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All time lines were drawn and discussed in class Removal of errors and omissions, if any, in this ppt are your responsibility
Agenda
Timeline Present Value - Future Value One period PV, NPV PV - different rates and time periods FV - different rates and time periods Multi-Period Case (incl. power of compounding) Annuities, Perpetuities - Simplifications Special Cases Effective Annual Rate APR and Loan Balance Risk and CF
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Timeline
Main issue is what value to place on a cash flow
When or time component (early part of the course) Uncertainty (risk-return latter part)
Importance is because we need to make apples-to-apples comparisons It is only possible to compare or combine values at the same point in time
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Timeline
A timeline is a linear representation of the timing of potential cash flows Drawing a timeline of the cash flows will help you visualize the financial problem Usually cash flows are assumed to be at the end of the period unless o/w stated By convention, inflows are positive and outflows are negative
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Present Value
Key insight is that a Rupee today is worth more than a Rupee tomorrow the Rupee today can be invested to earn interest which can be obtained along with the original Rupee invested (tomorrow)
Conversely one could ask how much is it worth to me today to have a Rupee tomorrow or How much do I have to put away today to get a Rupee tomorrow
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Present Value
The PV of a delayed payment is obtained by multiplying the payoff by the discount factor
Consider the following example
Suppose you receive Rs.1 tomorrow and the bank pays an interest rate of 15% (reward for waiting) , what is the PV? r is the rate of return, X (1+r)1 = 1 hurdle rate,
Future Value
If I had a Rupee today what is it worth tomorrow?
Consider the following example
Suppose you have Rs.1 today, the bank pays an interest rate of 15% (rate of return), what is the FV? 1* (1+r)1 = 1*(1.15)1 = 1.15
Discount rate (also called future value factor,
compound factor)
PV & FV
Present Value Value today of a future cash flow Future Value Amount to which an investment will grow after earning interest
Discount Rate Interest rate used to compute present values of future cash flows
One Period: PV
Consider the following example
Suppose you are offered an investment that pays Rs.12,000 in three years. If you expect to earn a 13% return, what is the value of this investment?
One Period: PV
Consider the following example
John Doe wishes to find the present value of Rs.1,700 that will be received 8 years from now; Johns opportunity cost is 8%
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One Period: FV
Consider the following example
Jane Farber places Rs.800 in a savings account paying 6% interest compounded annually. She wants to know how much money will be in the account at the end of five years
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Suppose an investment that promises to pay Rs.15,500 in one year is offered for sale for Rs.12,500. Your interest rate is 8%. Should you buy?
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0%
Multi-period Case
What happens when the number of period increases? FV = X* (1+r)t PV = X/(1+r)t
FV = PV * (1+r)t or PV = FV /(1+r)t
Consider a simple example
Multi-period Case
Consider the following example
Suppose you have a choice between receiving Rs.5,000 today or Rs.10,000 in five years. You believe you can earn 10% on the Rs.5,000 today. What should you do?
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Multi-period Case
Consider the following example
Suppose that Brealey invested in the initial public offering of the Myers company. Myers pays a current dividend of Rs.1.15, which is expected to grow at 40% per year for the next five years. What will the dividend be in five years?
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Multi-period Case
Consider the following example
Suppose we plan to save Rs.1000 today, and Rs.1000 at the end of each of the next two years. If we can earn a fixed 10% interest rate on our savings, how much will we have three years from today?
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Multi-period Case
Consider the following example (PV case)
You have an opportunity to invest in a business that will pay Rs.200,000 in year one, Rs.400,000 in year two, Rs.600,000 in year three and Rs.800,000 in year four. You can earn 12% per year compounded annually on a mutual fund that has similar risk. If it costs Rs.1.2 million to start this business, should you invest?
0 1 2 3 4
| 1.2 mil
| 200K
| 400K
| 600K
800K
Multi-Period Case
In general when you have multiple cash flows C0 ..CN, the PV of those Cash flows is
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Multi-period Case
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PV & FV
Only values at the same point in time can be combined or compared (time travel) When cash flows occur at different points in time they must be discounted or compounded appropriately To move cash flow forward compound it To compound cash flows, multiply the amount by (1 + r)n where r is the periodic interest rate and n is the number of compounding periods To move cash flow backward discount it To discount cash flows, divide the amount by (1 + r)n where r and n are as defined previously
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Growing perpetuity - A stream of cash flows that grows at a constant rate forever.
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If you can afford a Rs.400 monthly car payment, what is the maximum price of the car you can buy if the interest rates is 7% on 36-month loan
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What is the present value of a four-year annuity of Rs.100 per year that makes its first payment two years from today if the discount rate is 9%?
297.05
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Braden Company, a small producer of plastic toys, wants to determine the most it should pay to purchase a particular annuity. The annuity consists of cash flows of Rs.1000 at the end of each year for 10 years. The required return is 9%.
6417.66
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Ellen is 35 years old today and wants to begin saving for retirement from next year. At the end of each year until she is 65 she will save Rs.10,000 each year in a retirement account. If the account earns 10% per year how much would Ellen have saved at age 65?
1644940.27
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The PV of a growing annuity with the initial cash flow c, growth rate g, and interest rate r is
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In the Ellen example Suppose Ellen expects to salary to increase and so she plans to save 5% more each year - how much will she have saved by at age 65? All other details remain the same
2625491.98
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You have won the Rs. 30 Million state lottery. You have two options to claim the prize (a) 30 payments of 1 million starting today or (b)15 million lump-sum paid today If the interest rate is 8% which is the option you should choose (you are rational!)
a 11.26
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What is the value of a British consol that promises to pay 15 each year, every year until the sun turns into a red giant and burns the planet to a crisp? The interest rate is 10-percent
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How much would I have to deposit today in order to withdraw Rs.2,500 each year forever if I can earn 9% on my deposit?
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You want to endow a graduation party at IIMK. You want the event to be memorable and plan Rs.5,000 per year for ever for the party. If IIMK can invest at 7% year and the first party is a year from now how much will you need to donate to endow the party?
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The PV of a growing perpetuity with the initial cash flow c, growth rate g, and interest rate r is
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The expected dividend next year is Rs.1.30 and dividends are expected to grow at 5% forever; If the discount rate is 10%, what is the value of this dividend stream?
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If in the MBA graduation party endowment case you realize that the inflation rate will be 4% per year after the first year and that will also need to be factored in in your original donation amount what do you now have to donate. All other details remain the same.
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Your firm is about to make its initial public offering of stock and your job is to estimate the correct offering price. Forecast dividends are as follows
If investors demand a 10% return on investments for stocks of similar risk, what price will they be willing to pay? 32.81
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Special Cases
So far, we have computed either the PV or the FV of a stream of CF (unequal or equal) for a given number of time periods and interest rate Sometimes we know the present value or future value, but do not know one of the other variables we have previously been given as an input
For example, when you take out a loan you may know the amount you would like to borrow, but may not know the loan payments that will be required to repay it
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Special Cases
Consider the following example
Your firm plans to buy a warehouse for Rs.500,000. The bank requires you to pay 20% down payment and will lend Rs.400,000 to you for a 30-year time period at 9% annual rate of interest. What is your annual payment amount?
38934.54
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Special Cases
At times it may be necessary to compute the r (also called IRR) more on this later in the session but let us do an example Jane has just graduated and is offered a fantastic job at ABC investment corporation. She ponders but decides to set up her own business and asks them for funding. ABC lends her Rs.2 million with the agreement that she will pay back Rs.200,000 at the end of each year for the next 30 years. Assuming she fulfills her agreement what is the rate at which ABC has lent Jane the money? 9.5%
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Special Cases
Suppose ABC corporation gives Jane another option pay 200,000 in the first year and 4% more in perpetuity all other details remain the same. What is the rate that ABC is lending at (IRR)?
14%
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Special Cases
Consider the following example
Assume the total cost of a college education will be Rs.100,000 when Ms.Xs child enters college in 12 years. She has Rs.50,000 to invest today. What rate of interest must she earn on the investment to cover the cost of her childs education?
6%
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Special Cases
Calculating time T (or N) If we deposit Rs.20,000 today in an account paying 10%, how long does it take to grow to Rs.100,000?
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You invest Rs.100 for 3 years at 12% compounded semi-annually, what will your investment grow to at the end of that period
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So, investing at 12.36% compounded annually is the same as investing at 12% compounded semiannually
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Problem Solving
Mini case see word doc
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Problem Solving
Mini case see word doc
Problem Solving
Ms. Ann Chen receives an annuity of $550,payable once every two years The annuity stretches out over 20 years. The first payment occurs at date 2, that is, two years from today. The annual interest rate is 8%
2596
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Risk and CF
A safe Rupee is worth more than a risky one
It is also easy to watch what is done in class and convince yourself that you can do it, if needed There is no substitute for getting out the calculator, paper and pen and working out many, many problems from the book until you can do them correctly and quickly
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Thank you !
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