepts of economic value, including economic assets, opportunity costs, and the principles of time value of money. Test your understanding of how to calculate the present value of future cash flows and the role of interest rates in finance. Perfect for students looking to deepen their grasp of financial concepts.