McGraw-Hill/I rwin

Copyright 2012 by The McGraw-Hill Companies, I nc. All rights reserved.

Quantitative Analysis
5-2
Quantitative Analysis is needed
for good Decision Making
Benefits Need to Exceed Costs!
Need to Quantify the Benefits
Need to Quantity the Costs
Understand the Risks Involved
Need to Know the Assumptions
5-3
Business Discipline Specific
Strategy Determine a competitors
response to a price increase to the
industry
Operations Evaluate if
modernization of equipment will
decrease production costs
5-4
Business Discipline Specific
Marketing Determine revenue
increases resulting from an
advertising campaign
Organizational Behavior
Determine the effects of change on
productivity
5-5
Chapter Five Concepts
Future Value & Compound Interest
Calculating Present Value
Finding Interest Rates
Calculating Multiple Cash Flows
Perpetuities and Annuities
Effective Annual Interest Rates
Inflation
5-6
Time Value of Money
Why? Economic Theory! (ECO201)
What?
Calculation of Present Value, Future
Value and Interest Rates.
How? Textbook Page 121

5-7
Adam Smith

5-8
1776 The Wealth of Nations
All people in a society consume goods and
services (not just aristocracy / business)
The invisible hand guides the market
results in goods the society wants, in the
quantity society desires for the price that
society is prepared to pay.


5-9
Key Terms
Competitive Market A market in which the
good can be bought and sold at the same price
(due to market forces).
Valuation Principle When the value of the
benefits exceeds the value of the costs, the
decision will increase the market value of the
firm.
5-10
Time Value of Money
Need for an Apple-to-Apples Comparison

Example 1 $10,000 needed later

Example 2 Delay of Sony PlayStation 3
5-11
5-12
Money has a time value. It can be expressed in
multiple ways:
A dollar today held in savings will grow.

A dollar received in a year is not worth as
much as a dollar received today.
Time Value of Money
5-13
Future Values
Future Value: Amount to which an
investment will grow after earning
interest.

Example: $10,000 Needed Later


5-14
Future Values
Let r = annual interest rate
Let t = # of years
Simple Interest vs. Compound Interest

FV = Initial investment (1 )
t
Compound
r +
FV = Initial investment (1 )
Simple
r t +
5-15
Simple Interest: Example
Interest earned at a rate of 7% for five years on a
principal balance of $100.

Example - Simple Interest
Today Future Years
1 2 3 4 5
Interest Earned
Value 100
Value at the end of Year 5: $135
7
107
7
114
7
121
7
128
7
135
5-16

Interest earned at a rate of 7% for five years on the
previous years balance.

Example - Compound Interest
Today Future Years
1 2 3 4 5
Interest Earned
Value 100


Compound Interest: Example
7
107
7.49
114.49
8.01
122.50
8.58
131.08
9.18
140.26
Value at the end of Year 5 =$140.26
5-17
The Power of Compounding
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
1 6 11 16 21 26 31 36
F
u
t
u
r
e

V
a
l
u
e

Year
Simple Interest
Compound Interest
Interest earned at a rate of 7% for the first forty years on
the $100 invested using simple and compound interest.
5-18
Time Value of Money

Video: The Big Picture
5-19
Present Value
Present Value:
Discount Rate:
Discount Factor:
1
(1 )
t
r
PV FV
+
=
1
(1 )
t
r
DF
+
=
Recall: t = number of years
r
5-20
Present Value: Example

Always ahead of the game, Tommy, at 8 years old, believes
he will need $100,000 to pay for college. If he can invest at a
rate of 7% per year, how much money should he ask his rich
Uncle GQ to give him?
10
1
(1.07)
1
$100, 000 $50,835
(1 )
t
PV FV
r
= = ~
+
Note: Ignore inflation/taxes
$100, 000 10 7% FV t yrs r = = =
5-21
The PV formula has many applications. Given
any variables in the equation, you can solve for
the remaining variable.
1
(1 )
t
r
PV FV
+
=
Time Value of Money
(applications)
5-22
0
20
40
60
80
100
120
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
P
V

o
f

$
1
0
0
0%
5%
10%
15%
Present Values: Changing Discount Rates
Discount Rates
The present value of $100 to be received in 1 to 20 years at varying discount rates:
5-23
PV of Multiple Cash Flows
1 2
1 2
(1 ) (1 ) (1 )
....
t
t
C C C
r r r
PV
+ + +
= + + +
The present value of multiple cash flows can be calculated:
1
2
:
The cash flow in year 1
The cash flow in year 2
The cash flow in year t (with any number of cash flows in between)
t
Denote
C
C
C
=
=
=
Recall: r = the discount rate
5-24
Multiple Cash Flows: Example
Your auto dealer gives you the choice to pay $15,500 cash now or
make three payments: $8,000 now and $4,000 at the end of the
following two years. If your cost of money (discount rate) is 8%, which
do you prefer?

1
2
4,000
1
(1 .08)
4,000
2
(1 .08)
Initial Payment* 8,000.00
3, 703.70
3, 429.36
Total PV $15,133.06
PV of C
PV of C
+
+
= =
= =
=
* The initial payment occurs immediately and therefore would not be discounted.
5-25
Perpetuities
Let C = Yearly Cash Payment
PV of Perpetuity:




C
r
PV =
What are they?
Recall: r = the discount rate
5-26
Perpetuities: Example
In order to create an endowment, which pays $185,000 per year
forever, how much money must be set aside today if the rate of
interest is 8%?



What if the first payment wont be received until 3 years from
today?
185,000
.08
$2, 312, 500 PV = =
2
2,312,500
(1 .08)
$1, 982, 596 PV
+
= =
5-27
Annuities
What are they?
Annuities are equally-spaced, level streams of cash flows lasting
for a limited period of time.
Why are they useful?
5-28
Present Value of an Annuity
Let:
C = yearly cash payment
r = interest rate
t = number of years cash payment is received
1 1
(1 )
t
r
r r
PV C
+
(
=

The terms within the brackets are
collectively called the annuity factor.

5-29
Annuities: Example

You are purchasing a home and are scheduled to make 30
annual installments of $10,000 per year. Given an interest
rate of 5%, what is the price you are paying for the house
(i.e. what is the present value)?
30
1 1
.05
.05(1 .05)
$10, 000
$153, 724.51
PV
PV
+
(
=

=
5-30
Future Value of Annuities:
Example

You plan to save $4,000 every year for 20 years and then retire.
Given a 10% rate of interest, how much will you have saved by
the time you retire?
20
20
1 1
.10
.10(1 .10)
$4, 000 (1 .10)
$229,100
FV
FV
+
(
= +

=
5-31
Annuity Due
How does it differ from an ordinary annuity?




What is it?
Recall: r = the discount rate
(1 )
Annuity Due Annuity
FV FV r = +
How does the future value differ from an ordinary annuity?



(1 )
Annuity Due Annuity
PV PV r = +
5-32
Annuities Due: Example
) 1 ( r FV FV
Annuity AD
+ =
Example: Suppose you invest $429.59 annually at the
beginning of each year at 10% interest. After 50 years,
how much would your investment be worth?
000 , 550 $
) 10 . 1 ( ) 000 , 500 ($
) 1 (
=
=
+ =
AD
AD
Annuity AD
FV
FV
r FV FV
5-33
Interest Rates: EAR & APR
Effective Annual Interest (EAR): Interest
rate that is annualized using compound
interest.

Annual Percentage Rate (APR): Interest
rate that is annualized using simple
interest.

5-34
*where MR = monthly interest rate
EAR & APR Calculations
1 ) 1 (
12
+ = MR EAR
Effective Annual Interest Rate (EAR):
Annual Percentage Rate (APR):
12 = MR APR
5-35
EAR and APR: Example

Given a monthly rate of 1%, what is the Effective Annual
Rate(EAR)? What is the Annual Percentage Rate (APR)?


% 00 . 12 ) 12 ( ) 01 . 0 (
% 68 . 12 1 ) 01 . 1 (
12
= =
= =
APR
EAR
5-36
Inflation
What is it?
What determines inflation rates?
What is deflation?
5-37
Inflation and Real Interest
1+nominal interest rate
1+inflation rate
1 real interest rate= +
Exact calculation:
Approximation:
rate inflation - rate interest nominal rate interest Real ~
5-38
Inflation: Example
If the nominal interest rate on your interest-bearing savings
account is 2.0% and the inflation rate is 3.0%, what is the
real interest rate?
1+.02
1+.03
1 real interest rate=
1 real interest rate= 0.9903
real interest rate = -.0097 or -.97%
Approximation = .02-.03 = .01 1%
+
+
=
5-39
Appendix A: Inflation
Annual U.S. Inflation Rates from 1900 - 2010