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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Discounted Cash Flow Valuation Chapter 5

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.1 Chapter Outline 1. Future and Present Values of Multiple Cash Flows 2. Valuing Level Cash Flows: Annuities and Perpetuities 3. APR and EAR 4. Different Types of Loans

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.2 Steps in Time Value of Money Calculation 1. Draw the time line; 2. Identify the problem: is it a single cash flow, annuity, or perpetuity problem? 3. Clarify the question: is it asking for PV, FV, periodic payment, etc? 4. Find out the right formula or the right keys on the calculator; 5. Double check how frequently the interest is earned, and make sure the number of period matches with the period rate.

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.3 Time Value of Money Calculation Three groups of formulas Single cash flow: FV = PV(1 + r) t Annuity: Perpetuity: PV = C / r Constant growth perpetuity: PV=C 1 /(r-g)

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.4 Time Value of Money Calculation Three sets of calculator keys Single cash flow: N, I/Y, PV, FV Annuity: N, I/Y, PV(or FV), PMT Combination of single cash flow and annuity for bond evaluation: N, I/Y, PV, PMT, FV

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Multiple Cash Flows – Future Value Example 1 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?

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.6 Multiple Cash Flows – Approaches to find FV in Year

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.7 Multiple Cash Flows – Approaches to find FV in Year

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.8 Multiple Cash Flows – FV Example 1 Find the value at year 3 of each cash flow and add them together. Today (year 0): FV = 7000(1.08) 3 = 8, Year 1: FV = 4,000(1.08) 2 = 4, Year 2: FV = 4,000(1.08) = 4,320 Year 3: value = 4,000 Total value in 3 years = = 21, Value at year 4 = 21,803.58(1.08) = 23,547.87

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.9 Multiple Cash Flows – FV Example 2 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%?

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.10 Example Timeline

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.11 Example Timeline FV = 100(1.08) (1.08) 2 = =

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.12 Multiple Cash Flows – Present Value Example 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?

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.13 Example Timeline

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.14 Multiple Cash Flows – PV Example Find the PV of each cash flow and add them Year 1 CF: 200 / (1.12) 1 = Year 2 CF: 400 / (1.12) 2 = Year 3 CF: 600 / (1.12) 3 = Year 4 CF: 800 / (1.12) 4 = Total PV = =

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Annuities and Perpetuities Defined 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 If the first payment occurs at the beginning of the period, it is called an annuity due Perpetuity – infinite series of equal payments

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.16 Annuities and Perpetuities 4000 PVFV Annuity PV Perpetuity FV-due PV-due Annuity Due

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.17 Annuities and Perpetuities – Basic Formulas Ordinary Annuities: Perpetuity: PV = C / r

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Ordinary Annuity: Present Value 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 ] C C C C C... C

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.19 Ordinary Annuity: Future Value 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] C C C C C... C

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.20 Annuities and the Calculator You can use the PMT key on the calculator for the equal payment The sign convention still holds

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.21 Annuity PV – Example (5.5) 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?

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.22 Annuity PV– Example (5.5) You borrow money TODAY so you need to compute the present value. 48 N; 1 I/Y; -632 PMT; CPT PV = 23, ($24,000) Formula:

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.23 Annuity – Finding the Payment 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? 20,000 = C[1 – 1 / ] / C = Calculator: 4(12) = 48 N; 20,000 PV; I/Y; CPT PMT =

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.24 Annuity –Number of Payments (5.6) 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.

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.25 Annuity –Number of Payments (5.6) Calculator: 1.5 I/Y; 1000 PV; -20 PMT CPT N = MONTHS = 7.75 years And this is only if you don’t charge anything more on the card!

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.26 Annuity – Finding the Rate Suppose you borrow $10,000 from your parents to buy a car. You agree to pay $ per month for 60 months. What is the monthly interest rate? Sign convention matters!!! 60 N 10,000 PV PMT CPT I/Y =.75%

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.27 Annuity – Finding the Rate Without a Financial Calculator Trial and Error Process Choose an interest rate and compute the PV of the payments based on this rate Compare the computed PV with the actual loan amount If the computed PV > loan amount, then the interest rate is too low If the computed PV < loan amount, then the interest rate is too high Adjust the rate and repeat the process until the computed PV and the loan amount are equal

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.28 Future Values for Annuities 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? FV = 2000( – 1)/.075 = 454, Calculator: (Remember the sign convention!!!) 40 N; 7.5 I/Y; PMT CPT FV = 454,513.04

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Annuity vs. Annuity Due PV FV-due PV-due FV Annuity Annuity Due

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.30 Annuity Due 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? 2 nd BGN, 2 nd Set N=3, PMT=-10,000, I/Y=8 CPT FV=35, nd BGN 2 nd Set (Be sure to change it back to an ordinary annuity) If in END mode, N=3, PMT=-10,000, I/Y=8, CPT FV=32,464

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

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.32 Illustration on Perpetuity Formula PV= C/(1+r) + C/(1+r) 2 + C/(1+r) 3 + … PV= C/r Amount of Cash $5000 $5000 $ Value of Cash (Interest Rate = 3%) $166, C C C C C...

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.33 Perpetuity – Example 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? $44.44 = $4 / r r = 9.0%

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.34 Table 5.2

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

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.36 Effective Annual Rate (EAR) This is the actual rate paid (or received) after accounting for compounding that occurs during the year If you want to compare two alternative investments with different compounding periods you need to compute the EAR and use that for comparison. Example: if quarterly rate=3%, what is EAR? You should NEVER divide the effective rate by the number of periods per year – it will NOT give you the period rate

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.37 Calculate EAR 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? First account: EAR = ( /365) 365 – 1 = 5.39% Second account: EAR = ( /2) 2 – 1 = 5.37% Which account should you choose and why?

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.38 Calculate EAR Let’s verify the choice. Suppose you invest $100 in each account. How much will you have in each account in one year? First Account: Daily rate =.0525 / 365 = FV = 100( ) 365 = Second Account: Semiannual rate =.053/ 2 =.0265 FV = 100(1.0265) 2 = You have more money in the first account.

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.39 Computing EARs from APRs Remember that the APR is the quoted rate

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Different Types of Loans Amortized Interest only Pure discount

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.41 Pure Discount Loans – Example 5.11 Treasury bills are excellent examples of pure discount loans. The principal amount is repaid at some future date, without any periodic interest payments. 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? PV = 10,000 / 1.07 =

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.42 Interest Only Loan - Example Consider a 5-year, interest only loan with a 7% interest rate. The principal amount is $10,000. Interest is paid annually. What would the stream of cash flows be? Years 1 – 4: Interest payments of.07(10,000) = 700 Year 5: Interest + principal = 10,700 This cash flow stream is similar to the cash flows on corporate bonds and we will talk about them in greater detail later.

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.43 Amortized Loan with Fixed Payment - Example Each payment covers the interest expense plus reduces principal, such as mortgage payment Consider a 4 year loan with annual payments. The interest rate is 8% and the principal amount is $5000. What is the annual payment? 5000 = C[1 – 1 / ] /.08; C = Calculator 4 N; 8 I/Y; 5000 PV CPT PMT =

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.44 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?

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McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 5.45 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?

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