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NCBA&E
Learning Objectives
What is FV & Compounding? Simple Interest Compound Interest What is PV & Discounting? How to find the Return on Investment?
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?
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
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
FV = PV ( 1 + r.n)
Simple Interest FV Deposit today (t=0) Interest Rate per Period Number of Time Periods
FV: PV: r: n:
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
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
1.
$100 (1 + .10) $110 (1 + .10) = $100 1.10 1.10 = = $100 $121 (1 + .10) = $100 1.10 1.10 ________
COMPOUNDING:
Notice that
1.
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
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
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?
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
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
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
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?
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?
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)
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
Compound Interest:
REVERSE
COMPOUNDING:
PV = FVn / (1 + r)n
The expression
1/(1 + r)n
is the Discount Factor (DF) or PVF
r = 0%
.60
.50 .40 .30
r = 5%
r = 10%
r = 15%
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:
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?
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
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?
FV = 68500 R= 9% N=2
Step 2 Use formula
PV = FV/ ( 1+ i)^n
PV BASIC PROBLEM # 4 You need $1000 in three yrs. You can earn 15%. Calculate discount factor to solve.
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.
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.
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.
a) R?#6 Step 1
FV = 1350 PV= 1250 N = 1 (i=?)
FV/PV = ( 1+ i)^n
= 1350/1250 -1 = 1.08 - 1 = 8%
a) R?#7 Step 1
FV = 200 PV= 100 N = 8 (i=?)
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%
R = 72/n = 72/10 = 7.2% NOTE: check with calculator & other formula method
CALCULATING R METHODS
a) Will you have enough for college? b) At what rate will you just make it?
FV=PV* ( 1+ i)^n
= 35000*(1.20)^8 = 150493.59 YES
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.
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
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.
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?
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?
Step 1
Step 1
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%.
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?
PV BASIC PROBLEM # 9 You need $60,000 in eight yrs. If you can earn .75% per month,
PV BASIC PROBLEM # 9 You need $60,000 in eight yrs. If you can earn .75% per month,
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
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
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
What is DCF?
2 ways of calculating FVs
Compound accumulated balance 1 yr at a time OR
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
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?
What is DCF?
PV of Annuity
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
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.
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 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 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%.
= 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.
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
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:
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
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
What is DCF?
Perpetuities?
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
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.
PV = C / r
100 = C / .025
40 = 1 / r
r = 1/40 = .025
What is DCF?
Different Types of Rates
Stated Interest 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
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
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
What is DCF?
Different Types of Rates Example
Bank A: 15%, compounded daily
Bank B:
Bank C:
What is DCF?
Different Types of Rates Example
Bank A: 15%, compounded daily EAR = 16.18% n=365
Bank B:
Bank C:
What is DCF?
Calculating EAR
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
What is DCF?
Calculating EAR Example
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%
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
LOANS
Types of Loans
3 Basic Types
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
LOANS
Types of Loans
Amortized Loans Calculate the following
Beg 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
1st year 5000 2nd year 4000 3rd year 3000 4th year 2000 5th year 1000
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:
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
Complete amortization
Loan Amt
Interest Rate Loan Term Loan Payment
5,000
9% 5
$1,285.46
Year
Begin Balance
Total Payment
Interest Paid
1 2 3 4 5
$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
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