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BCOR 2200 Chapter 5

BCOR 2200 Chapter 5. Discounted Cash Flow Valuation: Valuing Multiple CFs. Chapter Outline FV and PV of Multiple Cash Flows When the CFs are different When the CFs are all the same Valuing Annuities and Perpetuities Comparing Rates with Different Compounding Periods

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BCOR 2200 Chapter 5

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  1. BCOR 2200Chapter 5 Discounted Cash Flow Valuation: Valuing MultipleCFs

  2. Chapter Outline • FV and PV of Multiple Cash Flows • When the CFs are different • When the CFs are all the same • Valuing Annuities and Perpetuities • Comparing Rates with Different Compounding Periods • Comparing “apples to apples” given the different ways rates are quoted (annual, semi-annual, monthly…) • Loan Types and Loan Amortization • Definitions of different finance contracts

  3. 5.1 Multiple CF’s • To find the FV of multiple CF’s • When the CFs are different • Calculate the FV of each individualCF • Then ADDthe individual CFs FVs together: Example: • Receive $100 at t = 0 and t = 1 • Return is 8% • Calculate the Future Value at t = 2 • The first $100 increases twice. • The second $100 increases once. • $100(1.08)2 + $100(1.08) = $224.64

  4. 5.1 Multiple CF’s Figure 5.1:

  5. Example 5.1 Page 117 • You currently have $7,000 in an account (at t = 0) • You will deposit $4,000 at the end of each of the next 3 years (at t = 1, t = 2 and t = 3) • How much will you have at time 3 at 8%? $7,000 at t = 0 with 3 years of interest  $7,000(1.08)3 = $8,818 $4,000 at t = 1 with 2 years of interest  $4,000(1.08)2 = $4,666 $4,000 at t = 2 with 1 year of interest  $4,000(1.08)1 = $4,320 $4,000 at t = 3  $4,000 = $4,000

  6. Example continued • Same Example, but now… • How much will you have at time 4 at 8%? $7,000 at t = 0 with 4 years of interest  $7,000(1.08)4 = $9,523 $4,000 at t = 1 with 3 years of interest  $4,000(1.08)3 = $5,039 $4,000 at t = 2 with 2 years of interest  $4,000(1.08)2 = $4,666 $4,000 at t = 3 with 1 year of interest  $4,000(1.08)1 = $4,320

  7. FV at t = 3: $7,000(1.08)3 = $8,818 $4,000(1.08)2 = $4,666 $4,000(1.08)1 = $4,320 $4,000(1.08)0 = $4,000 $21,804 FV at t = 4: $7,000(1.08)4 = $9,523 $4,000(1.08)3 = $5,039 $4,000(1.08)2 = $4,666 $4,000(1.08)1 = $4,320 $23,548 Calculations:

  8. Clicker Question: • You currently have $600 in an account • You will deposit $1,000 at time 1and at time 2. • How much will you have at time 2 if your account earns 10%? • $1,600 • $2,600 • $2,826 • $3,600 • $3,826

  9. Clicker Answer: • The $600 in the account at time 0 will earn 10% for 2 years $600(1 + 0.10)2 = $726 • The first $1,000 deposited at time 1 will earn 10% for 1 year $1,000(1 + 0.10) = $1,100 • The second $1,000 deposited at time 2 will earn no interest $1,000 FV = $726 + $1,100 + $1,000 = $2,826 The Answer is C

  10. Another FV Example: $2,000 at the end of each year for 5 years Calculate FV at time 5 at 10%

  11. Now Calculate the PVof Multiple CFs: You need $1,000 at t = 1 and $2,000 at t = 2 How much do you need to invest today if you earn 9%? Or what is the PV of these cash flows at 9%? $1,000/(1.09) + $2,000/(1.09)2= $2,600.79

  12. Think about the PV this way: • Invest $2,601 at 9%. • Show that you can withdraw $1,000 at t = 1and withdraw $2,000 at t = 2: $2,600.79(1.09) = $2,834.86 (at t = 1) $2,834.86 - $1,000 = $1,834.86 (withdraw $1,000 at t = 1) $1,834.86(1.09) = $2,000 (available at t = 2) • So if you invest $2,601 at 9%, you can withdraw $1,000 at time 1 and $2,000 at time 2 • The PV of $1,000 at time 1 and $2,000 at time 2 is $2,601

  13. Clicker Question: • If your investment earns 10%, how much do you need to invest now to be able to withdraw $500 in one year and $800 in two years? • (Hint: Compute the PV of these amounts) • $1,000 • $1,116 • $1,200 • $1,226 • $1,300

  14. Clicker Answer: • In order to withdraw $500 in one year and then $800 in two years, you must invest the sum of the PVs of these withdrawals. PV of $500 in one year = $500/(1.1) = $455 PV of $800 in two years = $800/(1.1)2 = $661 Sum = $455 + $661 = $1,116 The answer is B.

  15. 5.2 Annuities The word Annuity has two definitions Economic Definition: • All CFs are the same • CFs occur at regular intervals (Annually, Semi-annually, Quarterly, Monthly…) • All CFs are discounted at the same rate The Financial Product: • Pay an insurance company or a bank a lump sum today • Receive CFs at regular intervals for a fixed period or until you die • Sometimes you pay now (or make regular payments starting now) and then receive payments when you retire at 65 Same pattern of Cash Flow rules for: • Loans (you pay) • Purchased Annuities (you are paid)

  16. Formula for PV of an Annuity (PVA) PVA = C{[1 - 1/(1 + r)t]/r} (Same thing but typed) Text Book’s Notation: 1/(1 + r)t = Present Value Factor (PVF) PVA = C{[1 - PVF]/r} Other Notation: {[1 - 1/(1 + r)t]/r} = Present Value AnnuityFactor (PVAF) PVA = C{PVAF}

  17. PV of $1,000 per year for 5 years @ 6%: We’ll use your calculator’s TVM function: N = 5 I/YR = 6 PMT = 1000 PV = -4,212 (You don’t have to enter FV since it is zero) The TI: press <CPT> <PV>

  18. Clicker Question: • An investment pays $15,000 at the end of each of the next four years. • Assume a discount rate of 8% • Calculate the present value of the investment. (Or you can say “calculate the PV of this annuity?”) • $15,000 • $20,000 • $29,682 • $49,682 • $60,000

  19. Clicker Answer: • Use the TVM Function to calculate the PV the annual payments of $15k per year for 4 years: N = 4 PMT = 15,000 I/YR = 8 FV = 0 PV = -49,682 The answer is D

  20. Consumer Loans • Consumer loans by custom have monthly payments • Credit card loans • Mortgages • Similar structure to rent payments and traditional worker pay periods

  21. Clicker Question: • What is the monthly payment for a thirty year, 6.00% fixed rate $250,000 mortgage loan? • We have not covered how to calculate this yet, so just give me your best guess. • $299 • $499 • $1,099 • $1,499 • $1,899

  22. Clicker Answer: • What is the monthly payment for a thirty year, 6.00% fixed rate $250,000 mortgage loan? • Use the TVM function on your calculator. (We’ll cover this procedure in more detail later) N = 30 x 12 = 360 I/YR = 6/12 = 0.5 PV = 250,000 PMT = -1,499 So the monthly payment is $1,499.

  23. Consumer Loans • Consumer loans have monthly payments • Mortgages • Credit card loans • Car loans • Rates are quoted at the monthly rate times 12 • Called the Annual Percentage Rate (APR) • Or APR-Monthly • 12% APR-Monthly really means 1% per month • 18% APR-Monthly really means 1.5% per month

  24. Example: The bank quotes a rate of 12% APR on a 5-yearcar loan You can afford to pay $500 per month. How much can you borrow? • t = 5 x 12 = 60 • r = 12%/12 = 1% • C = $500 PVA = C{[1 - 1/(1 + r)t]/r} = $500{[1 - 1/(1 + 0.01)60]/0.01} = $500{[1 - 1/(1 + 0.01)60]/0.01} = $500{44.9550} = $22,477.52

  25. Using the TVM Calculator Function: Same Example: Calculate the loan size for a 5-year, 12% APR loan with $500 monthly payments. Two ways to do this: Set to 1payments per year and enter 1%: N = 60 PMT = 500 I/Y = 1FV = 0 PV = -22,477.52 Set to 12 payments per year and enter 12%: N = 60 PMT = 500 I/Y = 12FV = 0 PV = -22,477.52 • I recommend you keep your calculator set to1 payment per year and adjust your inputs

  26. Finding Loan Payments: You want to borrow $100,000 to buy a house Calculate the monthly payments on a 30 year 9% APR loan r = 9%/12 = 0.75% t = 30 x 12 = 360 PV = C{[1 - 1/(1 + r)t]/r} = PV = C/PVAF C = PV/{[1 - 1/(1 + r)t]/r} = C = PV/PVAF C = $100,000{[1 - 1/(1 + 0.0075)360]/0.0075} C = $100,000/124.2819 = $804.62 Can also use this notation: PV = C{PVAF} C = PV/PVAF Using TVM Function(Set to 1 payment per year): N = 360 I/YR = 0.75 PV = 100,000 PMT = -804.62

  27. Clicker Question: • You put $8,000 on your credit card. • The card has a stated rate of 18% APR-Monthly • Calculate the monthly payments assuming the credit card uses a 30 year payback period. • $30 • $121 • $333 • $3,284 • $8,120

  28. Clicker Answer: N = 30 x 12 = 360 PV = 8,000 I/YR = 18/12 = 1.5 PMT = 121 The answer is B. Bonus Question: • Now assume that you actually read the fine print and find that a single late payment will cause the credit-card rate to increases to 30% APR-Monthly. • Calculate the new monthly payment: N = 360 PV = 8,000 New I/YR = 30/12 = 2.5 New PMT = 200

  29. Finding Annuity Payments: (Before we did PV of an annuity) • You want to buy an annuity from an insurance company • You will pay $100,000today for equal monthly payments for the next 30 years • The Annuity is offered at 9% • Calculate the payments Same Calculation: N = 30 x 12 = 360 I/YR = 9/12 = 0.75 PV = 100,000 PMT = -804.62

  30. Finding the Number of Periods • Put $2,000 on your credit card • Choose to pay $40 per month. • How many months to payoff at 18% APR-Monthly? PV = C{[1 - 1/(1 + r)t]/r} PV/C = [1 - 1/(1 + r)t]/r r(PV/C) = 1 - 1/(1 + r)t (1 + r)t = 1/[1 - r(PV/C)] t [ln(1 + r)]= ln{1/[1 - r(PV/C)]} t = ln{1/[1 - r(PV/C)]}/[ln(1 + r)] = ln{1/[1 – 0.015($1,000/$40)]}/[ln(1.015)] = 93.11 But we’ll use the TVM function 

  31. Finding # of Periods using TVM Function 18% annual = 18/12 = 1.5 per month: I/YR = 1.5 PV = 2,000 PMT = -40 N = 93.11 I/Y R= 1.5 PV = -2,000 PMT = 40 N = 93.11 (One must be negative) Potential Errors when using the TVM function: • Set at 1 P/YR: (Neither PV or PMT are negative) I/YR = 1.5 PV = 2,000 PMT = 40 N = -37.59 (wrong) • Set at 12 P/YR: I/YR = 1.5 PV = 2,000 PMT = -40 N = 51.66 (wrong) I/YR = 18 PV = 2,000 PMT = -40 N = 93.11

  32. Clicker Question: • You charge $5,000 on your credit card. • The card has a stated rate of 24% APR-Monthly • Calculate the number of months needed to payoff the debt assuming monthly payments of $150 • 24 • 36 • 56 • 60 • 94

  33. Clicker Answer: PV = 5,000 I/YR = 24/12 = 2 PMT = -150 N = 55.48 So you will payoff the loan in 56 months The Answer is C

  34. Future Value of Annuities FVA = C{[(1 + r)t -1]/r} FVA = C{FVAF} Example: Make $5,000 annual contributions to retirement fund for 40 years. Earn 10% per year. t = 40 r = 10% C = $5,000 FVA = $5,000{[(1.10)40 -1]/0.10} = $5,000{442.59} = $2,212,963 • 442.59 is called the Future Value Annuity Factor (FVAF) Calculator TVM Function: N = 40 I/YR = 10 PMT = $5,000 FV = $2,212,963

  35. Clicker Question: • To save for your child’s education, you invest $1,000 a year for 18 years in a college savings account. • The account earns 10% per year. • What will be the value of the account in 18 years? • What if you don’t start saving until your kid is 5 (save for 13 years)? • $18,000over 18 years and $13,000over 13 years • $36,000over 18 years and $26,000over 13 years • $36,900 over 18 years and $26,300over 13 years • $45,599 over 18 years and $24,523over 13 years • $45,599 over 18 years and $30,250over 13 years

  36. Clicker Answer: • $1,000 per year over 18 years at 10%: N = 18 I/YR = 10 PMT = 1000 FV = 45599 • $1,000 per year over 13 years at 10%: N = 13 I/YR = 10 PMT = 1000 FV = 24523 The answer is $45,599 over 18 years and $24,523 over 13 years (D) • So roughly half as much ($24,523/$45,599 = 54%) if you only save for 13 years. How do you need to save each year for 18 years to have $100k? N = 18 I/YR = 10 FV = 100,000 PMT = 2,193 Note that $100,000/$45,599 = 2.193

  37. Annuities Due An Annuity Duemeans the payments are made at the beginning of each period, not at the end of each period: So the First payment is made immediately, not at the end of the first period. The figure below shows the payment timing of a four year $100 Annuity and an Annuity Due:

  38. Compare an Annuity Due to an Annuity • Is the PV of a 4 yr Annuity Due greater than a regular 4 yr annuity? • Would you rather get the Annuity or the Annuity Due? • The 4 yr Annuity Due is the same as a 3 yr (regular) Annuity plus an extra $100 now (at time zero): • PV 3 yr Annuity: N=3 I/Y=10 PMT=100 PV=248.69 • PV 4 yr Annuity Due = 248.69 + 100 = 348.69 • PV 4 yr (regular) Annuity: N=4 I/Y=10 PMT=100 PV=316.99

  39. Clicker Question: • You will pay $1,000 per month to rent apartment for a year • The lease requires monthly payments at the beginning of each month. • Assume a 12% APR-Monthly discount rate. • Calculate the NET BENEFIT (in present value terms) to the landlord of receiving the rent payments at the beginning of each month as opposed to the end of each month. • $1,343 • $1,000 • $743 • $500 • $113

  40. Clicker Answer: • PV of a 12 month, $1,000 Annuity discounted at 12% APR: N = 12 I/Y = 12/12 = 1 PMT = 1,000 PV = 11,255 • PV of a 12 month, $1,000 Annuity Due discounted at 12% APR: N = 11 I/Y = 12/12 = 1 PMT = 1,000 PV = 10,368 PV of Annuity Due = $10,368 + $1,000 = $11,368 • Net Benefit = $11,368 – 11,255 = $113 • The Answer is E

  41. Perpetuities: Level stream of cash flows forever: PV Perpetuity = C/(1+r) + C/(1 + r)2 + C/(1 + r)3 + … = C[1/(1+r) + 1/(1 + r)2 + 1/(1 + r)3 + …] • The term in brackets is a “convergent sequence” for any value of r between 0 and 1 • Since each subsequent term is divided by (1+ r) taken higher and higher power, the ratio becomes a smaller number, approaching zero • Eventually, you are just adding zeros • Economically, payments made 100 years out (divided by 1+r taken to the 100th power) aren’t really adding anything For 0 < r < 1: [(1+ r)-1 + (1 + r)-2 + (1 + r)-3 + …] = 1/r PV Perpetuity = C[1/r] = C/r The PV of $500 per year forever discounted at 8% = $500/.08 = $6,250

  42. Review of Formulas and Symbols Page 139

  43. 5.3 Comparing Rates: APR vs. EAR Banks (and other financial institutions) must quote loan and deposit rates as Annual Percentage Rate (APR) An APR is the periodic rate times the number of periods: • 5% every six months is 10% APR Semi-Annual • 1% every month is 12% APR Monthly • 2% every quarter is 8% APR Quarterly An EAR (Effective Annual Rate) is the annual rate that is equivalent to a given APR • What annual rate is the same as half of 10% (10%/2 = 5%) compounded twice a year? (10% APR Semi-Annual) • (1.05)(1.05) = 1.1025 • So the equivalent is 1.1025 – 1 = 0.1025 = 10.25% • So either pay me 10% APR S-A or 10.25% per year • They are the same!

  44. APR and EAR Formulas APR: Annual Percentage Rate • APR = (Periodic Rate) x (# of periods) • 5% every six months = 10% APR SA • 12% APR Monthly = 1% every month EAR: Effective Annual Rate • Annual rate that is equivalent to the compounded APR • 10% APR-Semi Annual = 5% compounded twice • (1.05)(1.05) – 1 = 10.25% EAR • 12% APR-Monthly = (1.01)12 – 1 = 12.68% EAR Let m = # of periods Calculate the EAR if the quoted rate is 18% APR monthly: APR = 18% m = 12 EAR = (1 + APR/m)m – 1 = (1 + 0.18/12)12 - 1 = 1.01512 – 1 = 19.56% You would be indifferent between paying/earning 19.56% per year and 18% APR monthly (1.5% per month)

  45. APR and EAR Formulas Convert EAR to APR: APR = m[(1 + EAR)1/m -1] What semi-annual APR is equivalent to 10% EAR? EAR = 10% m = 2 APR = 2[(1.1)1/2 -1] = 9.76% Show this works: 9.76% APR means 4.88% each 6 month period: EAR = (1 + APR/m)m – 1 = (1.0488)2 – 1 = 10%

  46. Terminology and Calculators EAR is also called: • Effective Rate (EFF) • Effective Annual Yield (EAY) • Annual Percentage Yield (APY) APR is also called: • Nominal (NOM) Using the function in your HP Calculator: Calculate EAR for 18% APR monthly: FunctionButtons Display Set payments per year to 12 12 {Yellow Shift} {P/Y} 12. Input 18% APR 18 {Yellow Shift} {NOM%} 18. Calculate EAR {Yellow Shift} {EFF%} 19.5618

  47. Clicker Question: • You want to invest for one year • A bank is offering 3.10% APR-Quarterly on a three-month CD and 3.25% on a one-year CD • Assume you can roll-over the three-month CD at the same 3.10% rate three more times • So assume rates will not change until you have rolled over the three-month CD three more times • Which investment alternative is better? • The three-month CD 4 times • The one-year CD once • There is not enough information

  48. Clicker Answer: • Compare 3.10% APR-Quarterly to 3.25% Annual • So calculate the EAR of 3.10% APR-Quarterly: m = 4, APR = 3.10% EAR = (1 + APR/m)m – 1 = (1 + 0.0310/4)4 – 1 = (1.00775)4 – 1 = 0.0314 = 3.14% Since 3.10 APR-Quarterly is the same as 3.14% Annual, 3.25% Annual is better than 3.10% APR-Quarterly. The Answer is B.

  49. 5.4 Loan Types and Amortization There are a number of different ways a loan can be repaid: • Ways in which interest can be paid • Ways in which the loan amount (called the principal) can be repaid There are common loan structures for different types of loans • Loans made to people • called consumer or retail loans) • Loans make to business by banks • Called institutional or business loans) • Loans make to business by “the market” • The company sells Commercial Paper to the market • The company sells Bonds to the market (long term loans) • The way the loan is repaid is called the Amortization Schedule

  50. 5.4 Loan Types and Amortization Amortization refers to how the loan is repaid • Pure Discount Loans • Only one payment • Payment Includes both the principal (loan amount) and interest • Amount loaned is the Present Value of the one payment • The payment is the Future Value of the loan amount • The payment is also called the Face Value of the loan (also FV)

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