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CONCEPTS OF VALUE & RETURN

R E V IS ION OF S OME C ON C E PT S
SOME BASICS
Mary purchased some Energy Start Future Value (FV)
stock for Rs.6125.00. After 6 months,
the stock had risen in value by The amount an investment is worth
Rs.138.00 and had paid dividends after one or more periods.
totaling Rs.144.14. Simple interest
What is the simplest way to find her Interest earned only on the original
return principal amount invested.
SIMPLE INTEREST
FUTURE VALUE
(a) If Rs.8000 is invested for 2 years at an annual interest rate of 9%, how much
interest will be received at the end of the 2-year period?
𝐼 = 𝑃𝑟𝑡
𝑅𝑠. 8,000(0.09)(2) = 𝑅𝑠. 1,440
The future amount of an investment, or its future value, at the end of an interest
period is the sum of the principal and the interest. Thus, in Example (a), the future
value is
S = Rs.8000+Rs1440 = Rs.9,440.00
FUTURE VALUE
(b) If Rs.4000 is borrowed for 39 weeks at an annual interest rate of 15%, how
much interest is due at the end of the 39 weeks?
Use with year. Thus
39
𝐼 = 𝑃𝑟𝑡; 𝑡 = = 0.75 𝑦𝑒𝑎𝑟 ; 𝐼 = 𝑅𝑠. 4000(0.15)(0.75) = 𝑅𝑆. 450
52
Similarly, the future amount of a loan, or its future value, is the amount of money
that must be repaid. In Example (b), the future value of the loan is the principal
plus the interest, or
S = Rs.4000+Rs.450 = Rs.4,450.00
The principal P of a loan is also called the face value or the present value of
the loan.
BACK TO THE FIRST EXAMPLE 20
31

Mary purchased some Energy Start stock for Rs.6125.00. After 6 months, the stock
had risen in value by Rs.138.00 and had paid dividends totaling Rs.144.14.
What was her return on her investment?
To find the simple interest rate that Mary earned on this investment, we find the
rate that would yield an amount of simple interest equal to all of Mary’s gains
(that is, equal to the rise in the stock’s price plus the dividends she received).
Thus the principal is Rs.6125.00,
the time is ½ year, and the interest earned is the total of all gains 138 + 144.14 =
282.14
𝑅𝑠282.14
𝐼 = 𝑃𝑟𝑡 ; 282.14 = 6125 × 𝑟 × 0.5; 𝑟 = = 0.092 = 9.2%
𝑅𝑠6,125∗.05
COMPOUND INTEREST
Suppose Alan and Milan established such a Compounding
plan for their baby daughter Meera. If this
account earns 9.8% compounded quarterly The process of accumulating interest on an
and if their goal is to have Rs.200,000 by investment over time to earn more interest.
Meera’s eighteenth birthday, what would
be the impact of having Rs.10,000 in the Interest on interest
account by Meera’s first birthday? Interest earned on the reinvestment of
A compound interest investment (such as previous interest payments.
Alan and Milan’s account) is one in which Compound interest
interest is paid into the account at regular
intervals. In this section we consider Interest earned on both the initial principal
investments of this type and develop and the interest reinvested from prior
formulas that enable us to determine the periods.
impact of making a Rs.10,000 investment
in Meera’s college tuition account by her
first birthday.
EXAMPLE
To see how compound interest is computed, consider the following table, which
tracks the annual growth of Rs.20,000 invested for 3 years at 10% compounded
annually.

Year Beginning Principal = P 10% Annual Interest - I Ending Principal = P+I


1 20,000.00 2,000.00 22,000.00
2 22,000.00 2,200.00 24,200.00
3 24,200.00 2,420.00 26,620.00
MORE
If Rs.3,000 is invested for 4 years at 9% compounded annually, how much interest
is earned?
3000 × 1 + .09 4 = 𝑅𝑠. 4,234.74 to the nearest paisa. Sometimes the interest is
compounded
1. Annually
2. Semiannually
3. Quarterly
4. Monthly
Unless specifically stated otherwise, a stated interest rate, called the nominal
annual rate, is the rate per year and is denoted by 𝒓. The interest rate per period,
denoted by 𝒊, is the nominal rate divided by the number of interest periods per
year
COMPOUNDING
If 𝑅𝑠. 𝑃 is invested for 𝑡 years at a nominal interest rate 𝑟, compounded m times
per year, then the total number of compounding periods is
𝒏 = 𝒎𝒕
the interest rate per compounding period is
𝒓
𝒊= Expressed in decimals
𝒎

𝒏 𝒓 𝒎𝒕
and the future value is 𝑺 = 𝑷 𝟏 + 𝒊 =𝑷 𝟏+
𝒎
OPENING EXAMPLE 20
31

Alan and Milan want to have Rs.200,000 in Meera’s college fund on her
eighteenth birthday, and they want to know the impact on this goal of having
Rs.10,000 invested at 9.8%, compounded quarterly, on her first birthday. To advise
Alan and Milan regarding this, find
(a) the future value of the Rs.10,000 investment,
(b) the amount of compound interest that the investment earns, and
(c) the impact this would have on their goal.
SOLUTION
a) Future value of the Rs.10,000 investment
0.098
𝑖= = 0.0245
4
𝑛 = 4 ∗ 17 = 68 𝑃 = 𝑅𝑠. 10,000
𝑆 =𝑃 1+𝑖 𝑛 = 𝑅𝑠. 10,000 1 + 0.0245 68 = 𝑅𝑠. 51,857.73
b) Amount of interest earned is
𝑅𝑠. 51,857.73 − 10,000 = 𝑅𝑠. 41,857.73
c) ??
APPLICATION As Figure shows, three years after
Google stock was first sold publicly,
its share price had risen 650%. The
figure also shows that this growth
far exceeded Microsoft’s
performance at the same point
since its stock was first publicly
traded. Google’s 650% increase
means that $10,000 invested in
Google stock at its initial public
offering (I.P.O.) was worth
$65,000 three years later.
What interest rate compounded
annually does this represent?
CONTINUOUS COMPOUNDING
Because more frequent compounding means that interest is paid more often (and
hence more interest on interest is earned), it would seem that the more frequently
the interest is compounded, the larger the future value will become.
CONTINUOUS COMPOUNDING
We say that as the number of periods increases, the future value approaches a
limit, which is the number 𝑒 = 2.7182818 . . . .
In general, if $P is invested for t years at a nominal rate r compounded
continuously, then the future value is given by the exponential function
𝑆 = 𝑃𝑒 𝑟𝑡
(a) Find the future value if $1000 is invested for 20 years at 8%, compounded
continuously.
(b) What amount must be invested at 6.5%, compounded continuously, so that it
will be worth $25,000 after 8 years?
CONTINUOUS COMPOUNDING
SOLUTIONS TO QUESTIONS IN PREVIOUS SLIDE

(a) Find the future value if $1000 is invested for 20 years at 8%, compounded
continuously.
𝑆 = 𝑃𝑒 𝑟𝑡
$1000 ∗ 𝑒 20∗.08 = $4,953.03
(b) What amount must be invested at 6.5%, compounded continuously, so that it
will be worth $25,000 after 8 years?
𝑆 = $25,000; 𝑟 = 0.065; 𝑡 = 8
$25,000 = 𝑃𝑒 0.065∗8 ; $25,000 = 𝑃 ∗ 1.6820
$25,000
𝑃= = $14,863.01
1.6820
ANNUAL PERCENTAGE YIELD
When we invest money at a given compound interest rate, the method of
compounding affects the amount of interest we earn. As a result, a rate of 8% can
earn more than 8% interest if compounding is more frequent than annually. The
rate of interest earned in reality per year is called annual percentage yield (APY),
or effective annual rate. This can be calculated as below
Let 𝑟 represent the annual (nominal) interest rate for an investment. Then the
annual percentage yield (APY) found as follows.
Periodic Compounding. If 𝑚 is the number of compounding periods per year, then
𝑟 𝑟 𝑚
𝑖 = is the interest rate per period, and 𝐴𝑃𝑌 = 1 + −1= 1+𝑖 𝑚−1
𝑚 𝑚
𝑟
and in continuous compounding 𝐴𝑃𝑌 = 𝑒 − 1
COMPARING YIELDS 20
31

Suppose a young couple such as Alan and Milan from our Application
Preview found three different investment companies that offered college
savings plans:
a) one at 10% compounded annually,
b) another at 9.8% compounded quarterly, and
c) a third at 9.65% compounded continuously.
Find the annual percentage yield (APY) for each of these three plans in
order to discover which plan is best.
TIME
How long does it take an investment of $10,000 to double if it is invested at
(a) 8%, compounded annually?
(b) 8%, compounded continuously?
FUTURE VALUE OF ANNUITIES
Twins graduate from college together and start their careers. Twin 1 invests $2000
at the end of each of 8 years in an account that earns 10%, compounded annually.
After the initial 8 years, no additional contributions are made, but the investment
continues to earn 10%, compounded annually.
Twin 2 invests no money for 8 years but then contributes $2000 at the end of each
year for a period of 36 years (to age 65) to an account that pays 10%,
compounded annually. How much money does each twin have at age 65?
An annuity is a financial plan characterized by regular payments. We can view an
annuity as a savings plan in which the regular payments are contributions to the
account, and then we can ask what the total value of the account will become (as
in above). Also, we can view an annuity as a payment plan (such as for
retirement) in which regular payments are made from an account, often to an
individual.
ANNUITIES

Annuities may be classified into two categories—annuities certain and contingent


annuities. An annuity certain is one in which the payments begin and end on fixed dates.
In a contingent annuity the payments are related to events that cannot be paced
regularly, so the payments are not regular.
To find the future value of your annuity at the end of the 5 years, we compute the future
value of each payment separately and add the amounts
FV OF ANNUITY

The sum of all payments plus all interest earned is called the future amount
of the annuity or its future value. The value of 𝑠𝑛¬ 𝑖 can be computed
directly with a financial calculator or found in an annuity table.
EXAMPLES
Richard Lloyd deposits $200 at the end of each quarter in an account that pays
4%, compounded quarterly. How much money will he have in his account in 2 ¼
years?
Twin 2 in the earlier example invests $2000 at the end of each year for 36 years
(until age 65) in an account that pays 10%, compounded annually. How much
does twin 2 have at age 65?
1+𝑖 𝑛 −1 1.136 −1
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑅 ∗ = 2000 ∗ = $598,254
𝑖 0.1
TWINS
CONTINUED

Twin 1 invests $2000 at the end of each of 8 years in an account that earns 10%,
compounded annually. After the initial 8 years, no additional contributions are
made, but the investment continues to earn 10%, compounded annually, for 36
more years (until twin 1 is age 65). How much does twin 1 have at age 65?
The first part is an ordinary annuity
1+𝑖 𝑛 −1 1.18 −1
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑅 ∗ = 2000 ∗ = $22,871.78
𝑖 0.1

This is then reinvested in the a deposit


𝑛
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑃 ∗ 1 + 𝑖 = 22,871.78 ∗ 1.136 = $707,028
COMPARING THE VALUE OF TWINS
Contribution per Number of Total Account value @65
year years Contribution
Twin 1 $2000 8 $16000 $707.028
Twin 2 $2000 36 $72,000 $598,254

Note that twin 1 contributed $56,000 less than twin 2 but had $108,774 more at age 65.
This illustrates the powerful effect that time and compounding have on investments
FUTURE VALUE OF $1 FOR
DIFFERENT PERIODS AND
RATES
TIME TO REACH A GOAL
Sometimes we want to know how long it will take for an annuity to reach a desired future
value. A small business invests $1000 at the end of each month in an account that earns
6% compounded monthly. How long will it take until the business has $100,000 toward
the purchase of its own office building?
0.06
1+𝑖 𝑛 −1 (1+( 12 )𝑛 −1
𝑆=𝑅∗ = 1000 ∗ 0.06 = $100,000
𝑖 ( 12 )
1.005𝑛 −1 1.005𝑛 −1
1000 ∗ = $100,000 ; = 100 ; 1.005n − 1 = 0.5
0.005 0.005
1.005n = 1.5; ln[1.005n ] = ln1.5;
nln 1.005 = ln1.5;
ln1.5
n= = 81.29 Months
ln1.005
PAYMENT FOR AN ORDINARY ANNUITY
A young couple wants to save $50,000 over the next 5 years and then to use this
amount as a down payment on a home. To reach this goal, how much money
must they deposit at the end of each quarter in an account that earns interest at
a rate of 5%, compounded quarterly?
SINKING FUNDS
A company establishes a sinking fund to discharge a debt of $300,000 due in 5
years by making equal semiannual deposits, the first due in 6 months. If the
deposits are placed in an account that pays 6%, compounded semiannually, what
is the size of the deposits?
ANNUITIES DUE
Deposits in savings accounts, rent payments, and insurance premiums are
examples of annuities due. Unlike an ordinary annuity, an annuity due has the
periodic payments made at the beginning of the period. The term of an annuity
due is from the first payment to the end of one period after the last payment.
Thus an annuity due draws interest for one period more than the ordinary
annuity.
ANNUITIES DUE

Find the future value of an investment if $150 is deposited at the beginning


of each month for 9 years and the interest rate is 7.2%, compounded
monthly.

Suppose a company wants to have $450,000 after 2 ½ years to modernize


its production equipment. How much of each previous quarter’s profits
should be deposited at the beginning of the current quarter to reach this
goal, if the company’s investment earns 6.8%, compounded quarterly?
PRESENT VALUES OF ANNUITIES
If you wanted to receive, at retirement,
$1000 at the end of each month for 16
years, what lump sum would you need to Discount
invest in an annuity that paid 9%, Calculate the present value of some future
compounded monthly? (See Example 2.) amount.
We call this lump sum the present value of Discount rate
the annuity. Note that the annuity in this
case is an account from which a person The rate used to calculate the present
receives equal periodic payments value of future cash flows.
(withdrawals).
Discounted Cash Flow (DCF) Valuation
Present value (PV)
Calculating the present value of a future
The current value of future cash flows cash flow to determine its value today.
discounted at the appropriate discount
rate.
ORDINARY ANNUITIES
Suppose we wish to invest a lump sum of money (denoted by An ) in an annuity
that earns interest at rate i per period in order to receive (withdraw) payments of
size $R from this account at the end of each of n periods (after which time the
account balance will be $0). Recall that receiving payments at the end of each
period means that this is an ordinary annuity. To find a formula for , we can find
the present value of each future payment and then add these present values
ORDINARY ANNUITIES
PRESENT VALUE
What is the present value of an annuity of $1500 payable at the end of each 6-month
period for 2 years if money is worth 8%, compounded semiannually?
.08
𝑖= = .04 = 4%; 𝑛 = 2 ∗ 2 = 4
2
1− 1+.04 −4
𝐴4 = $1500 × = $1500 × 3.6298 = $5,444.84
.04

Find the lump sum that one must invest in an annuity in order to receive $1000 at the end
of each month for the next 16 years, if the annuity pays 9%, compounded monthly.
.09
𝑖= = .0075 = 0.75%; 𝑛 = 16 ∗ 12 = 192
12
1− 1+.0075 −192
𝐴192 = $1000 × = $1000 × 101.5728 = $101,572.80
.0075
PAYMENTS FROM AN ANNUITY
Suppose that a couple plans to set up an ordinary annuity with a $100,000
inheritance they received. What is the size of the quarterly payments they will
receive for the next 6 years (while their children are in college) if the account pays
7%, compounded quarterly?
.07
𝑖= = .0175 = 4%; 𝑛 = 6 ∗ 4 = 24
4
1− 1+.0175 −24
𝐴24 = $100,000 = 𝑅 × = 𝑅 × 19.4607
.0175
$100,000
𝑅= = $5,138.57
19.4607
NUMBER OF PAYMENTS FROM AN ANNUITY
An inheritance of $250,000 is invested at 9%, compounded monthly. If $2500 is
withdrawn at the end of each month, how long will it be until the account balance
is $0?
.09
𝑖= = .0075 = 0.75%; 𝑛 =?
12
1+0.0075 −𝑛 −1
$250,000 = $2500 ∗
0.0075
250000 0.0075
= 1 − 1.0075 −n ; 0.75 = 1 − 1.0075 −n ;
1.0075 −n
= 0.25
2500
𝑙𝑛 1.0075 −n = ln 0.25 ; ⇒ −n ln 1.0075 = ln 0.25
ln0.25
−n = ≈ −185.532 Months ⇒ 𝑛 ≈ 185.532 𝑚𝑜𝑛𝑡ℎ𝑠
ln1.0075
BONDS
Bonds represent a relatively safe investment similar to a bank certificate of
deposit (CD), but unlike CDs (and like stocks), bonds can be traded. And, as
is also true of stocks, the trading or market price of a bond may fluctuate.
Most commonly, bonds are issued by the government, corporations, or
municipalities for periods of 10 years or longer. Bonds actually constitute a
loan in which the issuer of the bond is the borrower, the bond holders (or
purchasers) are the lender, interest payments to the bond holders are called
coupons. In the simplest case, a bond’s issue price, or par value, is the
same as its maturity value, and the coupons are paid semi-annually.
BOND PRICING
0.05
An investor will typically invest in the bond $10,000 × = $250
only if the bond’s price makes its rate of 2
return comparable to the market rate. The 𝑖=
.072
= .036 = 4%; 𝑛 = 15 ∗ 2 = 30
rate of return that the investor requires in 2
order to buy the bond is called the yield Market value of the bond is sum of present
rate. Hence the return from a bond is a mix values of coupons and maturity value of the
of its Coupon rate and Yield rate. principal bond
Suppose a 15-year corporate bond has a $10,000
maturity value of $10,000 and coupons at 𝑃=
1.03630
≈ 3,461.05
5% paid semi-annually. If an investor wants
to earn a yield of 7.2% compounded semi- 1− 1+.036 −30
𝐴30 = $250 ×
annually, what should he or she pay for this .036
bond? = $250 × 18.164 = $4,540.94
Each semi-annual coupon payment is
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝑃 + 𝐴30 = $8,001.99
DISCOUNT AND PREMIUM
In this case the bond is said to be selling at a discount. This has to be the case in
order for the yield rate to exceed the coupon rate. Similarly, if the yield rate is
lower than the coupon rate, then the market price of the bond will exceed its
maturity value. When this happens, the bond is said to be selling at a premium. In
general, the market price of a bond moves in the opposite direction from current
yield rates.
ANNUITIES DUE
ANNUITIES DUE
What lump sum will be needed to generate payments of ₹5000 at the beginning
of each quarter for a period of 5 years if money is worth 7%, compounded
quarterly?
.07
𝑖= = .0175 = 1.75%; 𝑛 = 5 ∗ 4 = 20
4
1− 1+.0175 −20
𝐴20 𝐷𝑢𝑒 = $5000 × × 1.0175 = $5000 × 41.0968 = $205,484
.0175
DEFERRED ANNUITIES
A deferred annuity is one in which the first payment is made not at the beginning
or end of the first period, but at some later date. An annuity that is deferred for k
periods and then has payments of $R per period at the end of each of the next n
periods is an ordinary deferred annuity.
A deferred annuity is purchased that will pay $10,000 per quarter for 15 years
after being deferred for 5 years. If money is worth 6% compounded quarterly,
what is the present value of this annuity?

Suppose a lottery prize of $50,000 is invested by a couple for future use as their
child’s college fund. The family plans to use the money as 8 semi-annual payments
at the end of each 6-month period after payments are deferred for 10 years. How
much would each payment be if the money can be invested at 8.6% compounded
semi-annually?
LOANS AND AMORTIZATION
Just as we invest money to earn interest, banks and Pure Discount Loans
lending institutions lend money and collect interest
for its use. Although your aunt may lend you The pure discount loan is the simplest form of loan.
money with the understanding that you will repay With such a loan, the borrower receives money
the full amount of the money plus simple interest today and repays a single lump sum at some time
at the end of a year, financial institutions generally in the future.
expect you to make partial payments on a regular
basis (often monthly). Interest-only Loans
Most consumer loans (for automobiles, appliances, When loan repayment plan calls for the borrower
televisions, and the like) are classed as equated to pay interest each period and to repay the entire
monthly instalment (EMI) loans. principal (the original loan amount) at some point
in the future.
This type of loan is usually repaid by making all
payments (including principal and interest) of Amortized Loans
equal size. This process of repaying the loan is
called amortization. A loan in which the lender may require the
borrower to repay parts of the loan amount over
the period of the loan. The process of providing for
a loan to be paid off by making regular principal
reductions is called amortizing the loan
LOANS AND AMORTIZATION
When a bank makes a loan of this type, it is purchasing from the borrower an
ordinary annuity that pays a fixed return each payment period. The lump sum the
bank gives to the borrower (the principal of the loan) is the present value of the
ordinary annuity, and each payment the bank receives from the borrower is a
payment from the annuity.
PAYMENTS TO AMORTIZE A DEBT
A debt of $1000 with interest at 16%, compounded quarterly, is to be amortized
by 20 quarterly payments (all the same size) over the next 5 years. What will the
size of these payments be?
0.16
𝐴𝑛 = $1000; 𝑛 = 20; 𝑖 = = 0.04
4
𝑖 0.04
𝑅 = 𝐴𝑛 = $1000 = $73.58
1− 1+𝑖 −𝑛 1− 1.04 −20
BUYING A HOME
A man buys a house for $200,000. He a) 𝐴𝑛 = $200,000 − $50,000 = $150000;
makes a $50,000 down payment and 0.12
agrees to amortize the rest of the debt 𝑛 = 4 × 10 = 40; 𝑖 = = 0.03
4
with quarterly payments over the next 𝑖
10 years. If the interest on the debt is 𝑅 = 𝐴𝑛 =
1− 1+𝑖 −𝑛
12%, compounded quarterly, find $150,000
0.03
= $𝟔, 𝟒𝟖𝟗. 𝟑𝟔
1− 1.03 −40
(a) the size of the quarterly payments,
b) 40 × $6,489.36 = $259,574.40 +
(b) the total amount of the payments, $50,000 = $𝟑𝟎𝟗, 𝟓𝟕𝟒. 𝟒𝟎
and
c) $309,574.40 − $200,000 = $𝟏𝟎𝟗, 𝟓𝟕𝟒. 𝟒𝟎
(c) the total amount of interest paid.
AFFORDABLE HOME
Alan and Milan have ₹300,000 for a down payment, and their budget can
accommodate a monthly mortgage payment of ₹ 12,000.00. What is the most
expensive home they can buy if they can borrow money for 30 years at 7.8%,
compounded monthly?
AMORTIZATION TABLE
We can construct an amortization schedule that summarizes all the information
regarding the amortization of a loan. For example, a loan of $10,000 with interest
at 10% could be repaid in 5 equal annual payments of size
0.10
𝑅 = $10,000 = $10,000 0.263797 = $2637.97
1−1.1−5

Each time this $2637.97 payment is made, some is used to pay the interest on the
unpaid balance, and some is used to reduce the principal.
For the first payment, the unpaid balance is $10,000, so the interest payment is
10% of $10,000, or $1000. The remaining $1637.97 is applied to the principal.
An Amortization table summarizes the information regarding all payments of a
loan showing the split up of each payment and balance due on the loan.
AMORTIZATION TABLE

Balance
Period Payment Interest Reduction Unpaid balance
0 $ 10,000.00
1 $2,637.97 $ 1,000.00 $1,637.97 $ 8,362.03
2 $2,637.97 $ 836.20 $1,801.77 $ 6,560.25
3 $2,637.97 $ 656.03 $1,981.95 $ 4,578.30
4 $2,637.97 $ 457.83 $2,180.14 $ 2,398.16
5 $2,637.97 $ 239.82 $2,398.16 $ -
UNPAID BALANCE OF A LOAN
The unpaid balance of a loan (also called the payoff amount and the outstanding
principal of the loan) is the present value needed to generate all the remaining
payments
UNPAID BALANCE
In and earlier example we found that the monthly payment for a loan of
$150,000 at 12%, compounded quarterly, for 10 years is $6489.36 (to the nearest
cent). Find the unpaid balance immediately after the 15th payment.
1−1.03− 40−15
𝐴40−15 = $6,489.36 = $6489.36 17.4131477 = $113,000.18
0.03
EFFECT OF PAYING AN EXTRA AMOUNT
Consider the a loan $100,000 borrowed at 6% compounded monthly for 30 years,
with monthly payments of $599.55. The unpaid balance after 24 monthly
payments is $97,468.25. Suppose that from this point the borrower decides to pay
$650 per month.
(a) How many more payments must be made?
(b) How much would this save over the life of the loan?
GEOMETRIC SEQUENCES
If $P is invested at an interest rate of i per period, compounded at the end of each
period, the future value at the end of each succeeding period is
𝑃 1 + 𝑖 , 𝑃 1 + 𝑖 2, 𝑃 1 + 𝑖 3, … . . 𝑃 1 + 𝑖 𝑛 ….

The future values for each of the succeeding periods form a sequence in which
each term (after the first) is found by multiplying the previous term by the same
number. Such a sequence is called a geometric sequence.
A sequence is called a geometric sequence (progression) if there exists a number
𝑟, called the common ratio, such that
𝑎𝑛 = 𝑟𝑎𝑛−1 𝑤ℎ𝑒𝑛 𝑛 > 1
GEOMETRIC SEQUENCES
Because each term after the first in a (b) 4, 2, 1, . . .
geometric sequence is obtained by
multiplying the previous term by 𝑟, the The common ratio is ½ so the next
second term is 𝑎1 𝑟 is the third is three terms are ½, ¼, 1/8
𝑎1 𝑟 2 … . and the 𝑛th term is 𝑎1 𝑟 𝑛−1 (c) 3, -6, 12, . .
Thus we have the following formula.
The common ratio is -2 so the next
Write the next three terms of the three terms are -24, 48, -96
following geometric sequences.
(a) 1, 3, 9, . . .
The common ratio is 3, so the next
three terms are 27, 81, 243.
𝑛TH TERM OF A GEOMETRIC SEQUENCE

Find the seventh term of the geometric sequence with first term 5 and common ratio -2

Ans. 320
SUM OF A GEOMETRIC
SEQUENCE

(a) Find the sum of the first five terms of the geometric progression with first term 4 and
common ratio -3
244
1 1 1
(b) Find the sum of the first six terms of the geometric sequence , , , … .
4 8 16
63
128
EXAMPLE
If changing market conditions cause a company earning $8,000,000 in 2005 to
project a loss of 2% of its profit in each of the next 5 years, what profit does it
project in 2010?
𝑎𝑛 = 𝑎1 × 𝑟 𝑛−1 = $8,000,000 × 0.985 = $7,231,366
RAMESH’S LIFETIME SALARY
Ramesh recently attended a seminar on human capital where the speaker talked
about a person's human capital as the present value of his life time earnings.
Ramesh is curious to find out the present value of his lifetime salary.
For the sake of simplicity assume that his present salary of Rs 400,000 will be paid
exactly one year from now, and his salary will be paid in annual installments.
What is the present value of his life-time salary, if the discount rate is 8 percent?
Remember that Ramesh expects his salary to increase at the rate of 12 percent per
year until his retirement 30 years from now..
VALUATION OF SHARES/STOCK
Revision of concepts
CASH FLOWS FOR STOCKHOLDERS
If you buy a share of stock, you can receive cash in two ways
 The company pays dividends
 You sell your shares, either to another investor in the market or back to the company

As with bonds, the price of the stock is the present value of these expected cash
flows

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ONE-PERIOD EXAMPLE
Suppose you are thinking of purchasing the stock of Moore Oil, Inc. You expect it
to pay a $2 dividend in one year, and you believe that you can sell the stock for
$14 at that time. If you require a return of 20% on investments of this risk, what is
the maximum you would be willing to pay? Compute the PV of the expected cash
flows
14 + 2
 𝑃𝑟𝑖𝑐𝑒 = = $13.33
1.2
 Or 𝐹𝑉 = 16; 𝐼/𝑌 = 20; 𝑁 = 1; 𝐶𝑃𝑇 𝑃𝑉 = −13.33

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TWO-PERIOD EXAMPLE
Now, what if you decide to hold the stock for two years? In addition to the
dividend in one year, you expect a dividend of $2.10 in two years and a stock price
of $14.70 at the end of year 2. Now how much would you be willing to pay?

 PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33

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THREE-PERIOD EXAMPLE
Finally, what if you decide to hold the stock for three years? In addition to the
dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205
at the end of year 3 and the stock price is expected to be $15.435. Now how much
would you be willing to pay?

 PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 = 13.33

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DEVELOPING THE MODEL
You could continue to push back the year in which you will sell the stock
You would find that the price of the stock is really just the present value of all
expected future dividends
So, how can we estimate all future dividend payments?

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ESTIMATING DIVIDENDS:
SPECIAL CASES
Constant dividend
 The firm will pay a constant dividend forever
 This is like preferred stock
 The price is computed using the perpetuity formula

Constant dividend growth


 The firm will increase the dividend by a constant percent every period
 The price is computed using the growing perpetuity model

Supernormal growth
 Dividend growth is not consistent initially, but settles down to constant growth eventually
 The price is computed using a multistage model

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ZERO GROWTH
If dividends are expected at regular intervals forever, then this is a perpetuity and
the present value of expected future dividends can be found using the perpetuity
formula
𝐷
𝑃0 =
𝑅
Suppose stock is expected to pay a $0.50 dividend every quarter and the required
return is 10% with quarterly compounding. What is the price?

.50
𝑃0 = = $20
0.10
4
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DIVIDEND GROWTH MODEL
Dividends are expected to grow at a constant percent per period.
𝐷1 𝐷2 𝐷3
𝑃0 = + 2
+ 3
+ …
1 + 𝑅 (1 + 𝑅) 1+𝑅

𝐷0 1 + 𝑔 𝐷0 1 + 𝑔 2 𝐷0 1 + 𝑔 3
𝑃0 = + + 3
+⋯
1+𝑅 1+𝑅 2 1+𝑅
With a little algebra and some series work, this reduces to:

𝑫𝟎 𝟏 + 𝒈 𝑫𝟏
𝑷𝟎 = =
𝑹−𝒈 𝑹−𝒈
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DGM – EXAMPLE 1
Suppose Big D, Inc., just paid a dividend of $0.50 per share. It is expected to
increase its dividend by 2% per year. If the market requires a return of 15% on
assets of this risk, how much should the stock be selling for?

.50 1 + .02
𝑃0 = = $3.92
.15 − .02

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DGM – EXAMPLE 2
Suppose TB Pirates, Inc., is expected to pay a $2 dividend in one year. If the
dividend is expected to grow at 5% per year and the required return is 20%, what
is the price?
2
𝑃0 = = $13.33
.2 − .05
Why isn’t the $2 in the numerator multiplied by (1.05) in this example?

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STOCK PRICE SENSITIVITY TO DIVIDEND GROWTH, G

250
D1 = $2; R = 20%
200

Stock Price
150

100

50

0
0 0.05 0.1 0.15 0.2
Growth Rate

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STOCK PRICE SENSITIVITY TO REQUIRED RETURN, R

250
D1 = $2; g = 5%
200

Stock Price
150

100

50

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Growth Rate

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EXAMPLE 8.3 GORDON GROWTH
COMPANY - I
Gordon Growth Company is expected to pay a dividend of $4 next period, and
dividends are expected to grow at 6% per year. The required return is 16%.
What is the current price?
4
𝑃0 = = $40
.16 − .06
Remember that we already have the dividend expected next year, so we don’t
multiply the dividend by 1 + 𝑔

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EXAMPLE 8.3 – GORDON GROWTH
COMPANY - II
What is the price expected to be in year 4?

𝐷4 1 + 𝑔 𝐷5 4 1 + .06 4
𝑃4 = = ; 𝑃4 = = 50.50
𝑅– 𝑔 𝑅– 𝑔 .16 − .06
What is the implied return given the change in price during the four year period?

50.50 = 40 1 + 𝑟𝑒𝑡𝑢𝑟𝑛 4 ; 𝑟𝑒𝑡𝑢𝑟𝑛 = 6%

𝑃𝑉 = −40; 𝐹𝑉 = 50.50; 𝑁 = 4; 𝐶𝑃𝑇 𝐼/𝑌 = 6%


The price is assumed to grow at the same rate as the dividends
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NONCONSTANT GROWTH
PROBLEM STATEMENT
Suppose a firm is expected to increase dividends by 20% in one year and by 15% in
two years. After that, dividends will increase at a rate of 5% per year indefinitely.
If the last dividend was $1 and the required return is 20%, what is the price of the
stock?
Remember that we have to find the PV of all expected future dividends.

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NON-CONSTANT GROWTH
EXAMPLE SOLUTION

Compute the dividends until growth Find the present value of the expected
levels off future cash flows
1.20 1.38+9.66
𝐷1 = 1(1.2) = $1.20 𝑃0 = + = 8.67
1.2 1.2 2
𝐷2 = 1.20(1.15) = $1.38
𝐷3 = 1.38(1.05) = $1.449
Find the expected future price
𝐷3 1.449
𝑃2 = = = 9.66
𝑅–𝑔 .2 − .05

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QUICK QUIZ – PART I
What is the value of a stock that is expected to pay a constant dividend of $2 per
year if the required return is 15%?
What if the company starts increasing dividends by 3% per year, beginning with
the next dividend? The required return stays at 15%.

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USING THE DGM TO FIND R
Start with the DGM:

𝑫𝟎 𝟏 + 𝒈 𝑫𝟏
𝑷𝟎 = =
𝑹−𝒈 𝑹−𝒈

𝐃𝟎 𝟏 + 𝐠 𝐃𝟏
𝐑= +𝐠= +𝒈
𝐏𝟎 𝑷𝟎

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FINDING THE REQUIRED RETURN - EXAMPLE
Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend, and dividends
are expected to grow at 5% per year. What is the required return?

1 1.05
𝑅 = + .05 = 15%
10.50
What is the dividend yield?
1 1.05
= 10%
10.50
What is the capital gains yield?
𝑔 = 5%

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TABLE 8.1
- STOCK VALUATION SUMMARY
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FEATURES OF COMMON STOCK
Voting Rights
Proxy voting
Classes of stock
Other Rights
 Share proportionally in declared dividends
 Share proportionally in remaining assets during liquidation
 Preemptive right – first shot at new stock issue to maintain proportional ownership if desired

8-85
DIVIDEND CHARACTERISTICS
Dividends are not a liability of the firm until a dividend has been declared by the
Board
Consequently, a firm cannot go bankrupt for not declaring dividends
Dividends and Taxes
 Dividend payments are not considered a business expense; therefore, they are not tax deductible
 The taxation of dividends received by individuals depends on the holding period
 Dividends received by corporations have a minimum 70% exclusion from taxable income

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FEATURES OF PREFERRED STOCK
Dividends
 Stated dividend that must be paid before dividends can be paid to common stockholders
 Dividends are not a liability of the firm, and preferred dividends can be deferred indefinitely
 Most preferred dividends are cumulative – any missed preferred dividends have to be paid before
common dividends can be paid

Preferred stock generally does not carry voting rights

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STOCK MARKET
Dealers vs. Brokers
New York Stock Exchange (NYSE)
 Largest stock market in the world
 License holders (1,366)
 Commission brokers
 Specialists
 Floor brokers
 Floor traders
 Operations
 Floor activity

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NASDAQ
Not a physical exchange – computer-based quotation system
Multiple market makers
Electronic Communications Networks
Three levels of information
 Level 1 – median quotes, registered representatives
 Level 2 – view quotes, brokers & dealers
 Level 3 – view and update quotes, dealers only

Large portion of technology stocks

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READING STOCK QUOTES
Sample Quote

What information is provided in the stock quote?


Click on the web surfer to go to Bloomberg for current stock quotes.
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QUICK QUIZ – PART II
You observe a stock price of $18.75. You expect a dividend growth rate of 5%, and
the most recent dividend was $1.50. What is the required return?
What are some of the major characteristics of common stock?
What are some of the major characteristics of preferred stock?

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ETHICS ISSUES
The status of pension funding (i.e., over- vs. under-funded) depends heavily on the
choice of a discount rate. When actuaries are choosing the appropriate rate,
should they give greater priority to future pension recipients, management, or
shareholders?
How has the increasing availability and use of the internet impacted the ability of
stock traders to act unethically?

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COMPREHENSIVE PROBLEM
XYZ stock currently sells for $50 per share. The next expected annual dividend is
$2, and the growth rate is 6%. What is the expected rate of return on this stock?
If the required rate of return on this stock were 12%, what would the stock price
be, and what would the dividend yield be?

8-93
References
Mathematical Applications for the Management, Life, and Social Sciences 9E; Ronald J. Harshbarger, Beaufort James J. Reynolds
Fundamentals Of Corporate Finance 10E; Ross Westerfield Jordan

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