Discounted Cash Flow Valuation Chapter 5 Mc Graw-Hill Irwin

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Chapter Outline 1. 2. 3. 4. Future and Present Values of Multiple Cash Flows Valuing Level Cash Flows: Annuities and Perpetuities APR and EAR Different Types of Loans 1 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Steps in Time Value of Money Calculation 1. 2. 3. 4. 5. Draw the time line; Identify the problem: is it a single cash flow, annuity, or perpetuity problem? Clarify the question: is it asking for PV, FV, periodic payment, etc? Find out the right formula or the right keys on the calculator; Double check how frequently the interest is earned, and make sure the number of period matches with the period rate. 2 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Time Value of Money Calculation Three groups of formulas n Single cash flow: FV = PV(1 + r)t n Annuity: n Perpetuity: n PV = C / r Constant growth perpetuity: PV=C 1/(r-g) 3 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Time Value of Money Calculation Three sets of calculator keys n Single cash flow: N, I/Y, PV, FV n Annuity: N, I/Y, PV(or FV), PMT n Combination of single cash flow and annuity for bond evaluation: N, I/Y, PV, PMT, FV 4 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

1. Multiple Cash Flows – Future Value Example 1 n You think you will be able to deposit $4, 000 at the end of each of the next three years in a bank account paying 8 percent interest. You currently have $7, 000 in the account. How much will you have in three years? In four years? 7000 4000 0 1 2 3 4 5 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Multiple Cash Flows – FV Example 1 n Find the value at year 3 of each cash flow and add them together. Today (year 0): FV = 7000(1. 08)3 = 8, 817. 98 n Year 1: FV = 4, 000(1. 08)2 = 4, 665. 60 n Year 2: FV = 4, 000(1. 08) = 4, 320 n Year 3: value = 4, 000 n Total value in 3 years = 8817. 98 + 4665. 60 + 4320 + 4000 = 21, 803. 58 n n Value at year 4 = 21, 803. 58(1. 08) = 23, 547. 87 8 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Multiple Cash Flows – FV Example 2 n Suppose you plan to deposit $100 into an account in one year and $300 into the account in three years. How much will be in the account in five years if the interest rate is 8%? 9 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Example Timeline 0 1 2 100 3 4 5 300 349. 92 136. 05 100(1. 08)4 300(1. 08)2 FV = + = 136. 05 + 349. 92 = 485. 97 11 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Multiple Cash Flows – Present Value Example n You are offered an investment that will pay you $200 in one year, $400 the next year, $600 the next year and $800 at the end of the next year. You can earn 12 percent on very similar investments. What is the most you should pay for this one? 12 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Multiple Cash Flows – PV Example n Find the PV of each cash flow and add them Year 1 CF: 200 / (1. 12)1 = 178. 57 n Year 2 CF: 400 / (1. 12)2 = 318. 88 n Year 3 CF: 600 / (1. 12)3 = 427. 07 n Year 4 CF: 800 / (1. 12)4 = 508. 41 n Total PV = 178. 57 + 318. 88 + 427. 07 + 508. 41 = 1432. 93 n 14 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. Annuities and Perpetuities Defined n Annuity – finite series of equal payments that occur at regular intervals If the first payment occurs at the end of the period, it is called an ordinary annuity n If the first payment occurs at the beginning of the period, it is called an annuity due n n Perpetuity – infinite series of equal payments 15 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuities and Perpetuities Annuity 4000 PV 4000 FV Annuity Due 4000 PV-due Perpetuity 0 PV Mc. Graw-Hill/Irwin Mc. Graw-Hill FV-due 4000 . . . 1 2 3 4 . . . 16 © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. 1 Ordinary Annuity: Present Value C 1 C C 2 3 4 5 . . . C . . . t PV= C/(1+r) + C/(1+r)2 + C/(1+r)3 + …+ C/(1+r)t PV= C[1/(1+r) + 1/(1+r)2 + 1/(1+r)3 + …+ 1/(1+r)t] 18 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Ordinary Annuity: Future Value C 0 1 C C 2 3 4 5 . . . C . . . t FV= C(1+r)t-1+ C(1+r)t-2 + C(1+r)t-3 + …+ C FV= C[(1+r)t-1+ (1+r)t-2 + (1+r)t-3 + …+ 1] 19 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuities and the Calculator n You can use the PMT key on the calculator for the equal payment n The sign convention still holds 20 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuity PV – Example (5. 5) n After carefully going over your budget, you have determined you can afford to pay $632 per month towards a new sports car. You call up your local bank and find out that the going rate is 1 percent per month for 48 months. How much can you borrow? 21 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuity PV– Example (5. 5) n You borrow money TODAY so you need to compute the present value. n 48 N; 1 I/Y; -632 PMT; CPT PV = 23, 999. 54 ($24, 000) n Formula: 22 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuity – Finding the Payment n Suppose you want to borrow $20, 000 for a new car. You can borrow at 8% per year, compounded monthly (8/12 =. 66667% per month). If you take a 4 year loan, what is your monthly payment? n n n 20, 000 = C[1 – 1 / 1. 006666748] /. 0066667 C = 488. 26 Calculator: 4(12) = 48 N; 20, 000 PV; . 66667 I/Y; CPT PMT = 488. 26 23 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuity –Number of Payments (5. 6) n You ran a little short on your spring break vacation, so you put $1000 on your credit card. You can only afford to make the minimum payment of $20 per month. The interest rate on the credit card is 1. 5 percent per month. How long will you need to pay off the $1, 000. 24 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuity –Number of Payments (5. 6) n Calculator: 1. 5 I/Y; 1000 PV; -20 PMT CPT N = 93. 111 MONTHS = 7. 75 years n And this is only if you don’t charge anything more on the card! 25 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuity – Finding the Rate n Suppose you borrow $10, 000 from your parents to buy a car. You agree to pay $207. 58 per month for 60 months. What is the monthly interest rate? Sign convention matters!!! n 60 N n 10, 000 PV n -207. 58 PMT n CPT I/Y =. 75% n 26 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuity – Finding the Rate Without a Financial Calculator n Trial and Error Process Choose an interest rate and compute the PV of the payments based on this rate n Compare the computed PV with the actual loan amount n If the computed PV > loan amount, then the interest rate is too low n If the computed PV < loan amount, then the interest rate is too high n Adjust the rate and repeat the process until the computed PV and the loan amount are equal n 27 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Future Values for Annuities n Suppose you begin saving for your retirement by depositing $2000 per year. If the interest rate is 7. 5%, how much will you have in 40 years? n FV = 2000(1. 07540 – 1)/. 075 = 454, 513. 04 n Calculator: (Remember the sign convention!!!) 40 N; 7. 5 I/Y; -2000 PMT CPT FV = 454, 513. 04 28 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. 2 Annuity vs. Annuity Due Annuity 4000 0 4000 1 2 3 4 PV FV Annuity Due 4000 0 1 2 3 PV-due 4 FV-due 29 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Annuity Due n You are saving for a new house and you put $10, 000 per year in an account paying 8%. The first payment is made today. How much will you have at the end of 3 years? If in END mode, 2 nd BGN, 2 nd Set N=3, PMT=-10, 000, I/Y=8, CPT FV=35, 061. 12 CPT FV=32, 464 2 nd BGN 2 nd Set (Be sure to change it back to an ordinary annuity) 30 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. 3 Perpetuity n Perpetuity 1 2 formula: PV = C / r 3 4 5 . . . PV= C/(1+r) + C/(1+r)2 + C/(1+r)3 + … PV= C/r 31 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Illustration on Perpetuity Formula C 1 C C 2 3 4 5 . . . PV= C/(1+r) + C/(1+r)2 + C/(1+r)3 + … PV= C/r 2004 2005 2006 2007 $5000. . . Amount of Cash $5000 Value of Cash (Interest Rate = 3%) $166, 666. 67 32 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Perpetuity – Example n The preferred stock of Placer Corp. currently sells for $44. 44 per share. The annual dividend of $4 is fixed. Assuming a constant dividend forever, what is the rate of return on this stock? n $44. 44 = $4 / r r = 9. 0% 33 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

3. Annual Percentage Rate (APR) n This is the annual rate that is quoted by law n By definition APR = period rate times the number of periods per year n Example: if quarterly rate=3%, what is APR? n Consequently, to get the period rate we rearrange the APR equation: n Period rate = APR / number of periods per year 35 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Effective Annual Rate (EAR) This is the actual rate paid (or received) after accounting for compounding that occurs during the year n If you want to compare two alternative investments with different compounding periods you need to compute the EAR and use that for comparison. n Example: if quarterly rate=3%, what is EAR? n You should NEVER divide the effective rate by the number of periods per year – it will NOT give you the period rate n 36 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Calculate EAR n You are looking at two savings accounts. One pays 5. 25%, with daily compounding. The other pays 5. 3% with semiannual compounding. Which account should you use? n First account: n n EAR = (1 +. 0525/365)365 – 1 = 5. 39% Second account: n EAR = (1 +. 053/2)2 – 1 = 5. 37% n Which account should you choose and why? 37 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Calculate EAR n Let’s verify the choice. Suppose you invest $100 in each account. How much will you have in each account in one year? n First Account: n n n Daily rate =. 0525 / 365 =. 00014383562 FV = 100(1. 00014383562)365 = 105. 39 Second Account: n n n You Semiannual rate =. 053/ 2 =. 0265 FV = 100(1. 0265)2 = 105. 37 have more money in the first account. 38 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Pure Discount Loans – Example 5. 11 n Treasury bills are excellent examples of pure discount loans. The principal amount is repaid at some future date, without any periodic interest payments. n If a T-bill promises to repay $10, 000 in 12 months and the market interest rate is 7 percent, how much will the bill sell for in the market? n PV = 10, 000 / 1. 07 = 9345. 79 41 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Interest Only Loan - Example n Consider a 5 -year, interest only loan with a 7% interest rate. The principal amount is $10, 000. Interest is paid annually. n What would the stream of cash flows be? n n Years 1 – 4: Interest payments of. 07(10, 000) = 700 Year 5: Interest + principal = 10, 700 n This cash flow stream is similar to the cash flows on corporate bonds and we will talk about them in greater detail later. 42 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Amortized Loan with Fixed Payment - Example Each payment covers the interest expense plus reduces principal, such as mortgage payment n Consider a 4 year loan with annual payments. The interest rate is 8% and the principal amount is $5000. n What is the annual payment? n 5000 = C[1 – 1 / 1. 084] /. 08; C = 1509. 60 n Calculator 4 N; 8 I/Y; 5000 PV CPT PMT = -1509. 60 43 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Review Questions 1. Know how to calculate PV and FV of multiple cash flows. 2. Know how to calculate PV, FV, and PMT of annuities; Know how to calculate PV and r of perpetuity cash flows. What is ordinary annuity and what is annuity due? Can you calculate the FV of perpetuity cash flows? 44 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Review Questions (cont. . ) 3. What is the definition of APR, and EAR? What are the differences between APR and EAR? Know how to compute EAR using APR information. Which rate should you use to compare alternative investments? 4. What is a pure discount loan? What is a good example of a pure discount loan? What is an interest only loan? What is a good example of an interest only loan? What is an amortized loan? What is a good example of an amortized loan? 45 Mc. Graw-Hill/Irwin Mc. Graw-Hill © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved