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Topic:FinancialMathematics.TheValuationofCashFlows

Agenda:

MotivatingExample:Winningthelottery
Futurevalue(FV),simpleinterest,compoundinterest
Presentvalue(PV)anddiscounting
PVandFVofmultiplecashflows
PVandFVofannuitiesandperpetuities
Effectiveannualreturnsandannualpercentagerate
SomeDifferentTypesofLoans

KyungHwanShim,FINS1613S2Yr2016 1

TimeValueofMoney.
MotivatingExample:Winningthe
Lottery

KyungHwanShim,FINS1613S2Yr2016 2

MotivatingExample:WinningtheLottery

Q)Ifyouwinthelotterywithajackpotadvertisedas$1,000,000
promisingtopay$100,000onceayearforthenext10years
(hence,thetotaljackpotof$1,000,000),istheprizemoneyreally
worth$1,000,000?

A)

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MotivatingExample:WinningtheLottery

Whyistheactualprizevaluelessthantheadvertisedprizeof
$1,000,000?

1. Timevalueofmoney: peoplevalueadollartodaymorethana
dollartomorrow. Why?
Gettingthemoneylaterposessomeinconveniences
Gettingthemoneylatermeansyoucantinvestorlendittoday
andearnmoreforlaterconsumption
Gettingthemoneylatermeansyoucandolesswithitthanifyou
receivedthemoneytoday
2. Risk: peopleareriskaverse
Adollarinthefutureisuncertain,whereasadollarinyourpocket
todaydoesnotcomewithanyuncertainty.
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MotivatingExample:WinningtheLottery

Implicationsformanagerialdecisions:

1. Everythingelseequal,adollarreceivedinthefutureshould
havealowercashvaluetoday.Thisiscalleddiscounting.

2. Conversely,adollarreceivedtodayshouldhaveagreater
nominalvalueinthefuture.Thisiscalledcompounding.

3. Everythingelseequal,theriskierthefuturedollarthelessit
shouldbeworthtoday.Thisiscalledcompensationforrisk
(Week8)

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TimeValueofMoney:
FutureValueandCompounding

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FutureValue

FutureValue(FV)referstotheamountofmoneyaninvestment
todaywillgrowoversomeperiodoftimeatsomegiveninterestrate
orreturnrate.

FVisafunctionof4things:
Theactualdollarinvestmenttoday,orprincipal.

Theinterestrate (orreturnrate)

Thetimehorizonorthelengthoftimethemoneyisinvested

Howfrequentlytheinterestiscompounded(assume1yearfor
now)
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Investingfora1year

Q)Supposeyouinvest$100inasavingsaccountfor1yearat
10%interestperyear.Howmuchisyourinvestmentworth1
yearfromnow?

A)
1

$100 1 0.10 $110

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Investingforanyears
Q)Supposeyouinvest$100inasavingsaccountfor3yearsat10%
interestperyear.Howmuchisyourinvestmentworth3yearsfrom
now?
A)
In1year:
$100 1 0.10 $110
In2years:
$110 1 0.10 $121
In3years:
$121 1 0.10 $133.1
Intyears:
1 1

1
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SimpleInterest

SimpleInterest:

10%intereston$100is$10.Investedover3years

$100 $10 3 $130

Withsimpleinterest,interestisearnedonlyontheprincipal.So$130
istheFVbasedonsimpleinterest.

Futurevaluebasedonsimpleinterestisgivenby

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CompoundInterest

CompoundInterest:

Compoundinterestisinterestearnedonthereinvestmentof
previousinterestpayments,notjusttheprincipal.

Inthepreviousexample,theactualyear3FVshouldbe$133.10,
not$130.Why?

Investmentsearninterestonprincipalaswellasoninterest
earnedinpreviousperiods.

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Compounding:FVof$100at10%

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Compounding:SimpleInterestvs.CompoundInterest

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Compounding:SimpleInterestvs.CompoundInterest

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Compounding:FVFactorTable

, 1

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TimeValueofMoney:
PresentValueandDiscounting

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PresentValueandDiscounting

FVquestion: Whatamount will growtobecomeifinvestedat

A)Recallthat
$ $ 1 $ ,

PVquestion: Howmuchmoney dowehavetoinvesttodayat

A)Thepresentvalueshouldbe
$
$ $ 1/ ,
1
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PresentValueandDiscounting

Q)Howmuchdowehavetoinvesttodayat10%inordertohave
$1inoneyear?
$1
$0.909
1 0.1

Q)Howmuchdowehavetoinvesttodayat10%inordertohave
$1inthreeyears?
$1
$0.7513
1 0.1

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PresentValueandDiscounting
1
,
1

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DeterminingtheRateofReturn

NotethatFVisthereciprocalofPV,andviceversa,i.e., ,
,
and , ,

Ifyouknowanythreeofr,t,PVorFV, thenyoucanfindthefourth.

Q)Ifyouhave$1todayandyouwanttodoublethemoneyin5years,
atwhatratemustthisinvestmentgrowth?
A)
2 1 1 2 5 1
2
Exp 1 14.87%
5

KyungHwanShim,FINS1613S2Yr2016 20

Findingthenumberofperiods

Similarly,youcanfindingthenumberofperiodsifyouknowthe
FV,PV andr.

Q)Howmanyyearswillittaketotripleyourmoneyifinvestedata
returnof10%?

A)
3 1 1 .10 3 1.1
3
11.5267
1.1
Investfor12years.

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PVandFVofMultipleCashFlows

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FVandPVwithMultipleCashFlows

Sofar,weonlyconsideredtheFVorthePVofasingleamount.

Formultiplecashflows distributedacrosstime

(1)determinethePVortheFVofeach cashflowasbefore,then

(2)addupthePVorFVofeachindividualcashflowtodeterminethe
PVortheFVofthestream ofcashflows.

PVandFVcalculationsareadditive.

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FutureValuewithMultipleCashFlows
Q)Supposeyouinvest$100thatwillofferareturnof8%peryear.
Inoneyearyouinvestanother$100.Howmuchwillyouhavein2
years?

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FutureValuewithMultipleCashFlows

Byfindingtheyear2FVofeachcashflow:

, $100 1.08 $116.64

, , , $116.64 $108 $224.64

Alternatively,byfindingtheyear1FVandthentheyear2FV:

, , $100 1.08
$100 1.08 $100 1.08 $224.64

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PresentValuewithMultipleCashFlows
Q)Youreofferedaninvestmentthatwillpay$200inYear1,$400
thenextyear;$600thefollowingyear;and$800inthefourth
year.Youcanearn12%onsimilarinvestments.Whatisthemost
youshouldpayforthisinvestment?
0 1 2 3 4
Time
(years)

200 400 600 800

PVandFVofAnnuities

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PVandFVofAnnuities

Wehaveanannuity iftheperiodsareregular,thecashflowsare
paidattheendofeachperiod,andcashflowsareallthesame
amount
0 1 2 3 4 n

Time
(years)

C C C C C
PVandFVofannuitiesarecalculatedwiththefollowingformulas:
1
1 1 1
1
,

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AnnuitiesDue

If the cash flows occur in the beginning of each period, rather than
in the end, then we have annuities due.

0 1 2 3 n1 n
Time
(years)

C C C C C

ThePVandFVofannuitiesduearecalculatedwiththefollowingformulas:
1
1 1 1
1
1 , 1

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PVandFVofAnnuities

Q)Supposeyoureceive$100inoneyear,and$100intwoyears.
Howmuchwillyouhavein2yearsifyourinvestmentreturnis8%
peryear?
A)
1 .08 1
$100 $208
.08

Q)Supposeyoureceive$100today,$100inoneyearandthenyou
receiveanother$100intwoyears.Howmuchwillyouhavein2
yearsifyouinvestmentreturnis8%peryear?
A)
1 .08 1
$100 1 .08 $100 $324.64
.08

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PVandFVofAnnuities
Q) Supposeyouwillreceive$100nextyearandanother$100in2yearsand
theinterestis8%.WhatisthePVofthesecashflows?
A)
1
1
1 .08
$100 $178.33
.08

Q) Supposeyouwillreceive$100today,$100nextyearandanother$100in
2yearsandtheinterestis8%.WhatisthePVofthesecashflows?
A)
1
1
1 .08
$100 1 .08 $278.33
.08
Alternatively,
1
1
1 .08
$100 $100 $278.33
.08
KyungHwanShim,FINS1613S2Yr2016 31

PVandFVofAnnuities:Findingthenumberofperiods

Q)Youspent$50,000withyourcreditcardandyoucanmanageto
makepaymentsof$2,000permonth.Theinterestrateonthecredit
cardis2%permonth.Howlongwillittaketopayoffthecreditcard
fully?

A)
1
1
1 .02
$50,000 $2,000
.02
2
1 .02 2
1.02
35
Approximately 2.92, or 2 years and 11 months.
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Perpetuities

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PVofPerpetuities

AperpetuityisaninvestmentthatpaysthesameamountC
attheendofeachregularperiod,forever.ThePVofa
perpetuityiscomputedwiththefollowingformula:

Q)Yourbrokerinformsyouofastockpricedat$24that
paysa$2dividendattheendofeachyear.Youaresatisfied
earningareturnofnolessthan8%peryearforsimilar
investments.Itstheyearendandthestockwillpayits
annualdividendtomorrow.Isthisagoodinvestment?
$2
$2 $27
.08

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PercentageReturnRatevsEffective
ReturnRate

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CompoundingPeriods
Thequotedrateonloansdoesnotgenerallyequatetotheactualinterestone
earnsorpays.Intheloanmarket,ifarateisquotedas10%compounded
semiannually,itmeansthattheloancosts5%everysixmonths,not10%
everyyear.

Iftheloanisfor1yearthenattheendof1yeartheborrowerhastopay
.1 .1 .1
$1 1 1 1 $1.1025
2 2 2
Thatcorrespondstoaneffectivecostof10.25%,not10%.

10.25%issaidtobethe EffectiveAnnualRate(EAR),while10%istheannual
percentageinterestrate.Ifn isthenumberofcompoundingperiodsperyear,
then

1 1
EARistheactualcostoftheloan,notthestatedpercentagerate.
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CompoundingPeriods

Q)Threebanksquotethefollowingrates:
BankA:15.20%compoundeddaily
BankB:15.50%compoundedannually
BankC:15.70%compoundedsemiannually

Whatbankwouldyouchooseisyouwantaloan?Whatifyouwantto
openasavingsaccount?Assumethatthereisnodifferencebetween
loanratesanddepositrates.
.
EARforBankA: 1 1 0.1641 16.41%
EARforBankB: 15.5%
.
EARforBankC: 1 1 0.1632 16.32%
ForaloanchooseB.ForsavingchooseA.
KyungHwanShim,FINS1613S2Yr2016 37

EARandAPR

Statinginterestratesonlycanbeveryconfusingtoborrowers.The
lawstatesthatlendersmustfollowaharmonizedwayofstating
interestratesonloans.

TheAnnualPercentageRate(APR) istheinterestratenetoffees
chargedperperiodmultipliedbythenumberofperiodsperyear.

Q)AcarloanisstatedashavinganAPRof1.2%permonth.
Therefore,accordingtothedefinitionofAPR,theAPRis
1.2%x12=14.4%.Theactualcostoftheloanis
0.144
1 1 15.39%
12
whichisgreaterthantheAPRof14.4%
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TheDifferentKindsofLoans

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TypesofLoans:PureDiscountLoans

PureDiscountLoans:

Theborrowerreceivestheloantodayandrepaysthelenderinfulla
singleamountinthefuture.

Q)Aborrowercanrepaythelender$1,000in2years.Thelenderis
happyearning10%onthisloan.Howmuchshouldthelenderbe
willingtolend?

A)
$1,000
$826.45
1.1
Atmost$826.45.
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TypesofLoans:InterestOnlyLoans

InterestOnlyLoans:

Theborrowerrepaysinterestonlyeachperiod,andrepaysthe
principalinthefinalperiod

Forexample,a10%,4year,$1,000principalinterestonlyloan
hasthefollowingcashflowstothelender:

Inyear1:pays$100
Inyear2:pays$100
Inyear3:pays$100
Inyear4:pays$1,100.
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TypesofLoans:AmortizingLoans

AmortizingLoans:
Eachperiodthepaymentisthesame,partlycoveringtheinterestexpense
andtheremaindercoveringsomeoftheprincipalowed.Forexample,a
9%5yearamortizingloanwithaprincipalof$5,000hasthefollowing
annualpayments:
1
1
$5,000 1.09 1,285.45
.09
Theinterestportionofthepaymentinyear1is:
$5,000 9% $450
Theprincipalportionofthepaymentinyear1is:
$1,285.45 $450 $835.45
Theinterestportionofthepaymentinyear2is:
$5,000 835.45 9% $374.81
Theprincipalportionofthepaymentinyear2is:
$1,285.45 $374.81 $910.64
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TypesofLoans:AmortizingLoans

AmortizationTable

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Conclusions

Discounting,compounding,presentandfuturevaluesare
fundamentalconceptsinfinance.

Discountingisusedextensivelywhenvaluinginvestment
opportunities(projects)thatdelivercashflowsinthefuture.

Thisishowfinancialmarketspricefinancialsecuritiessuchasstocks
andbonds.

Textbookexercises:QuestionsandProblems 17,915,2932,34,35,
4759

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