FINA 3332 Week 6

TUESDAY THURSDAY
Discussion: Article Discussion: Articles
Time Value of Money: Time Value of Money:
Valuing Cash Flow Valuing Cash Flow
Streams, BDH, Chapter 4 Streams, BDH, Chapter 4
Applications Applications

These notes should be used by enrolled students only.

May not be copied, duplicated, or posted on a publicly available website.
FINA 3332 Lecture 10 1
FINA 3332
Lecture 10 2/23/2017
Discussion: Articles
Time Value of Money: Valuing Cash Flow Streams,
BDH, Chapter 4
Applications

These notes should be used by enrolled students only.

May not be copied, duplicated, or posted on a publicly available website.
FINA 3332 Lecture 10 2
 Discussion: Article 1

FINA 3332 Lecture 10 3

 Discussion: Article 2

FINA 3332 Lecture 10 4

 Personal Finance Application
[DISCUSSION]
Evaluate your monthly budget and decide which expense(s) you could eliminate
each month (e.g. 2 coffee drinks a week; one restaurant meal a week ; etc.)
Then, do the following:
1. Compute the amount you could save per year
2. Assume that you will deposit this amount at the end of each year at a
retirement account (e.g. IRA) for the next 10 years
3. Go to https://investor.vanguard.com/mutual-funds/target-retirement/#/
4. Find the appropriate target fund for your age and select the 10- or 5-year (or 3-
year if the others are not available) average annual return of this fund.
5. If you invest the amount you are saving every year on this fund, for the next 10
years, how much will you have when you reach 65?

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 Financing
Decision
(raising $)

Financial
Manager

Cash flow
Investment
Decision
(spending $)

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 -- Brief Review (Last Class) --

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 Special Cases:
Annuities, perpetuities, growing annuities
and growing perpetuities

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 4.3 Annuities
An annuity is a stream of N equal cash flows paid at regular intervals.

The difference between an annuity and a perpetuity is that an annuity ends

after some fixed number of payments
Note that, just as with the perpetuity, we assume the first payment takes
place one period from today (date 1)

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 4.3 Annuities
Present value of an Annuity
Present Value of an N-period annuity with payment C and interest rate r is:

= + + +
(1 + ) (1 + )2 (1 + )3 (1 + )

We can show that the above expression simplifies to:

FINA 3332 Lecture 10 10

 4.3 Annuities
Future Value of an Annuity
0 1 2 N

C C C

PV FV
1 1
= (1 + ) = 1 (1 + )=
(1 + )

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 Application: Mortgage & Loan Balance
PROBLEM
When you purchased your house, you took out a 30-year annual-payment
mortgage with an interest rate of 6% per year. The annual payment on the
mortgage is $12,000. You have just made a payment and have now decided
to pay the mortgage off by repaying the outstanding balance. What is the
payoff amount if:
a) You have lived in the house for 12 years (so there are 18 years left on the
mortgage)?
b) You have lived in the house for 20 years (so there are 10 years left on the
mortgage)?

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 -- End of Review --

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 Chapter 4

Time Value
of Money: Valuing
Cash Flow Streams
 Time Value of Money: Valuing Cash Flow
Streams
1. Valuing a Stream of Cash Flows
2. Perpetuities
3. Annuities
4. Growing Cash Flows
5. Solving for Variables Other Than Present Value or
Future Value

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 Special Cases (continued):
Annuities, perpetuities, growing annuities
and growing perpetuities

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 4.4 Growing Cash Flows
Growing Perpetuity
A growing perpetuity is a stream of cash flows that occur at regular intervals
and grow at a constant rate g forever
For example, a growing perpetuity with a first payment of $100 that grows at
a rate of 3% has the following timeline:

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 4.4 Growing Cash Flows
Growing Perpetuities
Present Value (PV) of a growing Perpetuity with payment C, growth rate and
interest rate r is given by:

(1 + ) (1 + )2
(1 + )1
= + + +=
(1 + ) (1 + )2 (1 + )3 (1 + )
=1

There is a shortcut for this calculation. We can show that the value of a growing
perpetuity is simply the cash flow divided by the difference between the interest rate
and the growth rate.
If r > g, the Present Value (PV) of a Growing Perpetuity simplifies to:

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 4.4 Growing Cash Flows
Growing Perpetuities: Example 4.6 , Textbook
In the perpetuity example from last class, you planned to donate money to
your alma mater to fund an annual $30,000 graduation party. Given an
interest rate of 8% per year, the PV of the required donation was $375,000
today.
Now assume that before accepting the money, the student association has
asked that you increase the donation to account for the effect of inflation on
the cost of the party in future years. They estimate that the cost will be
$30,000 next year, but the partys cost will rise by 4% per year thereafter.
How much do you need to donate now?

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 4.4 Growing Cash Flows
Growing Perpetuities: Example 4.6 , Textbook
Timeline:

The cash flows can be modeled as a growing perpetuity.

To finance the growing cost, you need to provide the present value today of:
$30,000
= = $750,000
(0.08 0.04)
Conclusion: You need to double the size of your gift!

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 4.4 Growing Cash Flows
Growing Annuity
A growing annuity is a stream of N growing cash flows, paid at regular
intervals.
It is a growing perpetuity that eventually comes to an end
The following timeline shows a growing annuity with initial cash flow C,
growing at a rate of g every period until period N:

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 4.4 Growing Cash Flows
Growing Annuity
Same conventions: (1) The first cash flow arrives at the end of the first
period and (2) the first cash flow is before growth
Present Value of an N-period growing annuity with initial cash flow C, growth
rate , and interest rate r is given by:

NOTE: this formula cant be used if r = g

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 4.4 Growing Cash Flows
Growing Annuities: Example 4.7, Textbook
Retirement Savings with a Growing Annuity
In Example 4.5, Ellen considered saving $10,000 per year for her retirement.
Although $10,000 is the most she can save in the first year, she expects her
salary to increase each year so that she will be able to increase her savings
by 5% per year.
With this plan, if she earns 10% per year on her savings, how much will Ellen
have saved at age 65?

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 4.4 Growing Cash Flows
Growing Annuities: Example 4.7, Textbook
Her new savings plan is represented by the following timeline:

This problem can me modeled as a 30-year growing annuity, with a growth rate of 5%
and an initial cash flow of $10,000

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 4.4 Growing Cash Flows
Growing Annuities: Example 4.7, Textbook
This problem can me modeled as a 30-year growing annuity, with a growth rate of 5%
and an initial cash flow of $10,000

1 1+
= 1
1+
30
1 1.05
= $10,000 1
0.10 0.05 1.10
= $10,000 15.0463
= $150,463

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 4.4 Growing Cash Flows

Growing Annuities: Example 4.7, Textbook

Ellens savings plan is equivalent to having $150,463 in the bank today.
To determine the amount she will have at age 65, we need to move this amount
forward 30 years:

= $150,463 1.1030

= $2.625 30

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 4.4 Growing Cash Flows

Growing Annuities: Example 4.7, Textbook

Ellen will have saved $2.625 million at age 65 using the new savings plan.
This sum is almost $1 million more than she had without the additional
annual increases in savings.
Because she is increasing her savings amount each year and the interest on
the cumulative increases continues to compound, her final savings is much
greater.

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 4.5 Solving for Variables Other Than Present Value or
Future Value
In some situations, we use the present and/or future values as inputs, and
solve for the variable we are interested in.
Example?
We examine several special cases in this section.

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Solving for Cash Flows
We know the PV of an investment, but do not know the cash flows.
We rearrange the PV(annuity) formula to solve for C:

=
1 1
1
(1 + )

[or equivalently]

=
1
1
(1 + )

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Computing a Loan Payment: Example 4.8, Textbook
Your firm plans to buy a warehouse for $100,000.
The bank offers you a 30-year loan with equal annual payments and an
interest rate of 8% per year.
The bank requires that your firm pay 20% of the purchase price as a down
payment, so you can borrow only $80,000.
What is the annual loan payment?

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Computing a Loan Payment: Example 4.8, Textbook
We start with the timeline (from the banks perspective):

Applying the formula, can solve for the loan payment, C, given N=30, r = 8% (0.08) and
P=$80,000:

=
1
1
(1 + )

80,000 0.08
= = $7,106.19
1
1
(1 + 0.08)30

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Computing a Loan Payment: Example 4.8, Textbook
Your firm will need to pay $7,106.19 each year to repay the loan.
The bank is willing to accept these payments because the PV of 30 annual
payments of $7,106.19 at 8% interest rate per year is exactly equal to the
$80,000 it is giving you today.

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 In-Class Application
Calculating a loan payment
Problem

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Rate of Return
The rate of return is the rate at which the present value of the benefits
exactly offsets the cost
Example:
Suppose you have an investment opportunity that requires a $1000
investment today and will pay $2000 in six years
What interest rate, r, would you need so that the present value of what you
get is exactly equal to the present value of what you give up?
Timeline

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Rate of Return
Example -- Solution:

2000
1000
(1 r)6

1000 (1 r) 6 2000
1

2000 6
1 r
1000
1.1225,or
r 12.25%

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Rate of Return
The rate of return is the rate at which the present value of the benefits
exactly offsets the cost
Example 2:
Suppose your firm needs to purchase a new forklift
The dealer gives you two options:
A price for the forklift if you pay cash ($40,000)
The annual payments if you take out a loan from the dealer (no money down
and four annual payments of $15,000)

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Rate of Return
Example 2 - Solution:
Setting the present value of the cash flows equal to zero requires that the
present value of the payments equals the purchase price:
1 1
40,000 15,000 1
r (1 r) 4
The solution for r is the (intrinsic) interest rate charged by the dealer, which
you can compare to the rate charged by your bank
r = 18.45%

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Rate of Return
There is no simple way to solve for the interest rate
The only way to solve this equation is to guess at values for r until you find
the right one
An easier solution is to use an Excel spreadsheet.

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 4.5 Solving for Variables Other Than Present Value or
Future Value
Solving for the Number of Periods
In addition to solving for cash flows or the interest rate, we can solve for the
amount of time it will take a sum of money to grow to a known value
In this case, the interest rate, present value, and future value are all known
We need to compute how long it will take for the present value to grow to
the future value
In Excel: function =NPER()

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 Next Class
News Articles
More applications and Chapter 5 -- BRING A CALCULATOR (or
Excel)

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