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Financial Management-2

Spring Semester 2012

NCBA&E

Instructor - Jamal Nasir Khan

Learning Objectives
What is FV & Compounding? Simple Interest Compound Interest What is PV & Discounting? How to find the Return on Investment?

What is FV & Compounding?


Which would you choose?
If Govt guarantees the following

Real Estate land which triples in 10 years? Real Estate land which pays a compounded rate of 15% pa at end of 10 years?

What is FV?
Financial Managers must be able to answer How to determine the value today of cash flows expected in the future?

What is FV?
Time Value of Money Basic Concept Dollar Today is worth more than a Dollar in future Why?

What is FV?
Time Value of Money Basic Concept Dollar Today is worth more than a Dollar in future Why?

Time & Interest Rate


Time = opportunity Interest Rate = opportunity cost

Time?
TIME allows you the opportunity to:
a) Postpone Consumption b)

Earn INTEREST.

Interest?
What is Interest?:

Interest?
Interest is:
PRICE OF MONEY OTHERS ARE WILLING TO PAY

2 Types of Interest

Simple Interest

Compound Interest

2 Types of Interest
Simple Interest Interest paid on only the original amount, OR principal amount

Compound Interest Interest paid on principal AS WELL AS any earned interest.

What is FV?
What is Future Value?

What is FV?
What is Future Value?

Cash Value of an investment at some point in the future. The amount an investment is worth after 1 or more periods. The amount of money an investment will grow to over some period of time at some interest rate.

What is FV?
Example of FV? Timeline

T=o

(100) PV

20 FV

20 FV

20
FV

20 FV

120

What is FV? What is Simple Interest?


Interest Earned only on the original principal amount invested.

Simple Interest: Future Value of $100 at 10 Percent


Year Beginning Amount Interest Earned 1 $100.00 $10.00 End Amount(FV) $110.00

2 100.00 3 100.00 4 100.00 5 100.00 Total interest

10.00 10.00 10.00 10.00 50.00

120.00 130.00 140.00 150.00

Simple Interest Formula


Formula

FV = PV ( 1 + r.n)
Simple Interest FV Deposit today (t=0) Interest Rate per Period Number of Time Periods

FV: PV: r: n:

Assuming same interest rate over all periods

What is FV?
What is Compound Interest?

What is FV?
What is Compound Interest?

Process of accumulating INTEREST in an investment over time to earn more interest. Also Interest on Interest: Interest earned on the reinvestment of previous interest payments.

Compound Interest:
Percent Compounded

Future Value of $100 at 10


End Amount (FV)

Year Beginning Amount Interest Earned

1
2 3 4 5

$100.00
110.00 121.00 133.10 146.41

$10.00
11.00 12.10 13.31 14.64 $61.05

$110.00
121.00 133.10 146.41 161.05

Total interest

Deriving the formula:


Notice that

Compounding: Future Value for a Lump Sum

1.

$110 = 2. $121 = $100 1.102 3. $133.10 1.10 =

$100 (1 + .10) $110 (1 + .10) = $100 1.10 1.10 = = $100 $121 (1 + .10) = $100 1.10 1.10 ________

DERIVING THE FORMULA FOR COMPOUNDING

COMPOUNDING:
Notice that

Future Value for a Lump Sum

1.

$110 = 2. $121 = $100 1.102 3. $133.10 1.10 =


n periods is

$100 (1 + .10) $110 (1 + .10) = $100 1.10 1.10 =


= $100 $121 (1 + .10) = $100 1.10 1.10 (1.10)3

In general, the future value, FVn, of PV invested today at r% for

FVn = PV x (1 + r)n
The expression (1 + r)n is the future value interest factor.

What is FV?
The equation of FV Compounded at r

FVn = PV. (1 + r)n

What is FV?
Applying to a problem set:
Simple Interest Practice

SIMPLE INTEREST BASIC PROBLEM Assume you are offered a return of 13% Simple Interest on a deposit, but you must keep the money in the investment for a period of 3 years. What is the future value after 3 yrs if you invest Rs. 42,000?

SIMPLE INTEREST BASIC PROBLEM Assume you are offered a return of 13% Simple Interest on a deposit, but you must keep the money in the investment for a period of 3 years. What is the future value after 3 yrs if you invest Rs. 42,000? Step 1: Setting up the problem: PV= 42,000 N=3 R = 13% Step 2: Using formula: FV = PV ( 1+ r.n) = 42,000 (1+ .13*3) = 42,000 ( 1.39) = 58,380

COMPOUND INTEREST BASIC PROBLEM # 1

Suppose you locate a two year investment paying 14% per year. If you invest $325,

a) how much will you have at the end of the 2 yrs? b) How much is compound interest?

Compound INTEREST BASIC PROBLEM


a) b) Suppose you locate a two year investment paying 14% per year. If you invest $325, how much will you have at the end of the 2 yrs? How much is compound interest?

Step 1 PV = 325 R= 14% N = 2 yrs Step 2

Use formula

Break down:

FV = PV(1+i)^n = 325 (1+.14)^2 =325 (1.14)^2 = 325 (1.29) =422.37 1st year interest is 325*(1.14)=370.5 2nd year interest is 370.5*(1.14)=422.37

COMPOUND INTEREST BASIC PROBLEM # 2


Youve located an investment which pays 12%. The rate sounds good to you, so you invest $400. a) How much will you have in three years? b) How much in seven years? c) At the end of seven years, how much interest have you earned?

a) How much will you have in three years? Step 1 PV = 400 R= 12% N = 3 yrs Step 2 Use formula FV = PV(1+i)^n = 400 (1+.12)^3 = 400 (1.12)^3 = 400 (1.404) = 561.97

b) How much in seven years?


Step 1
PV = 400 R= 12% N = 7 yrs

Step 2 Use formula

FV = PV(1+i)^n = 400 (1+.12)^7 = 400 (1.12)^7 = 400 (2.21) = 884.27

c) At the end of seven years, how much interest have you earned? We are getting compound interest total of 884.27 400 = 484.27

COMPOUND INTEREST BASIC PROBLEM # 3


You have two options to choose from: You must invest Rs. 130,000 minimum.

a) Govt. guarantees you triple your money in 10 years. b)Govt. guarantees you 15% compounded at end of 10 years.
Which do you choose, now that you know FV?

a) FV = 130,000 * 3 = 390,000 in 10 years.

b) FV = 130,000 (1.15)^10 = 130000 (4.04) = 525,922.50

Obviously you should choose option B, since 525,922 > 390,000

Time Value of Money


Learning Objectives
What is FV & Compounding? Simple Interest Compound Interest

What is PV & Discounting?


Valuing Cash Flows

How to find the return on investment?

What is PV?
Financial Managers must be able to answer

How to determine the value today (PV) of cash flows expected in the future? Involves bringing FV C/Fs back to Present

What is PV?
Present Value

PRESENT VALUE? The current value of cash flows discounted at the appropriate discount rate

What is PV?
Present Value vs FV

Basic Difference? FV: Adds value for Time & Interest Rate opportunities PV: Subtracts value for Time & Interest Rate PV is reverse of FV

What is PV?
Present Value
Properties?

PV: C/Fs are discounted at DISCOUNT FACTOR (i)


FV: C/Fs are compounded at INTEREST FACTOR (i) C/Fs cannot be added together PV allows you to understand & compare C/Fs at To Relevant C/F for analysis is PV C/F PV: inversely proportional to interest i FV: directly proportional to i

What is PV?
Adding C/Fs together?

T=o

(100)

20

20

20

20

120

PV

FV

FV

FV

FV

What is PV?
Adding C/Fs together?

T=o

(100)

20 35 FV

20

20 15
FV

20

120

PV

FV

FV

What is PV?
Present Value

Names?
Discount Rate

Discount Factor
PV Factor DCF (Discount Cash Flow)

PVIF (r,t) Present Value Interest Factor @ r & t

What is PV?
Example
What is $10,000 received in 10 yrs worth today? i=6.5% Just discount the FV at the i

What is PV?
Example

What is $10,000 received in 10 yrs worth today? i=6.5% 5,327.26

Compound Interest:

Future Value of $100 at 10 Percent Compounded

Year Beginning Amount Interest Earned


1 $100.00 PV 11.00 12.10 13.31 14.64 $61.05 2 110.00 3 121.00 4 133.10 5 146.41 Total interest

End Amount (FV)


121.00 133.10 146.41 FV 161.05 FV

REVERSE

COMPOUNDING:

Future Value for a Lump Sum

In general, the present value, PV, of FVn discounted at r% for n periods is

PV = FVn / (1 + r)n
The expression

1/(1 + r)n
is the Discount Factor (DF) or PVF

Present Value of $1 for Different Periods and Rates DISCOUNT FACTORS


1.00
Present value of $1 ($)

r = 0%

.90 .80 .70

.60
.50 .40 .30

r = 5%

r = 10%
r = 15%

.20 r = 20% .10 1 2 3 4 5 6 7 8 9 10 Time (years)

What is PV?
The equation of PV Disounted at r or i then is:

PV = FVn / (1 + r)n

What is FV?
Applying to problem sets:

PV SINGLE PERIOD BASIC PROBLEM #1

Suppose you need $400 to buy textbooks next year. U can earn 7% on your money. How much do you have to put up today?

BASIC PROBLEM #1 Step 1: Setting up the problem:

FV= $400 N=1 R = 7%


Step 2: Using formula: PV = FV/ ( 1+ i)^n = 400/ (1+ .07)^1 = 400 /( 1.07) = 373.83

PV BASIC PROBLEM # 2

Suppose you need to have $1000 in 2 yrs. If you can earn 7%, how much do you have to invest to make sure you get your $1000.

PV Multiple Periods #2
Step 1 FV = 1000 R= 7% N = 2 yrs Step 2

Use formula

PV = FV/ ( 1+ i)^n

= 1000/ (1+.07)^2 =1000/ (1.1449) =873.44

PV BASIC PROBLEM # 3
You would like to buy a new automobile. You have $50,000, but the car costs $68,500. If you can earn 9%.

a) How much should you invest today to buy the car in two yrs? b) Do you have enough? Assume price stays the same?

a) How much to invest? #3 Step 1

FV = 68500 R= 9% N=2
Step 2 Use formula

PV = FV/ ( 1+ i)^n

= 68500/ (1+.09)^2 = 400 (1.1881) = 57,655.08 b) Do u have enough? NO 50000-57655.08 = (7655)

PV BASIC PROBLEM # 4 You need $1000 in three yrs. You can earn 15%. Calculate discount factor to solve.

a) How much do u have to invest today? b) What's the discount factor?

a) How much to invest?#4 Step 1

FV = 1000 R= 15% N=3 Step 2 Use formula


PV = FV/ ( 1+ i)^n
= 1000/ (1+.15)^3 = 1000/ (1.5209) = 1/1.5209 = .6575 * 1000 = 657.50

PV BASIC PROBLEM # 5
Your company proposes to buy an asset for $335. This investment is very safe. You will sell off the asset in three yrs for $400. U know you can invest the $335 elsewhere at 10 percent with little risk.

a) Which do u think is a better choice?

a) Option 1 & 2 (comparing FVs for valuation) #5 Step 1


FV = 400 PV= 335 N = 3 (i=10% elsewhere)

Step 2 Use formula

Fv = PV* ( 1+ i)^n

= 335* (1+.1)^3 = 335* (1.331) = 445.89 Since the 1st option gives FV = 400 after 3 yrs & 2nd option gives FV= 445.89 > 400, then elsewhere 10% is better.

a) Another way (looking at PV of 400 at 10%) #5 Step 1


FV = 400 PV= 335 N = 3 (i=10% elsewhere)

Step 2 Use formula

PV = FV/ ( 1+ i)^n

= 400/ (1+.1)^3 = 400/ (1.331) = 300.53 Since the 1st option gives PV = 300.53 after 3 yrs & 2nd option gives PV= 335 > 300.53, then elsewhere 10% is better.

PV BASIC PROBLEM # 6 FINDING i


You are considering a one year investment. If you put up $1250, you will get back $1350.

a) What rate is this investment paying?

a) R?#6 Step 1
FV = 1350 PV= 1250 N = 1 (i=?)

Step 2 Use formula

FV/PV = ( 1+ i)^n
= 1350/1250 -1 = 1.08 - 1 = 8%

PV BASIC PROBLEM # 7 FINDING i


An investment offers to double our money in eight yrs. Cost is $100.

a) What rate is this investment paying?

a) R?#7 Step 1
FV = 200 PV= 100 N = 8 (i=?)

Step 2 Use formula

FV/PV = ( 1+ i)^n
(1+i)^8 = 200/100 (1+i)^8 = 2 (1+i)^8.(1/8) = 2^(1/8) 1+i = 2^0.125 i = 1.09 1 = .09

9%

Rule of 72 for doubling your money returns


The time it takes to double your money (n) is given by 72/r% 72/r = n or r = 72/n In this case 72/r% = 8, R% = 72/8 = 9% For discount rates b/w 5 & 20%, r can be approximated for doubling.

PV BASIC PROBLEM # 8 FINDING i


An investment promises to double your money every 10 yrs.

a) What rate is this investment paying using rule of 72?

PV BASIC PROBLEM # 8 FINDING i


An investment promises to double your money every 10 yrs.

a) What rate is this investment paying using rule of 72?

R = 72/n = 72/10 = 7.2% NOTE: check with calculator & other formula method

CALCULATING R METHODS

There are 3 ways to calculate r.


a) Use Financial Calculator OR Excel b) Solve equation for (1+r) taking roots both sides c) Use FV tables

PV BASIC PROBLEM # 9 FINDING i


You estimate u will need about $80,000 to send your child to college in 8 yrs. You have $35,000 now. If you earn 20%pa

a) Will you have enough for college? b) At what rate will you just make it?

a) Will u make it?#9 Step 1


FV = ? PV= 35000 N = 8 i=20%

Step 2 Use formula

FV=PV* ( 1+ i)^n
= 35000*(1.20)^8 = 150493.59 YES

b) Minimum Rate FV = 35000 * (1+r)^8 R =(80000/35000)^(1/8) = 2.2857^0.125 = 1.1089 1 = 10.89%

PV BASIC PROBLEM # 10 FINDING i You would like to retire in 30 years as a millionaire. If you have $50,000 today to invest.

a) What rate of return do you need to make it?

a) Will u make it?#10 Step 1


FV = 1000000 PV= 50000 N = 30 i=?

Step 2
b) Minimum Rate 1000000 = 50000 * (1+r)^30 (1+r)^30 = 1000000/50000 (1+r) = 20^(1/30) = 20^.0333 r = 1.105 = 0.105 = 10.5% 10.5% = i

Changing the texture of the problem

PV BASICPROBLEM # 11 - VALUATION

Your apartment house has burned down, leaving you with a vacant lot worth $50,000 and a check for $300,000 from the fire insurance company. You consider rebuilding, but your real estate agent suggests putting up an office building instead. The construction cost would be $300,000 & there would be the cost of the land, which otherwise may be sold for $50,000. On the other hand your advisor foresees a shortage of office space and predicts that a year from now the new building would fetch $400,000 if you sold it. Thus you would be investing $350,000 now in the expectation of realizing $400,000 a year hence. You should go ahead if the PV of the expected $400,000 payoff is greater than the investment of $350,000. US Govt securities are paying 7% with one year maturities.

PV BASIC PROBLEM # 11 - VALUATION


Your apartment house has burned down, leaving you with a vacant lot worth $50,000 and a check for $300,000 from the fire insurance company. You consider rebuilding, but your real estate agent suggests putting up an office building instead. The construction cost would be $300,000 & there would be the cost of the land, which otherwise may be sold for $50,000. On the other hand your advisor foresees a shortage of office space and predicts that a year from now the new building would fetch $400,000 if you sold it. Thus you would be investing $350,000 now in the expectation of realizing $400,000 a year hence. You should go ahead if the PV of the expected $400,000 payoff is greater than the investment of $350,000. US Govt securities are paying 7% with one year maturities.

a) b) c) d)

What is the value tdy of $400,000 to be received one year from now based on market returns? Is the PV greater than $350,000? What is the rate of return for the office bldg project? What decision should be made & why?

a) Will u make it?#10 Step 1 PROJECT


FV = 400000 PV= 350000 N = 1 i=? (14.28%)

Govt Security
FV = 400000 PV = ? (373,832) I = 7% n=1 PV = FV/(1+i)^n = 400000/(1.07)^1 = 373,832 PV = 373832 > 350000 373.832 will need to be
invested to reach

Step 2
b) Minimum Rate 400000 = 350000 * (1+r)^1 (1+r)^1 = 400000/350000 (1+r) = 1.1428^1 r = 1.1428-1 = 0.1428 = 14.28%
FV of 400,000. Thus project is better choice

i = 14.28%

I = 7% < 14.28%

Problem Practise
Rarely Prudent, Inc. has an unfunded pension liability of $425 million that must be paid in 23 years. If the relevant discount rate is 7.5 percent, what is the present value of this

liability?

Solution
Rarely Prudent, Inc. has an unfunded pension liability of $425 million that must be paid in 23 years. If the relevant discount rate is 7.5 percent, what is the present value of this

liability?
Future value = FV = $425 million t = 23 r = 7.5 percent Present value = ?

Solution: Set this up as a present value problem. PV = $425 million x PVIF(7.5,23) PV = $80,536,778

PROBLEM #1 Assume you deposit $1000 today in an account which pays 8%. How much will you have in 4 yrs? 14yrs? 50yrs?

PROBLEM #1 Assume you deposit $1000 today in an account which pays 8%. How much will you have in 4 yrs? (1.08^4)*1000 = 1.36*1000 = 1360.48 14yrs? 2.93*1000 = 2937.19 50yrs? 46.90*1000 = 46901.61

PROBLEM # 2

Suppose you just turned 21. A rich uncle had set up a trust fund which would pay you Rs.100,00,000 at age 40. Relevant discount rate is 12%.
a) how much is the fund worth today? b) If the fund was paid to you at age 50, how much would it be worth?

Compound INTEREST BASIC PROBLEM

Step 1

Fv = 100k R= 12% N = 40-21 = 19 yrs


Step 2
Use formula PV = FV/(1+i)^n = 1/8.61 = .1161*100000 =11610.67

Compound INTEREST BASIC PROBLEM


For age 50

Step 1

Fv = 100k R= 12% N = 50-21 = 29 yrs


Step 2
Use formula PV = FV/(1+i)^n = 1/26.74 = .0373*100000 =3738.32

PROBLEM # 3

Youve been offered an investment which will double your money in 12 yrs.

a) What rate of return are u being offered? b) Check using rule of 72? c) If the investment had doubled in half the time, what would the rate be?

PROBLEM # 3
Youve been offered an investment which will double your money in 12 yrs.
a) What rate of return are u being offered?

(1+i)^12=2, 2^1/12, = 1.059-1, = 5.9% b) Check using rule of 72? 72/12 = 6% c) If the investment had doubled in half the time, what would the rate be? n=6, 2^1/6, = 1.1224-1 = 12.24% 72/6 = 12%

PROBLEM # 4
You have three options to choose from: You must invest Rs. 300,000 minimum. Market interest rate is 12%.

a) DSC offers to give you an interest factor of 4.0 over

10 yrs. Whats the rate? b) Govt. savings scheme guarantees you 15.5% compounded over 9 yrs. c) A third option provides 10% first 5 yrs & then 20% next 5 yrs (compounded)
Which do you choose?

PROBLEM # 4
You have three options to choose from: You must invest Rs. 300,000 minimum. Market interest rate is 12% on deposits.

DSC offers to give you an interest factor of 4.0 over 10 yrs. Whats the rate? i=4^(1/10)-1 = 1.1486-1 = .1486 = 14.86% (FV=1,200,000) b) Govt. savings scheme guarantees you 15.5% compounded over 9 yrs. 1.155^9 = 3.6579*300000 = 1097385.23*1.12= (1,229,071.46) c) A third option provides 10% first 5 yrs & then 20% next 5 yrs (compounded) 1.10^5 = 1.6105*300k = 483153 (1.20)^5 = 2.488*483153 = 1,202,239.27
a)
Which do you choose? B

PROBLEM #5
GMAC offered some securities for sale to the public. Under the terms, GMAC promised to pay the owner of one of these securities $10,000 on Dec 1, 2012. Investors paid GMAC $500 for this security on dec 2, 1982.

a) What rate is GMAC paying? b) Suppose on dec 1,2000, this securitys price was $4490.22. If an investor had purchased it for $500 at the offering, what rate does she get? c) If the investor had purchased the security at market on dec 1, 2000, what annual rate of return would she have earned?

PROBLEM #5
GMAC offered some securities for sale to the public. Under the terms, GMAC promised to pay the owner of one of these securities $10,000 on Dec 1, 2012. Investors paid GMAC $500 for this security on dec 2, 1982.
a) What rate is GMAC paying? n=30 1+i^30 = 10k/500 = 20^1/30 = 20^.0333 = 1.1050 1 = 10.5% b) Suppose on dec 1,2000, this securitys price was $4490.22. If an investor had purchased it for $500 at the offering, what rate does she get? n=18 1+i^18 = 4490.22/500 =8.98^1/18 = 8.98^.0555 = 1.1295 1 = 12.95%

c) If the investor had purchased the security at market on dec 1, 2000, what annual rate of return would she have earned? n=12 1+i^12 = 10000/4490.22 =2.227^1/12 = 2.227^.0.0833 = 1.0689 1 = 6.89%

PROBLEM # 6
You are interested in a Ferrari costing $120,000. You have $30,000 tdy. If a mutual fund pays 10.5% & you want to buy the car in 10 yrs on the day you turn 30, a) b) how much must you invest today? Do you have enough?

PROBLEM # 6 You are interested in a Ferrari costing $120,000. You have $30,000 tdy. If a mutual fund pays 10.5% & you want to buy the car in 10 yrs on the day you turn 30, a) how much must you invest today? PV = 120k / (1.105)^10 = 120K. (1/2.714) = 120K. 0.36844 = 44213.86 b) Do you have enough? no

PROBLEM # 7 You are scheduled to receive $24,000 in two yrs. When you receive it, you will invest it for 6 more yrs at 6% per year.
a) How much will you have in eight yrs?

b) What is the worth tdy of this amount if the discount rate is 17%?

PROBLEM # 7 You are scheduled to receive $24,000 in two yrs. When you receive it, you will invest it for 6 more yrs at 6% per year.
a) How much will you have in eight yrs?

24000 (1.06)^6 = 24000. 1.418 = 34044 IN 8 YRS b) What is the worth tdy of this amount if the discount rate is 17%? 34044/ (1.17)^8 = 1/3.51*34044 = .2847*34044 = 9695.13

PROBLEM # 8
You have $10,000 to deposit. Alfalah offers 12% per year compounded monthly (1% per month), while MCB offers 12% but will only compound annually. How much will your investment be worth at each bank.
a) Alfalah?
b) MCB?

PROBLEM # 8
You have $10,000 to deposit. Alfalah offers 12% per year compounded monthly (1% per month), while MCB offers 12% but will only compound annually. How much will your investment be worth at each bank.
a) Alfalah?

=10000* (1.01)^12 = 10k. 1.12682 = 11268.25 a) MCB? = 10000*(1.12)^1 = 11200

PV BASIC PROBLEM # 9 You need $60,000 in eight yrs. If you can earn .75% per month,

a) how much will u have to deposit tdy?

PV BASIC PROBLEM # 9 You need $60,000 in eight yrs. If you can earn .75% per month,

a) how much will u have to deposit tdy?

n=96, PV = 60k / (1.0075)^96, 60k/ 2.0489 = 29283.70

PROBLEM # 10 You are considering a seven year investment. The initial amount is 80 lacs for 1 kanal plot. The plot is likely to sell for 1 crore in 2 yrs, 1.2 crore in 3 yrs, 1.5 crore in 4 yrs and 3 crore in 7 yrs. What re the respective rates of returns? Market interest rate on 7 year DSC is 18%. What would you choose?
a) What rate is this investment paying for respective years?

PROBLEM # 10 You are considering a seven year investment. The initial amount is 80 lacs for 1 kanal plot. The plot is likely to sell for 1 crore in 2 yrs, 1.2 crore in 3 yrs, 1.5 crore in 4 yrs and 3 crore in 7 yrs. What re the respective rates of returns? Market interest rate on 7 year DSC is 21%. What would you choose?
a) Rate for 2yrs?

1+i^2 = 100/80 = 1.25^1/2 = 1.1180-1 = 11.80% b) Rate for 3yrs? 1+i^3 = 120/80 = 1.5^1/3 = 1.1447-1 = 14.47% c) Rate for 4yrs? 1+i^4 = 150/80 = 1.875^1/4 = 1.1701-1 = 17.01% d) Rate for 7yrs? 1+i^7 = 300/80 = 3.75^1/7 = 1.2078-1 = 20.78% DSC

PROBLEM # 11 - VALUATION Your apartment house has burned down, leaving you with a vacant lot worth $50,000 and a check for $300,000 from the fire insurance company. You consider rebuilding, but your real estate agent suggests putting up an office building instead. The construction cost would be $300,000 & there would be the cost of the land, which otherwise may be sold for $50,000. On the other hand your advisor foresees a shortage of office space and predicts that a year from now the new building would fetch $400,000 if you sold it. Thus you would be investing $350,000 now in the expectation of realizing $400,000 a year hence. You should go ahead if the PV of the expected $400,000 payoff is greater than the investment of $350,000. US Govt securities are paying 7% with one year maturities.
a) What is the value tdy of $400,000 to be received one year from now based on market returns? b) Is the PV greater than $350,000? c) What is the rate of return for the office bldg project? d) What decision should be made & why?

PROBLEM # 11 - VALUATION
Your apartment house has burned down, leaving you with a vacant lot worth $50,000 and a check for $300,000 from the fire insurance company. You consider rebuilding, but your real estate agent suggests putting up an office building instead. The construction cost would be $300,000 & there would be the cost of the land, which otherwise may be sold for $50,000. On the other hand your advisor foresees a shortage of office space and predicts that a year from now the new building would fetch $400,000 if you sold it. Thus you would be investing $350,000 now in the expectation of realizing $400,000 a year hence. You should go ahead if the PV of the expected $400,000 payoff is greater than the investment of $350,000. US Govt securities are paying 7% with one year maturities.

a) What is the value tdy of $400,000 to be received one year from now based on market returns? 373,832 b) Is the PV greater than $350,000? yes c) What is the rate of return for the office bldg project? 14.28% d) What decision should be made & why? Project pays higher

a) Will u make it?#11 Step 1 PROJECT


FV = 400000 PV= 350000 N = 1 i=? (14.28%)

Govt Security
FV = 400000 PV = ? (373,832) I = 7% n=1 PV = FV/(1+i)^n = 400000/(1.07)^1 = 373,832 PV = 373832 > 350000 373.832 will need to be
invested to reach

Step 2
b) Minimum Rate 400000 = 350000 * (1+r)^1 (1+r)^1 = 400000/350000 (1+r) = 1.1428^1 r = 1.1428-1 = 0.1428 = 14.28%
FV of 400,000. Thus project is better choice

i = 14.28%

I = 7% < 14.28%

PROBLEM # 12

The office building project will have some changes in the cash flows according to new negotiations with the contractor. 1. $123,000 downpayment now 2. $ 76,000 retainer fee now 3. $133,000 final payment when building is ready for occupancy

a) What are the new cash flows? b) What is the rate on the project now? c) Which option is better now?

PROBLEM # 12
The office building project will have some changes in the cash flows according to the contractor. 1. $123,000 downpayment now 2. $ 76,000 retainer fee now 3. $133,000 payment when building is ready for occupancy

a)

a) a)

What are the new cash flows? 123k+76k = 199k cost (t0) PV, 400k-133k = 267k (t1) FV What is the rate on the project now? 1+i^1 = 267/199 = 1.34-1 = 34% Which option is better now? Project still better

PV & FV for Multiple cash Flows Annuities

Perpetuities
Calculating Loan Payments & interest rate on loans

Amortization

What is DCF?
What could be Multiple Cash Flows?

What is DCF?
Multiple Cash Flows?
Car Payments Home Mortgage Payments Credit Card payments Investments/Projects C/Fs

What is DCF?
FV & Multiple Cash Flows

Suppose u deposit $100 tdy in an account paying 8%? Then you deposit another $100 at t=1. How much will u have in 2 yrs?
Time line structure
Calculating one period at a time by adding at each T Calculating by compounding for n=2 & 1

What is DCF?
Example 1
U can deposit Rs 4000 at end of each year for next three years at an interest of 8%. You already have Rs 7000 in your account. How much will u have in 3 yrs? How much will u have in 4 yrs?

What is DCF?
Example 1
U can deposit Rs 4000 at end of each year for next three years at an interest of 8%. You already have Rs 7000 in your account. How much will u have in 3 yrs?
7000*1.08 + 4000 = 11560 11560*1.08+4000 = 16484.80 16484.8*1.08+4000=21803.58

How much will u have in 4 yrs?


21803.58*1.08=23547.87

What is DCF?
2 ways of calculating FVs
Compound accumulated balance 1 yr at a time OR

Find FV of each cash flow to the end & add up

What is DCF?
Example 2
Lets say you can deposit Rs2000 at end of each year for next five yrs. Rate is 10% & beginning balance is 0. What's the FV?
Calculate using compounding each period + CF (Beg amt+add)

What is DCF?
Example 2
Lets say you can deposit Rs2000 at end of each year for next five yrs. Rate is 10% & beginning balance is 0. Whats the FV?
Calculate using compounding each period + CF (Beg amt+add)
(0*1.1=0)
(0 + 2000)=2000 (2000*1.1)+2000 = 4200 (4200*1.1)+2000 = 6620 (=9282). =12210.20

What is DCF?
Example 2
Lets say you can deposit Rs2000 at end of each year for next five yrs. Rate is 10% & beginning balance is 0. Whats the FV?
Calculate using Fv for each C/F
(2000*1.1)^4 (2000*1.1)^3 (2000*1.1)^2 (2000*1.1)^1

(2000)

add up = 12210.20

What is DCF?
Example 3
Changing C/Fs FV. If u deposit $100 in one year, $200 in 2 yrs, $300 in 3 yrs. Interest rate is 7%. How much will u have in 3 yrs?

What is DCF?
Example 3
Changing C/Fs Fv.

If u deposit $100 in one year, $200 in 2 yrs, $300 in 3 yrs. Interest rate is 7%.
How much will u have in 3 yrs?
100(1.07)^2
200(1.07) 300 FV

= 114.49
= 214.00 = 300 =628.49

What is DCF?
Example
Changing C/Fs Fv.

If u deposit $100 in one year, $200 in 2 yrs, $300 in 3 yrs. Interest rate is 7%. How much will u have in 5 yrs?
628.49(1.07)^2 = 719.56

Try compounding C/F method for 5 yrs

PV & FV for Multiple cash Flows

Annuities Perpetuities
Calculating Loan Payments & interest rate on loans

Amortization

What is DCF?
What is an Annuity?
A level stream of C/Fs for a fixed period of time

What is DCF?
Annuity Examples?
Making equal payments All consumer loans Car Loans Home Mortgage Loans

What is DCF?
PV of Annuity

Suppose an asset promised to pay $500 at end of each of next 3 yrs. If we want to earn 10% on the money, how much should we offer for the annuity?

What is DCF?
PV of Annuity

Suppose an asset promised to pay $500 at end of each of next 3 yrs. If we want to earn 10% on the money, how much should we offer for the annuity?

PV = 500/1.1 + 500/1.1^2+500/1.1^3 = 1243.43

What is DCF?
PV of Annuity

When there are large no. of c/fs, shortcut helps

Annuity PV = C x ( 1-PV factor/ r)

OR
= C x (1-(1/(1+r)^n)/r)

What is DCF?
PV of Annuity Using Formula
Suppose an asset promised to pay $500 at end of each of next 3 yrs. If we want to earn 10% on the money, how much should we offer for the annuity?
PV Factor APV Factor = 1/1.1^3 = 0.75131 = (1-PV factor)/r = (1-0.75131)/0.1 = 2.48685

PV = 500 x 2.48685 = 1243.43

What is DCF?
Example 1
U can afford to pay $632 per month towards a new car. The interest is 1% per month for 48 months. How much can u borrow?

What is DCF?
Example 1
U can afford to pay $632 per month towards a new car. The interest is 1% per month for 48 months.

How much can u borrow?


Annuity PV factor = (1-PV factor)/r = 1 (1/1.01^48) / .01 = (1 0.6203) / .01 = 37.9740 PV = 632 x 37.9740 = $24,000 (is what u can afford to borrow & repay)

What is DCF?
Example 2
U can afford to pay Rs 35,000 per month towards a new home. The interest is 13% per year for 30 years.

What price home can you buy?

What is DCF?
Example 2
U can afford to pay Rs 35,000 per month towards a new home. The interest is 13% per year for 30 years.

What price home can you buy?


N=360 i = 13/12 = 1.083% per month = 1 (1/1.01083^360) / .01083 = (1 .0206954) / .01083 = 0.9793 / .01083 = 90.42 PV = 35000 x 90.42 = Rs 31,64,700 (price of house) Annuity PV factor = (1-PV factor)/r

What is DCF?
Example 3 Annuity

FINDING THE PAYMENT AMOUNT C Use the same formula & find the C, given the PV is already known

PV = C x (1- PVF) / r

What is DCF?
Example 3 Annuity

FINDING THE PAYMENT AMOUNT C You need to borrow $100,000. You can make 5 equal payments annually. Interest rate is 18%.

What will the payments be? PV = C x (1- PVF) / r Find the relevant annuity factor & solve for C

What is DCF?
Example 3 Annuity

You need to borrow $100,000. You can make 5 equal payments annually. Interest rate is 18%.

APV = 100,000 = C x (1- 1/1.18^5) / .18

= C x (1 - .4371)/.18
= C x 3.1272 C = 100,000 / 3.1272 = 31,978

What is DCF?
FV of Annuities
Found the same way as the PV for annuities with the relevant formula.

FV Annuity = C x (FV annuity Factor 1)/r

Or
FV annuity = C x (( 1+r)^n 1))/r

What is DCF?

Example 4 Annuity FVs You plan to contribute $2000 every year for 30 yrs. Account pays 8%. How much will you have?

FV Factor

= FV Factor -1 /r
= (1.08^30 1)/.08

= (10.0627 -1)/ .08


= 113.2832 FV annuity = 2000 x 113.2832 = 226,566.4

What is DCF?
Annuities Due
Annuity Due An annuity for which the C/Fs occur at the beginning of the period.
Example: apartment lease prepay rent Ordinary Annuity An annuity for which the C/Fs occur at the END of the period.

What is DCF?
Annuities Due
Annuity Due Calculation Since the C/Fs are one period earlier, we just adjust by (1+r) multiply by (1+r) the ordinary annuity Steps: 1) Calculate ordinary annuity PV or FV 2) Multiply by (1+r)

What is DCF?
Annuities Due Example
Annuity Due Calculation Since the C/Fs are one period earlier, we just adjust by (1+r) Steps:

1) Calculate ordinary annuity PV or FV 2) Multiply by (1+r)

What is DCF?
Example 4
An annuity has 5 payments of $400 each. Interest is 10%. Payments are beginning of period.
Calculate ordinary annuity for n=4 (time line)

PV factor
PV annuity PV

= (1/(1.1^4))
= .6830 = 1-.6830/ .1

= 0.3169/.1 = 3.169
= 400x3.169 = 1267.94

Add the last 400 to t=0 to PV = 1667.94

What is DCF?
Example 4 shorter way
An annuity has 5 payments of $400 each. Interest is 10%.
Calculate ordinary annuity for n=5 (time line) PV factor PV annuity = (1/(1.1^5)) = .6209 = 1-.6209/ .1 = 0.379/.1 = 3.7907

PV

= 400x3.7907 = 1516.314

Multiply by (1+r) = 1516.314 x 1.1 = 1667.94


NOTE: since we discount by 5 periods (1 too many), we adjust by multiplying by (1+r)

What is DCF?
Perpetuities?

Its a Special Case

What is DCF?
Perpetuities?
Its a Special Case

Perpetuity
An annuity in which the cash flows continue forever.
Other names:
CONSOLS (European & Canadian)

What is DCF?
Perpetuities?
Calculation

Its the easiest case


Perpetuity PV = C / r
Other names:
CONSOLS (European & Canadian)

OR

C x (1/r)

What is DCF?
Perpetuities Example 1
An investment offers a C/F of $500 every year forever. Interest rate is 8%. Whats the value of this investment?

What is DCF?
Perpetuities Example 1
An investment offers a C/F of $500 every year forever. Interest rate is 8%. Whats the value of this investment? Perpetuity PV = C / r = 500/.08 = 6250

What is DCF?
Perpetuities Example 2
Suppose JNJ wants to sell preferred stock at $100 per share. A similar stock OGDC already has a price of $40 per share & offers a dividend of $1 every quarter. What dividend must JNJ offer to give the same return?

What is DCF?
Perpetuities Example 2
Suppose JNJ wants to sell preferred stock at $100 per share. A similar stock OGDC already has a price of $40 per share & offers a dividend of $1 every quarter.

What dividend must JNJ offer to give the same return?


Step 1: Calculate the r for $40 stock

PV = C / r
100 = C / .025

40 = 1 / r

r = 1/40 = .025

Step 2: Find C giving the same r C = 100 * .025 C = $2.5


NOTE: the r is quarterly rate, not yearly so adjust in Qs

What is DCF?
Different Types of Rates
Stated Interest Rate

EAR (Effective Annual Rate)


APR (annual percentage rate)

What is DCF?
Different Types of Rates
Stated Interest Rate
Interest rate expressed in terms of interest payment per period. Also the quoted interest rate

EAR (Effective Annual Rate)


Interest rate based on per year compounding

APR (annual percentage rate) legally allowed!


Interest rate charged per period x no. of periods per year

What is DCF?
Examples
Stated Interest Rate (ONE U NEED TO CONVERT)
10% per year (paid semi-annually 5%)- 10 vs 10.25%
Calculate to see the equivalent rate

EAR (Effective Annual Rate) THE USEFUL ONE


The 10.25% is the actual effective rate
Interest rate based on per year compounding

APR (annual percentage rate) THE TRICKY ONE


Interest rate charged per period x no. of periods per year

What is DCF?
Examples
APR (annual percentage rate)
Interest rate charged per period x no. of periods per year REALITY: ITS JUST A STATED OR QUOTED RATE

NOTE: It is not necessarily the EAR!!

So, if a bank says it charges 12% APR on car loans,


With monthly payments, it actually means.. 1% per month x 12 mths (according to law).

But IN FACT its EAR is 12.6825%!

What is DCF?
Different Types of Rates Example
Bank A: 15%, compounded daily

Bank B:
Bank C:

15.5%, compounded quarterly


16%, compounded annually

Which is best if u want to open a savings account?

What is DCF?
Different Types of Rates Example
Bank A: 15%, compounded daily EAR = 16.18% n=365

Bank B:
Bank C:

15.5%, compounded quarterly


EAR = 16.42% n=4 16%, compounded annually

EAR = 16% n=1


Which is best if u want to open a savings account? Bank B

What is DCF?
Calculating EAR

EAR Formula EAR = (1+ Quoted rate / m )^m -1

where m = no. of times interest is compounded per year

What is DCF?
3 Steps to EAR

Step 1:

Divide the quoted rate in decimal by the # of times it is compounded (m) Add 1 to the result & raise by m Subtract 1 to get the rate

Step 2: Step 3:

What is DCF?
Calculating EAR Example

You are offered 12% compounded monthly. Whats the EAR?

What is DCF?
Calculating EAR Example

You are offered 12% compounded monthly.

Whats the EAR?


M = 12 so EAR = (1+ .12/12 )^12 1 = 12.6825% = 1.01^12 1 = 1.126825 1

What is DCF?
Calculating EAR Example 2

A Bank is offering 12% compounded quarterly. If you put $100 in an account, how much will you have at the end of the year? Whats the EAR?.

What is DCF?
Calculating EAR Example 2
A Bank is offering 12% compounded quarterly. If you put $100 in an account, how much will you have at the end of the year? Whats the EAR?. FV = 100*1.03^4 = 112.55 EAR is (1+ .12/4 )^4 -1 = .1255= 12.55%

Lets solve for 2 yrs .

What is DCF?
Calculating EAR Example 2
A Bank is offering 12% compounded quarterly. If you put $100 in an account, how much will you have at the end of the 2 years? Whats the EAR?. 2 yrs FV = 100*1.03^8 = 126.67 EAR is (1+ .12/4 )^4 -1 = .1255= 12.55% same For 2 yrs it would be 8 quarters.

What is DCF?
Calculating APR

A credit card quotes an interest rate of 18% APR. Monthly payments are required. What is the actual interest rate you pay on this credit card? EAR = (1+ APR / m )^m -1 where m = no. of times interest is compounded per year

What is DCF?
Converting APR
A credit card quotes an interest rate of 18% APR. Monthly payments are required. What is the actual interest rate you pay on this credit card? EAR = (1+ APR / m )^m -1

= (1+ .18/12)^12 1 = 1.015^12 1 = 1.1956 1 = 19.56%


NOW U KNOW HOW THEY CONFUSE CONSUMERS!!

LOANS
Types of Loans
3 Basic Types

Pure Discount Loans Interest Only Loans

Amortized Loans

LOANS
Types of Loans
Pure Discount Loan

Simplest Form
Borrower receives money today & repays a single lump sum

Example:
A one year, 10% discount loan means borrower pays $1.1 dollar for every dollar borrowed NOTE: Simple compounded FV T-bills are PDLs (short term)

LOANS
Types of Loans
Interest Only Loans
Borrower pays interest each period & repays the entire principal at some point in the future.

Example: A 3 year, 10% interest only loan of $1000, means borrower pays $100 for 1st & 2nd year & $1100 the 3rd year. NOTE: Bonds are interest only

LOANS
Types of Loans
Amortized Loans
Borrower pays part of principal & interest in payments over time. Process of paying a loan by making regular principal reductions is called amortizing.

Example:
A $5000, 5 year, 9% loan is taken out. The borrower pays interest each year & reduces the loan by $1000 each year. The loan balance declines by $1000 each year, it is paid up in 5 yrs.

LOANS
Types of Loans
Amortized Loans

The Principal drops every year & therefore,


The interest payments per year also DROP resulting in lower yearly payments.
Example: 1st year interest = 5000*.09 = 450 2nd year interest = 4000*.09 = 360 3rd year interest = 3000*.09 = 270

LOANS
Types of Loans
Amortized Loans Calculate the following

Beg Bal

Total Pymt Interest Paid Principal Paid Ending Bal

1st year 2nd year 3rd year 4th year 5th year

LOANS
Types of Loans
Amortized Loans different pymt amts Calculate the following

Beg Bal

Total Pymt Interest Paid Principal Paid Ending Bal

1st year 5000 2nd year 4000 3rd year 3000 4th year 2000 5th year 1000

1450 1360 1270 1180 1090

450 360 270 180 90

1000 1000 1000 1000 1000

4000 3000 2000 1000 0

LOANS
Types of Loans
Amortized Loans

The Principal drops every year & therefore, The interest payments per year also DROP resulting in lower yearly payments.
Example:

1st year interest = 5000*.09 = 450


2nd year interest = 4000*.09 = 360 3rd year interest = 3000*.09 = 270

LOANS
Amortized Loans CONSTANT PAYMENTS
First determine the CASH Payment on the loan. Step 1: It is an annuity, so use formula to get C

5000 = C x (1-(1/1.09^5)/.09 = C= 1285.46 or use PMT


Step 2: Calculate interest on the balance (e.g 5000*.09=450) based on C Step 3: Find principal amt. based on interest paid (eg 1285.46-450=835.46)

Complete amortization

Loan Amt
Interest Rate Loan Term Loan Payment

5,000
9% 5

$1,285.46

Payment is calculated using PMT fn

Year

Begin Balance

Total Payment

Interest Paid

Principal Paid $835.46 $910.65 $992.61 $1,081.94 $1,179.32

Ending Balance $4,164.54 $3,253.89 $2,261.28 $1,179.33 $0.01

1 2 3 4 5

$5,000.00 $4,164.54 $3,253.89 $2,261.28 $1,179.33

$1,285.46 Minus $450.00 = $1,285.46 $1,285.46 $1,285.46 $1,285.46 $374.81 $292.85 $203.52 $106.14

TOTALS

$6,427.3

$1,427.3

$5,000.0

What are major types of Financial Assets?


Intro
Capital Market Securities

What are major types of Financial Assets?


Intro
Capital Market Securities

Fixed Income (Bonds)


Treasuries Agencies Municipals Corporates

Equities
Preferred Stock Common Stock

What is DCF?
PV & Multiple Cash Flows

Suppose u need $1000 in 1 year & $2000 more in 2 yrs. If you can earn 9%. How much do u need to invest tdy?
Time line structure Discounting one period at a time & adding at each T backwards Calculating by discounting for n=1 & 2

What is DCF?
PV Example 4
How much do u have to put up?
2000/(1.09)^2 = 1683.36 1000/(1.09) PV = 917.43 =2600.79

What is DCF?
Example 5
An investment pays 1000 at end of every year for next five years. Discount rate is 6%. How much needs to be invested today?

What is DCF?
Example 5
An investment pays 1000 at end of every year for next five years. Discount rate is 6%. How much needs to be invested today?
1000/1.06^5 = 747.26

1000/1.06^4 = 792.09
1000/1.06^3 = 839.62 1000/1.06^2 = 890.00

1000/1.06^1 = 943.40
PV = 4212.37

What is DCF?
NOTE ON CASH FLOW TIMINGS
Timing is critically important Assumption is always: C/F occurs at end of period Unless specified otherwise.

What is DCF?
PV Uneven C/Fs Example 6
An investment pays 200 in one year, 400 next year, 600 the next year & 800 the next year. You can earn 12% on very similar investments. What should you pay?

What is DCF?
PV Uneven C/Fs Example 6
An investment pays 200 in one year, 400 next year, 600 the next year & 800 thye next year. You can earn 12% on very similar investments. What should you pay?
800/1.12^4 = 508.41 600/1.12^3 = 427.07 400/1.12^2 = 318.88 200/1.12^1 = 178.57 PV = 1432.93