Financial Economics

金融经济学

1
Chapter 3: Allocating Resources
Over Time

Objective
Explain the concept of
compounding and discounting, and
future value and present value
 To show how these concepts are
applied in making financial decisions.
 Contents
3.1 Compounding
3.2 The Frequency of Compounding
3.3 Present value and Discounting （现值和折现）
3.4 Alternative Discounted Cash Flow
Decision Rules
( 其他折现现金流决策规则 )
3.5 Multiple Cash Flows （复合现金流）
 Contents

3.6 Annuities
3.7 Perpetual Annuities （永续年金）
3.8 Loan Amortization （贷款的分期偿还）
3.9 Exchange Rates and Time Value of Money
3.10 Inflation and Discounted Cash Flow
Analysis
3.11 Taxes and Investment Decisions
 Introduction

Time Value of Money (TVM)

• Financial decision makers in
households and firms all have to
evaluate whether investing money
today is justified by the expected
benefits in the future.
• They must, therefore, compare the
values of sums of money at different
dates.
 Introduction
Time Value of Money (TVM)
• To do so requires a thorough
understanding of the time value of
money concepts and discounted cash
flow techniques.
• TVM refers to the fact that money in
hand today is worth more than the
expectation of the same amount to be
received in the future. (P64)
 Introduction
Time Value of Money (TVM)
$20 today is worth more than the
expectation of $20 tomorrow because:
– a bank would pay interest on the
$20
– inflation makes tomorrow’s $20
less valuable than today’s
– uncertainty of receiving
tomorrow’s $20
 3.1 Compounding

• Assume that the interest rate is 10%

p.a.
• What this means is that if you invest
$1000 for one year, you have been
promised $1000*(1+10/100) or
$1100 next year
 Value of Investing $1
– Continuing in this manner you
will find that the following
amounts will be earned:

1 Year $1100

2 Years $1210

3 Years $1331

4 Years $1464.1
4 Years $1464.
Future Value and Compound
Interest
Generalizing the method
• Generalizing the method requires
some definitions. Let
– i be the interest rate
– n be the life of the lump sum
investment
– PV be the present value
– FV be the future value
 Present Value of a Lump
Sum

n
FV PV * (1  i )
n
Divide both sides by (1  i ) to obtain :
FV n
PV  n
 FV * (1  i )
(1  i )
Example: Present Value of a Lump
Sum

• You have been offered

$40,000 for your printing
business, payable in 2 years.
Given the risk, you require a
return of 8%. What is the
present value of the offer?
Example: Present Value of a Lump
Sum

FV
PV  n
(1  i )
40,000
 2
(1  0.08)
34293.55281
$34,293.55 today
Lump Sums Formulae
• You have solved a present value
and a future value of a lump sum.
There remains two other variables
that may be solved for
– interest, i
– number of periods, n
Solving Lump Sum Cash Flow for
Interest Rate
n
FV PV * (1  i )
FV n
(1  i )
PV
FV
(1  i ) n
PV
FV
i n 1
PV
 Example: Interest Rate on a
Lump Sum Investment
• If you invest $15,000 for ten
years, you receive $30,000. What
is your annual return?
FV
i n 1
PV
30000 1
10  1  2  1 2  1
10 10

15000
0.071773463
7.18% (to the nearest basis point)
Solving Lump Sum Cash Flow for
Number of Periods
n
FV PV * (1  i )
FV n
(1  i )
PV
 FV 
ln  
 ln (1  i ) n * ln 1  i 
n

 PV 
 FV 
ln 
 PV  ln FV  ln PV 
n 
ln 1  i  ln 1  i 
3.2 The Frequency of Compounding

• APR: annual percentage rate( 年度百分率 )

-Interest rates on loans and saving
accounts are usually stated in the form
of annual percentage rate with a certain
frequency of compounding.

• EFF ： effective annual rate( 实际年利率 )

-defined as the equivalent interest rate, if
compounding were only once per year.
3.3 Present value and Discounting
• Future value factor (66)
FV=(1+i)n

• Present value factor (P69)

PVFV(FV,i,n)=FV/(1+i)n

• Discounting is just the reverse of

compounding.
3.3 Present value and Discounting

• 美国的一些州政府会发行福利彩票，有这样一种彩票是：最大
奖的金额为 2000 万美元，但支付方式是未来 20 年，
每年支付 100 万，获奖者的实际中奖金额？
 3.4 Alternative Discounted
Cash Flow Decision Rules

• Net present value (NPV) rule

– Simply: Accept any project
with a present value of future
cash flows that exceed the
initial investment. (P70)
 3.4 Alternative Discounted
Cash Flow Decision Rules

• Net present value (NPV) rule

– Formally: The NPV is the
difference between the value
of all future cash inflows
minus the present value of all
current and future cash
outflows. Accept a project if
its NPV is positive. Reject a
project if its NPV is negative.
(P70)
 3.4 Alternative Discounted
Cash Flow Decision Rules

• Net present value (NPV) rule

– Example: suppose that a ＄ 100
saving bond maturing in 5 years is
selling for a price of ＄ 75.Your next
best alternative for investing is 8%
bank account.
Is this saving bond a good investment?
(P70)
 3.4 Alternative Discounted
Cash Flow Decision Rules

• In general, for the NPV calculation of

any investment, we use the
opportunity cost of capital (also
called the market capitalization rate)
as the interest rate. (P70)
 3.4 Alternative Discounted
Cash Flow Decision Rules

• Opportunity cost of capital is simple the

rate that we could earn somewhere else if
we did not invest it in the project under
evaluation. (P70)
 3.4 Alternative Discounted
Cash Flow Decision Rules

• 市场资本化率（利率）为 8% ，某项投资周期为三年，
第一年投资 100 万，第二年投资 120 万，第三年投
资 60 万。第一年收益为 0 ，第二年收益为 150 万，
第三年收益为 210 万。这是一项好的投资吗？
 3.4 Alternative Discounted
Cash Flow Decision Rules

• Future value rule (P71)

• IRR rule (P72)
– Yield to maturity or
Internal rate of return
• Others (P73)
 3.4 Alternative Discounted Cash
Flow Decision Rules
• Another way to arrive at the same
conclusion is to use a slightly different
rule known as the future value rule.
• Future value rule
-It says to invest in the project if its
future value is greater than the future
value that will obtain in the next best
alternative. (This leads to the same
decision as the NPV rule)
 3.4 Alternative Discounted
Cash Flow Decision Rules
• Future value rule
– Example: suppose that a ＄ 100
saving bond maturing in 5 years is
selling for a price of ＄ 75.Your next
best alternative for investing is 8%
bank account.
Is this saving bond a good investment?
(P70)
3.4 Alternative Discounted Cash
Flow Decision Rules

• FV= $75*1.085=$110.2

• This is clearly better than the $100

future value of the savings bond.
Again, we find that the savings
bond is an inferior investment.
3.4 Alternative Discounted Cash
Flow Decision Rules

• But future value rule is not used as

often in practice is that, in many
circumstances the future value of
an investment cannot be
computed whereas the NPV rule
can still be used.
 3.5 Multiple Cash Flows
• Time Lines
 3.5 Multiple Cash Flows
• Future Value of a Stream of
Cash Flow
• Present Value of a Stream of
Cash Flows
• Investing with Multiple Cash
Flows
• 假设你得到机会投资于一个项目，该项目 1 年后向你支付
1000 美元，同时 2 年后向你支付另一笔 2000 美元。该
项目要求你现在投资 2500 美元。你相信这个项目完全没有风
险。如果你可以通过将资金存入银行赚取每年 10% 的利率，那
么这项投资是否是一项值得的投资？
Present Value of Multiple Cash Flows
 3.6 Annuities

• Annuity (P75)
• Immediate annuity (P75)
• Ordinary annuity (P75)
 3.6 Annuities

• Often the future cash flows in a savings

plan, an investment project, or a loan
repayment schedule are the same each
year. We call such a level stream of cash
flows or payments an annuity.
• Immediate annuity: If the cash flows
start immediately, as in a saving plan or
a lease.
• Ordinary annuity: If the cash flows
start at the end of the current period.
 Future value of annuities
Suppose that you intend to save $100 each
year for the next three years. How much will
you have accumulated at the end of that time
if the interest rate is 10% per year?
 Future value of annuities

Immediately: FV =
100*1.13+100*1.12+100*1.1 = 364.1
Ordinary : FV = 100*1.12+100*1.1+100 = 331
 Present value of Annuity

• PV = the present value of the

annuity
• i = interest rate to be earned
over the life of the annuity
• n = the number of payments
• pmt = the periodic payment
（定期缴款数额）
 Present value of Annuity

pmt pmt
PV   
1  i  1  i 
1 2

pmt pmt pmt

   
1  i 3
1  i  1  i 
n 1 n
 Present value of Annuity

1 1
PV  pmt *{  
1  i  1  i 
1 2

1 1 1
    }
1  i 3
1  i  1  i 
n 1 n
 Present value of Annuity

How much will you have to put into a

fund earning an interest rate of 10% per
year to be able to take out $100 per
year for the next three years?

PV = 100/1.1+100/1.12+100/1.13
 3.7 Perpetual Annuities
• Recall the annuity formula:

pmt  1 
PV  *  1  
n 
i  1  i  
• Let n -> infinity with i > 0:

pmt
PV 
i
Investing in preferred stock

Suppose you are currently earning a

nominal interest rate of 8%per year on
your money.
The preferred stock of Boston Gas and
Electric Co. offers a cash dividend of ＄
10 per year, and it is selling at a price
of ＄ 100 per share. Should you invest
some of your money in this stock?
 Investing in preferred stock

 To make your investment

decision, however, you must
consider risk, a subject we will
consider in detail later in the
next.
 Investing in preferred stock
 Suppose that you are considering
investing in a property for which
you expect the first year’s cash
flow to be ＄ 1000,and you expect
it to grow by 4%each year in
perpetuity. The discount rate is
9%.
pmt
PV 
i g
Investing in Common stock
 You have the opportunity to buy
stock in a company that is known
to pay a cash dividend that grows
by 3% every year. The next
dividend will be ＄ 1 per share, and
is to be paid a year from now. if
you require a 10% per year rate of
return, how much should you be
willing to pay for the stock?
3.8 Loan Amortization: Mortgage

• early repayment permitted at any

time during mortgage’s 360
monthly payments
• market interest rates may fluctuate,
but the loan’s rate is a constant
1/2% per month
• the mortgage requires 10% equity
and “three points”
• assume a $500,000 house price
 3
3.9 Exchange Rates and
Time Value of Money

• You are considering the choice:

– Investing $10,000 in dollar-denominated
bonds offering 10% / year
– Investing $10,000 in yen-denominated
bonds offering 3% / year
• Assume an exchange rate of 0.01(100 yen =
per dollar)
Tim U.S.A. Japan
e $10,000 0.01 $/¥ 1,000,000
¥

10% $/$ (direct) 3% ¥ / ¥

$11,000 ¥ ? $/¥ 1,030,000

¥
 Exchange Rate Diagram

• Review of the diagram indicates that

you will end the year with either
– $11,000 or
– ¥1,030,000
• If the $ price of the yen rises by
8%/year then the year-end exchange
rate will be $0.0108/ ¥
 U.S.A Japan
Time .
$10,000 0.01 $/¥ 1,000,000
¥

10% $/$ (direct) 3% ¥/¥

$11,124 0.0108 $/¥ 1,030,000

$11,000 ¥ ¥
Interpretation and Another
Scenario

• In the case of the $ price of ¥

rising by 8% you gain $124 on
your investment
• Now, if the $ price of ¥ rises by
6%, the exchange rate in one year
will be $0.0106
 U.S.A Japan
Tim
.
e $10,000 0.01 $/¥ 1,000,000
¥

10% $/$ (direct) 3% ¥ / ¥

$10,918 ¥ 0.0106 $/¥ 1,030,000

$11,000 ¥ ¥
 Interpretation

• In this case, you will lose $82 by

investing in the Japanese bond
• If you divide proceeds of the US
investment by those of the Japanese
investment, you obtain the exchange
rate at which you are indifferent
• $11,000/¥1,030,000 = 0.1068 $/¥
 U.S.A. Japan
Tim
e $10,000 0.01 $/¥ 1,000,000
¥

10% $/$ (direct) 3% ¥ / ¥

$11,000 ¥ 0.01068 $/¥ 1,030,000

$11,000 ¥ ¥
 Conclusion
• If the yen price actually rises by more than
6.8% during the coming year then the yen
bond is a better investment
• The answer depends on how much
the dollar/yen exchange rate will
change during the year.
Financial Decision in an
International Context

• International currency investors

borrow and lend in
– Their own currency
– The currency of countries with which
they do business but wish to hedge
– Currencies that appear to offer a
better deal
• Exchange rate fluctuations can
result in unexpected gains and
losses
Computing NPV in Different
Currencies

• In any time-value-of-money
calculation, the cash flows and
interest rates must be denominated
in the same currency
3.10 Inflation and Discounted Cash
Flow Analysis

• We will use the notation

– In the rate of interest in nominal
terms
– Ir the rate of interest in real terms
– R the rate of inflation
• From chapter 2 we have the
relationship
1  in in  r
1  ir   ir 
1 r 1 r
 Illustration
• What is the real rate of interest if
the nominal rate is 8% and
inflation is 5%?
1  in in  r
1  ir   ir 
1 r 1 r
0.08  0.05
ir  0.0286 2.86%
1.05
– The real rate or return determines the
spending power of your savings
– The nominal value of your wealth is
only as important as its purchasing
power
Inflation and Present Value

• A common planning situation is

determining how long it takes to save
for something
• The problem is that the thing being
saved for increases in (nominal) price
due to inflation
• Using a real approach solves this
issue
3.11 Taxes and Investment
Decisions
• Rule:
– Invest so as to maximize your after-
tax rate of return
( 为了最大化税后现金流的净现值而进行投资）
• This is not at all the same thing
as
– Minimize the tax you pay (False)
( 并不等同于为了最小化税收支付而进行投资）