Minors in Quantitative Finance

(FinIQ Consulting)

Numerical Methods in Finance

Lecture 3 & 4
NPV

Net Present Value

The value of all future cash flows (positive and negative) over the entire life of
an investment discounted to the present.
NPV : Net Present Value

What is Discount rate?

Discount Rate:

What is Discount rate?

• The discount rate is the interest rate used to calculate the present value of
future cash flows of a project or investment.
• The discount rate makes it possible to estimate how much the project’s future
cash flows would be worth in the present.
• The financial analyst needs to set the Discount Rate to calculate the NPV of
the project.
• Many companies use WACC (Weighted Average Cost of Capital) to set the
value of Discount rate.
• Discount Rate is not necessary to be the inflation rate or intrest rate in the
market, it depends on the cost of capital of the particular project.
IRR : Internal rate of return

The value of all future cash flows (positive and negative) over the entire life of
an investment discounted to the present
IRR : Internal rate of return
The internal rate of return (IRR) is a metric used in financial analysis
to estimate the profitability of potential investments.

IRR is a discount rate that makes the net present value (NPV) of all cash flows
equal to zero in a discounted cash flow analysis.

The ultimate goal of IRR is to identify the rate

of discount, which makes the present value of The higher an internal rate of return,
the sum of annual nominal cash inflows equal the more desirable an investment is to undertake.
to the initial net cash outlay for the investment.
Recap : TVM, NPV, IRR

Time Value of Money

A sum of money now is worth more than the same sum of money in future

Net Present Value

The value of all future cash flows (positive and negative) over the entire life of
an investment discounted to the present

Internal Rate of Return

The discount rate at which a project’s returns
become equal to its initial investment i.e. NPV
becomes zero
Questions:

● Invest 20,000 USD now and receive 3 yearly payments of 5,000 USD each along with 12,000 USD in
the 3rd year. Assume Discount rate as 10%. Justify whether it is a good Investment opportunity or not.
● A project with a 4 year life and a cost of Rs. 225,000 generates revenue of Rs. 48,000 in year 1,
Rs.67,000 in year 2, Rs. 95,000 in year 3 and Rs. 110,000 in year 4. If the discount rate is 15%,
should we accept this project?

● Invest 9,000 USD now and receive three yearly payments of 2,500 USD each along with 4,000 USD in
the 3rd year. What is the NPV? Assume discount rate=5%
● Find the NPV of an investment having initial cash outflow of Rs. 280,000. The cash inflows at first,
second, third and fourth years are expected to be Rs. 72,000, Rs. 97,000, Rs.105,000 and Rs,
110,000 respectively. What is the NPV? Assume discount rate=5%
What are bonds?
A bond is an instrument that represents a loan made by an investor to a borrower
(typically corporate or governmental). A bond could be thought of as an I.O.U. between
the lender and borrower that includes the details of the loan and its payments. Bonds
are used by companies, municipalities, states, and sovereign governments to finance
projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.
Types of Bonds

• Fixed Interest Bonds : Fixed interest payments till maturity

• Perpetual bonds : These have no maturity date. Issuers pay coupons on perpetual bonds forever,
and they do not have to redeem the principal
• Floating interest Bonds : Interest paid dependent on a reference benchmark rate
• Inflation linked bonds : Coupon is linked to inflation
• Zero-coupon bonds : No coupon payments ,their market price eventually converges to face value
upon maturity
• Callable bonds: The issuing company can call back these bonds from debt holders if interest
rates drop sufficiently. These bonds typically trade at a price lower than non-callable debt
• Putable bonds: In case of putable bonds, creditors can put the bond back to the issuer if interest
rates rise sufficiently
Pricing Bonds

● Bond value is determined by the present value of the coupon payments and par
value.

● The quoted price is for a bond with a face value of 100.

● The quoted price is not the same as the cash price that is paid by the purchaser.

● Cash price = Quoted price + Accrued Interest since last coupon date

● Quoted price is referred to as Clean Price and Cash price as Dirty Price by the traders
Pricing Bonds : Example

Suppose that it is May 5, 2020, and the bond under consideration is an 11% coupon bond with semi-annual
coupon maturing on September 10, 2022, with a quoted price of $95.50.

● The most recent coupon date is March 10, 2020, and the next coupon date is September 10, 2020.
● The number of days between March 10, 2020, and May 5, 2020, is 54, and 181 between March 10, 2020, and
September 10, 2020
● On a bond with $100 face value, the coupon payment is $5.50 on March 10 and September 10.
● The accrued interest on May 5, 2020, is the share of the September 10 coupon accruing to the bondholder on
May 5, 2020.
● Because actual/actual in period is used for Treasury bonds, this is (54/181)*$5.5 = $1.64
● The cash price per $100 face value for the September 10, 2020, bond is therefore $95.5+ $1.64 = $97.14
YTM : Yield to Maturity

● A bond's yield to maturity (YTM) is equal to the interest rate that makes the
present value of all a bond's future cash flows equal to its current price
● These cash flows include all the coupon payments and its maturity value.
● Relation of YTM to Coupon Rate and Par value of the bond:
○ When coupon rate = YTM, price = par value
○ When coupon rate > YTM, price > par value (premium bond)
○ When coupon rate < YTM, price < par value (discount bond)
YTM : Yield to Maturity
The term yield to maturity (YTM) refers to the total return anticipated on a bond if the bond is held until it matures.
Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the
internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all
payments made as scheduled and reinvested at the same rate.
YTM : Yield to Maturity : Graphical Representation
Pricing Bonds : Questions

Bond Price
● Compute the price of 4-year, 10% annual coupon bond with a par value of $1,000 (Discount rate 7%)
● Compute the price of $1,000 par, 4-year bond with a 10% coupon rate paid semi-annually and a yield-to-
maturity of 9%

YTM

● Compute the YTM of a 10-yr, 8% annual bond priced at 925 with a par value of $1,000

● Compute the YTM of a 10-year, $1,000 par bond with an 8% coupon rate that makes semiannual coupon
payments given that its current price is $925
Yield Curve

https://www.investopedia.com/terms/y/yieldcurve.asp
Attendance
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