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Discounted Cash Flow Valuation Chapter 5

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2 Topics Be able to compute the future value of multiple cash flows Be able to compute the present value of multiple cash flows Understand how interest rates are quoted Be able to compute loan payments Be able to find the interest rate on a loan Understand how loans are amortized or paid off

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3 Page 113 Students who learn this material well will find that life is much easier down the road Getting it straight now will save you a lot of headaches later

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4 Annuities Annuity Definition: A level steam of cash flows for a fixed period of time Each payment is for the same amount The time between payments is always the same Timing for annuities: Ordinary Annuity (Mortgage contracts) Payments are made at the end of each period The day you sign the contract, you do not make a payment Annuity due (Lease contracts) Payments are made at the beginning of each period

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5 Annuities Types of annuities: Savings plan: If I put $50 in the bank each month for 35 years, how much will I have when I retire? What is the future value? Future value of future cash flows valuation: If I want to be a millionaire, how much do I have to put in the bank each period. What is the PMT FV ? Loan (DEBT) periodic payment: If I take out a loan, what is the periodic repayment amount? What is the PMT PV ? Present value of future cash flows valuation If I know the asset will give me $50 at the end of each month for the next 25 years, what should I pay for this asset today? What is the present value?

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6 Annuities (Math) All the cash flow associated with an annuity represent a geometric sequences Geometric sequences: A geometric sequence is one in which each successive term of the sequence is the same nonzero constant multiple of the preceding term Constant multiple = (successive term)/(preceding term) Every two successive terms have a common ratio The total value of an annuity represents a finite geometric series Geometric series: The sum of the terms in a geometric sequence

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7 How To Determine The Present Value Of Investments With Multiple Future Cash Flows

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8 Annuity – Sweepstakes Example Suppose you win the Publishers Clearinghouse $10 million sweepstakes. The money is paid in equal annual installments of $333,333.33 over 30 years. If the appropriate discount rate is 5%, how much is the sweepstakes actually worth today? PV = 333,333.33[1 – 1/1.05 30 ] /.05 = 5,124,150.29

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9 Buying a House You are ready to buy a house and you have $20,000 for a down payment and closing costs. Closing costs are estimated to be 4% of the loan value. You have an annual salary of $36,000 and the bank is willing to allow your monthly mortgage payment to be equal to 28% of your monthly income. The interest rate on the loan is 6% per year with monthly compounding (.5% per month) for a 30-year fixed rate loan. How much money will the bank loan you? How much can you offer for the house?

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10 Buying a House - Continued Bank loan Monthly income = 36,000 / 12 = 3,000 Maximum payment =.28(3,000) = 840 PV = 840[1 – 1/1.005 360 ] /.005 = 140,105 Total Price Closing costs =.04(140,105) = 5,604 Down payment = 20,000 – 5604 = 14,396 Total Price = 140,105 + 14,396 = 154,501

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11 Quick Quiz: Part 2 You know the payment amount for a loan and you want to know how much was borrowed. Do you compute a present value or a future value? You want to receive 5000 per month in retirement. If you can earn.75% per month and you expect to need the income for 25 years, how much do you need to have in your account at retirement?

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12 Finding the Rate Suppose you borrow $10,000 from your parents to buy a car. You agree to pay $207.58 per month for 60 months. What is the monthly interest rate? Sign convention matters!!! 60 N 10,000 PV -207.58 PMT In EXCEL use the RATE function

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13 How To Determine The Future Value Of Investments With Multiple Future Cash Flows

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14 Future Values for Annuities Suppose you begin saving for your retirement by depositing $2000 per year in an IRA. If the interest rate is 7.5%, how much will you have in 40 years? FV = 2000(1.075 40 – 1)/.075 = 454,513.04

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15 Annuity Due You are saving for a new house and you put $10,000 per year in an account paying 8%, compounded yearly. The first payment is made today. How much will you have at the end of 3 years? FV = 10,000[(1.08 3 – 1) /.08](1.08) = 35,061.12 Annuity Due trick: Annuity due value = Ordinary annuity value*(1+i/n) PV Annuity Due trick: Subtract one period, then add one payment to PV

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16 Perpetuity (Consol) An annuity in which the cash flow continues forever Equal cash flow goes on forever (like most preferred stock pays dividend) Preferred Stock is a Perpetuity Capitalization of Income As x gets large, (1+i/n) Approaches zero

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17 Perpetuity If you buy preferred stock that pays out a contractual yearly dividend of $5.50 and the appropriate discount rate is 12%, what is the stock worth? (What is the present value of this perpetuity?) $5.5/.12 = $45.83 If RAD Corp. wants to sell preferred stock for $125 per share with a contractual quarterly dividend, and a similar company that pays a quarterly dividend of $2 and has a stock price of $150, what should the RAD Corp.’s dividend be if it wants to sell its stock? PMT/(i/n) = PV 2/(i/n) = $150 2/150 =.1333 Thus RAD Corp.’s quarterly dividend must be 1.33%, or.01333*$125 = $1.67

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18 How Interest Rates Are Quoted (And Misquoted) Interest Rates Periodic Rate Annual Percentage Rate Effective Annual Rate (EAR)

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19 Periodic Rate Interest rate per period

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20 Annual Percentage Rate Stated Interest Rates The interest rate expressed in terms of the interest payment made each period. Also: Quoted Interest Rate. Usually listed as: APR (Annual Percentage Rate) 10%, compounded quarterly Annual Percentage Rate The interest rate charged per period multiplied by the number of periods per year Truth-in-Lending Act Requires

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21 Computing APRs What is the APR if the monthly rate is.5%?.5(12) = 6% What is the APR if the semiannual rate is.5%?.5(2) = 1% What is the monthly rate if the APR is 12% with monthly compounding? 12 / 12 = 1% Can you divide the above APR by 2 to get the semiannual rate? NO!!! You need an APR based on semiannual compounding to find the semiannual rate.

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22 Things to Remember You ALWAYS need to make sure that the interest rate and the time period match. If you are looking at annual periods, you need an annual rate. If you are looking at monthly periods, you need a monthly rate. If you have an APR based on monthly compounding, you have to use monthly periods for lump sums, or adjust the interest rate appropriately if you have payments other than monthly

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23 Computing EARs - Example Suppose you can earn 1% per month on $1 invested today. What is the APR? 1(12) = 12% How much are you effectively earning? FV = 1(1.01) 12 = 1.1268 Rate = (1.1268 – 1) / 1 =.1268 = 12.68% Suppose if you put it in another account, you earn 3% per quarter. What is the APR? 3(4) = 12% How much are you effectively earning? FV = 1(1.03) 4 = 1.1255 Rate = (1.1255 – 1) / 1 =.1255 = 12.55%

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24 Effective Annual Rate (EAR) The interest rate expressed as if it were compounded once 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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25 Effective Annual Rate (EAR) One compounding period per year: APR = EAR When number of compounding periods per year goes up, EAR goes up, but up to a limit 365 periods per year is near the limit Limit of EAR = e i EAR = (1+.12/365) 365 -1 =.127474614 e.12 =.127496852 e 2.718281828

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26 Effective Annual Rate (EAR) If you want to compare two alternative investments with different compounding periods you need to compute the EAR and use that for comparison.

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27 Decisions, Decisions II 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 = (1 +.0525/365) 365 – 1 = 5.39% Second account: EAR = (1 +.053/2) 2 – 1 = 5.37% Which account should you choose and why?

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28 Decisions, Decisions II Continued 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 =.00014383562 FV = 100(1.00014383562) 365 = 105.39 Second Account: Semiannual rate =.0539 / 2 =.0265 FV = 100(1.0265) 2 = 105.37 You have more money in the first account.

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29 Loans Interest Only Loans Amortized Loans Pure Discount Loans Principal = Amount lent by lender = Amount received by borrower Interest Only Loans Principal stays the same until the end of the loan, then principal is paid back Amortized Loans A small amount of the principal is paid off each period and principal amount gets smaller as payments are made Periodic Interest = Principal*Periodic Rate

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30 Loans Each type of loan has different combinations of payments of cash flows: Amounts Timing Interest payments Principal payments Sign

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31 Loans How Loan Payments Are Calculated And How To Find The Interest Rate On A Loan How Loans Are Amortized Or Paid Off

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32 Interest Only Loans (Coupon) Pay fixed interest amount each period Principal* Periodic Rate Pay the principal back (all at once) at the end of the loan period (plus the last fixed interest amount) Example: Bonds

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33 Interest Only Loans (Coupon)

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34 Amortized Loans - Repay Part Interest And Part Principal Each Period Medium-term business loans Period payments: Interest amount paid changes each period Principal amount paid is fixed Consumer/mortgage loans Period payments: Interest amount paid changes each period Principal amount paid changes each period Ordinary annuity

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35 Amortized Loans - Medium-term Business Loans Periodic Interest Amount: Principal* Periodic Rate Pay changing interest amount each period (amount gets smaller each period) Principal amount paid: Fixed Amount Total Periodic payment gets smaller each period

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36 Amortized Loans: Medium-term Business Loans

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37 Amortized Loans - Consumer/mortgage loans & Effective Interest Rate Method for Bonds Periodic Interest Amount: Principal* Periodic Rate Pay changing interest amount each period (amount gets smaller each period) Principal amount paid: Periodic Payment - Periodic Interest Amount Total Periodic payment stays the same each period Ordinary Annuity: Solve for PMT

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38 Amortized Loans: Consumer/mortg age loans

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39 Pay Off Loan Early (Balloon Payment) The present value of all remaining future cash flows will give you the amount to pay off

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40 Pure Discount Loans (Zero Coupon) Borrow an amount today, then pay back principal and all interest at the end of the loan period Example: US Government Treasury Bills, or T-bills (government loans < 1year) Loan amount received today Payback Amount

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41 Pure Discount Loans (Zero Coupon)

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42 Multiple Cash Flows – FV Example 1 Suppose you invest $500 in a mutual fund today and $600 in one year. If the fund pays 9% annually, how much will you have in two years? FV = 500(1.09) 2 + 600(1.09) = 1248.05

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43 Example 1 Continued How much will you have in 5 years if you make no further deposits? First way: FV = 500(1.09) 5 + 600(1.09) 4 = 1616.26 Second way – use value at year 2: FV = 1248.05(1.09) 3 = 1616.26

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44 Multiple Cash Flows – Present Value Example 2 Find the PV of each cash flow and add them Year 1 CF: 200 / (1.12) 1 = 178.57 Year 2 CF: 400 / (1.12) 2 = 318.88 Year 3 CF: 600 / (1.12) 3 = 427.07 Year 4 CF: 800 / (1.12) 4 = 508.41 Total PV = 178.57 + 318.88 + 427.07 + 508.41 = 1432.93

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45 Example 2 Timeline 01234 200400600800 178.57 318.88 427.07 508.41 1432.93

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46 Multiple Cash Flows – PV Another Example You are considering an investment that will pay you $1000 in one year, $2000 in two years and $3000 in three years. If you want to earn 10% on your money, how much would you be willing to pay? PV = 1000 / (1.1) 1 = 909.09 PV = 2000 / (1.1) 2 = 1652.89 PV = 3000 / (1.1) 3 = 2253.94 PV = 909.09 + 1652.89 + 2253.94 = 4815.93

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47 Decisions, Decisions Your broker calls you and tells you that he has this great investment opportunity. If you invest $100 today, you will receive $40 in one year and $75 in two years. If you require a 15% return on investments of this risk, should you take the investment?

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48 Saving For Retirement You are offered the opportunity to put some money away for retirement. You will receive five annual payments of $25,000 each beginning in 40 years. How much would you be willing to invest today if you desire an interest rate of 12%?

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49 Summary Slide Annuities How To Determine The Present Value Of Investments With Multiple Future Cash Flows Finding the Rate How To Determine The Future Value Of Investments With Multiple Future Cash Flows Annuity Due (BEGIN mode) Perpetuity (Consol) How Interest Rates Are Quoted (And Misquoted) Loans Multiple Cash Flows

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Chapter 6 Calculators Calculators Discounted Cash Flow Valuation McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6 Calculators Calculators Discounted Cash Flow Valuation McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

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