Author(s) : Joyan Joseph

MichiganX: FIN101x : Finance For Everyone -

Smart Tools for Decision Making
Related Programs: Corporate Financial Analysis : University of Michigan

–Joyan’s Notes–

January 12, 2020

Springer
Contents

Part I Introduction

1 Introduction to the Course . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

1.1 Why Finance? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Why Finance for Everyone? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.3 Pre-Requisites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.4 Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2 Conventions and Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.1 Convention - Timelines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

3 Future Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.1 Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.2 Why is $1000 Today is better than $1000 a year later . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3.3 Formalization of Future Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3.4 Future Value over multiple time periods - Power of Compounding . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3.5 Real Power of Compounding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

4 Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
4.1 Present Value for One Time Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
4.2 Present Value for Multiple Time Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
4.3 Power of Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Part II Applications

5 Annuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
5.1 What is Annuity? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
5.2 Annuity Future Value Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
5.3 Annuity - Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
5.4 Present Value of Annuity Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

6 Perpetuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
6.1 Perpetuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
6.2 Other Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Part III Advanced Applications

7 Application 1 - Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
7.1 Structure of a Loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
7.2 Some Interesting Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
7.3 Real World Twist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
7.4 Effective Annual rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
 VI

8 Application 2 - Paying for Tuition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

8.1 College Tuition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
8.2 Check your calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

9 Application 3 - Financial Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

9.1 Financial Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

10 Application 4 - Making Complex Simple . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

10.1 Making Complex Simple . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
10.2 Verify the Calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Part IV Special Application - Bonds

11 Special Application - Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

11.1 What is a Bond? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
11.2 Structure of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
11.3 Government Bonds - Zero Coupon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
11.4 Government Bonds - Yield to Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
11.5 Coupon Paying Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
11.6 Bond Price versus Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
11.7 Real World Bond Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Part V Special Application - Stocks

12 Special Application - Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

12.1 Stocks Versus Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
12.2 Stocks - Some Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
12.3 Pricing a Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
12.4 Pricing a Stock - Dividend and Growth Stocks - Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
12.5 Stocks - Real world Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Part VI Wrap Up What Next?

13 Wrap Up What Next? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

13.1 Lessons from this course . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
13.2 Personal Investing - Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Introduction

This course - MichiganX: FIN101x - Finance For Everyone - Smart Tools for Decision Making - is designed to
teach basics of financial decision making to absolute beginners. Given below is an except for course introduction
from the instructor.
"This offering of the course launched on Tuesday, June 27, 2017. I have been teaching for several years at Ross
School of Business, University of Michigan and to all kinds of audiences, including undergraduates, MBAs, PhDs
and executives all over the globe. Most pertinently, I offered a MOOC titled "An Introduction to Finance" nine
times over the past three years and have been fortunate to reach out to all types of learners across the entire
globe. More than 850,000 learners enrolled for the course. Thanks to overwhelming support for that effort and
consistent feedback to provide a course that was more accessible to a beginner, I have decided to create the
Finance for Everyone course. The feedback from learners had two regular themes: the majority of the learners
wanted the 15-week MOOC to be more modular (that is, of a shorter duration) and more accessible to a begin-
ner. I have therefore created a six-week long course that introduces you to finance at a more basic level. I have
also recently launched an XSeries with a colleague on edX that is a much broader exposure to finance and more
advanced as well. A smaller proportion of learners, but nevertheless a large number, wanted more advanced
content and I have therefore launched a multi-course Specialization as well on a different (Coursera) platform
where my original MOOC was hosted.."
Introduction

This course - MichiganX: FIN101x - Finance For Everyone - Smart Tools for Decision Making - is designed to
teach basics of financial decision making to absolute beginners. Given below is an except for course introduction
from the instructor.
"This offering of the course launched on Tuesday, June 27, 2017. I have been teaching for several years at Ross
School of Business, University of Michigan and to all kinds of audiences, including undergraduates, MBAs, PhDs
and executives all over the globe. Most pertinently, I offered a MOOC titled "An Introduction to Finance" nine
times over the past three years and have been fortunate to reach out to all types of learners across the entire
globe. More than 850,000 learners enrolled for the course. Thanks to overwhelming support for that effort and
consistent feedback to provide a course that was more accessible to a beginner, I have decided to create the
Finance for Everyone course. The feedback from learners had two regular themes: the majority of the learners
wanted the 15-week MOOC to be more modular (that is, of a shorter duration) and more accessible to a begin-
ner. I have therefore created a six-week long course that introduces you to finance at a more basic level. I have
also recently launched an XSeries with a colleague on edX that is a much broader exposure to finance and more
advanced as well. A smaller proportion of learners, but nevertheless a large number, wanted more advanced
content and I have therefore launched a multi-course Specialization as well on a different (Coursera) platform
where my original MOOC was hosted.."
 Part I

Introduction
1

Introduction to the Course

1.1 Why Finance?

This course is meant as an introduction to finance for beginners. At the bottom of it, finance is a study of value.
It is not study of money. By value , we mean the impact of any action we take. When you make a decision
today, it has an impact on future. We use building blocks of finance to understand this decision making. Key
components of such a decision making are two. One is Time and the other is Uncertainty.When you make
a decision, you are exercising choices. The choice you made has an impact in future. You need to consider
that future impact today to evaluate if that choice is a good one. This is the fundamental value proposition
of finance, it helps you understand value of time. Also, Finance is not just conceptual. It makes applications
very much practical, which can be used in real life decision making. No matter what you do in life, finance,
though it’s value analysis, is a process which help you make good choices at the time at which you are making
decisions.

1.2 Why Finance for Everyone?

This course, as stated earlier is intended as an introduction to Finance. Aim is to teach everyone about finance.
When we say "to teach everyone" , the course must be modular and handle only basic stuff. This course, compares
to it initial offering is 6 weeks instead of 15 weeks and do not demand people knowing stuff ahead of learning it.
People also look for a more detailed study after this and that can be accesses in coursers under this Specialization

Note : I am skipping the section on the "process" of the course and "Philosophy of learning", as they are more
about the nature of course than about content of the course.

1.3 Pre-Requisites

Finance is very structured and this structure is applied to real world problems. Hence the learner should be able
to handle number, algebra and problem solving. As you go alone, need to get more understanding of Microsoft
Excel. Lastly the person should be willing to dedicate time get in to details.

1.4 Expectations

As this course is played for varied audiences across world, with various kind of economies around them, there
are a few basic assumptions made. This assumptions are called out to make it very clear about differences in
economies.
1. Competitive markets : Assumption is that for most parts, there is competition in markets, competition
in financial investments etc... To understand the finance and its depth and beauty, you need competitive
markets.
 6

2. Less Friction : Frictions in economic systems are small compared to power of good ideas. This means not
high taxes, no high fee for starting something etc... If there are such frictions in abundance, then value
proposition becomes questionable. Over a period of time, frictions are reducing globally.
3. Capital flow easily. If there is artificial interest rates and fees, then capital flow will be affected, affecting
financial situations.
2

Conventions and Assumptions

In this part of the course we will study the Time Value of Money (TVM) and its related concepts.This course
is about decision making with finance in consideration.

• Virtually every decision will affect you in future.

• Very important decision will affect you more significantly and for longer.
• Due to this we need to understand how passage of time affects the decisions we make and its effects.

2.1 Convention - Timelines

You make a decision at time zero and it affects you at time one. Generally time 1 means end of Time period
one. In beginning we start with one period. Generally most decisions affect more than one period. So later we
will extend it to more periods. As you can see in picture below (Fig2.1), point in time is 0 and 1 and time period
is time between these points 1 and 0.

Fig. 2.1. Time Periods - Simple representation

2.2 Terminology

There are a few terminologies we will use for explaining time value of money. These terminologies are general
lingo of finance and used worldwide in financial information.
1. Present Value - PV : Value of an item at point in time zero. Generally measured in a currency.
2. Future Value - PV : Value of an item at point in time 1 ( or any future period). Generally measured in
a currency.
3. Number of Periods - n . Number of periods in our scenarios. Measured as a number. Period could be
days, weeks, months, years or any such units of time. Whichever be the unit of time, number of periods is
a number measured.
4. Interest Rate - r . Rate of return from an investment of money. It is generally positive ( assumption).
There are times it can be negative, but for the general discussion of this course, it is considered as positive.
This rate is generally measured as a percentage (%).
5. No Explicit Risk : In any financial investment, there is a risk involved. However, for general discussion of
this course, although there is a implicit risk, no explicit risk will be considered for calculations.
3

Future Value

A dollar today is worth more

than a dollar tomorrow

Unknown

If somebody says you that they will give you $1000 today or $1000 a year from now, your obvious choice will
be $1000 today. This is because of Time Value of Money. If you take $1000 and deposit it in a bank, bank will
provide you interest for an year and the value of that $1000 after 1 year is more than the offer of $1000 after
an year from someone.

3.1 Rate of Return

Assume that somebody has given you $100 today and you deposited it in bank. Bank gives you $102 after a
period of time ( Time 1). Your rate of return is 2%. This is calculated by below formula.

Future Value − Present Value

Rate of return = ∗ 100 (3.1)
Present Value

Below picture note (Fig3.1) clearly explains this with an example.

Fig. 3.1. Interest Rate Calculation

 10

3.2 Why is $1000 Today is better than $1000 a year later

Assume that you have two offers. Offer A : $1000 today or Offer B : $1000 a year later. Let’s assume that bank
interest rate for an year is 10%.

Present Value of offer A (at time point 0) : $1000

10
Future Value of offer A (at time point 1) : $1000 + $1000 * = $1100
100

Offer B is not valid time time point 0.

Future Value of offer B (at time point 1) : $1000

Obviously offer A is better. This is a very intuitive example. However it states the importance of passage of
time.

3.3 Formalization of Future Value

Future value has two components. Initial payment and Accumulated interest.

Future Value = Present Value + Accumulated interest (3.2)

This can be represented as

F =P +P ∗r (3.3)

where r is the interest rate.

We can rewrite the equation as,
F = P ∗ (1 + r) (3.4)

(1+r) is called Future Value Factor - FVF. Simply stated, it is the future value of one dollar for a period of
time in future for which interest rate is r%.

3.4 Future Value over multiple time periods - Power of Compounding

Assume that you have $1000 in bank and you keep it there for 2 years. Interest rate is 10% annually. Here,
if we consider one year as unit of time, there are two time periods. Period 1 and Period 2. At end of period
1, you have $1100 with you as future value. At end of time period 2, you have $1210 available in your bank
account.

F (at end of time period 1) = P ∗ (1 + r) (3.5)

Total Value of money you have at end of time period 1 = P * (1+r)

F (at end of time period 2) = P ∗ (1 + r) ∗ (1 + r) = P ∗ (1 + r)2 (3.6)

If the calculation is over n time periods, the amount will become

F (at end of time period n) = P ∗ (1 + r)n (3.7)

For our example of , After 2 years , the amount is = 1210.

For same example, if period is 10 years, then the amount is $2593.74

We can do the same calculation in Microsoft Excel using Function "FV"

11

FV Syntax : FV(rate,nper,pmt,[pv],[type])
• Rate : Required. The interest rate per period.
• Nper : Required. The total number of payment periods in an annuity.
• Pmt : Required. The payment made each period; it cannot change over the life of the annuity. Typically,
pmt contains principal and interest but no other fees or taxes. If pmt is omitted, you must include the pv
argument. Note that, since you are not making any payments at start or end of each period other than
initial amount, this is zero for our example.
• Pv : Optional. The present value, or the lump-sum amount that a series of future payments is worth right
now. If pv is omitted, it is assumed to be 0 (zero), and you must include the pmt argument. For our example,
it is $1000.
• Type : Optional. The number 0 or 1 and indicates when payments are due. If type is omitted, it is assumed
to be 0. 0 means payment is due at end of the period and 1 means payment is due at start of each period.
When you use this formula in Excel, you may get a negative value for FV. This is because, you entered positive
value for PV. At any point in time, you are either the person depositing in bank or the bank itself, you can not
be both. So when you deposit money in bank, you are losing your money (outflow) and bank is gaining money
(inflow). If you considered this outflow as negative ( i.e. PV as negative), then inflow to you at end of 10 years
must be positive, adding money to you.
If you did not have this compounding of interest, at end of 10 years, you will get only $2000. This is 25% lesser
than what you will get with compound interest.

3.5 Real Power of Compounding

To see the real power of compounding, see the below question.

Question : What are the future values of investing $1000 at 5% versus 15% for 90 years.
Answer : We have done below calculation in excel (Fig 3.2).

Fig. 3.2. Power of Compounding

Rate Initial Investment Years Future Value

5% 1000 90 ($80,730.37)
15% 1000 90 ($290,272,325.21)

You can see that the difference between these two interest rates for the same initial investment and same number
of years. There are two reasons for this difference. One is the number of years. That is with each year passing,
the amount and the compounded value till then, gets compounded again. Second is the difference in the rate at
which it compounds, i.e. the interest rate. 15 and 5 mentioned here has a significance. We have reliable values of
Stock market and bank deposit returns in USA for last 90+ years. And 5% is the average bank deposit interest
rate. 15% is the return from high risk stocks , if done right.
4

Present Value

A dollar today is worth more

than a dollar tomorrow

Unknown

4.1 Present Value for One Time Period

Question : What is the present value of $1000 given to you after one year. Interest rate is 10%.
You normally make decisions which will have impact in future now. That is, at present. Normally we calculate
the returns of our investments in future. We need t bring them to "now" to decide if that result in future is
good enough to make a decision in favor of such an investment. For this we need to calculate the present value
of future cash/money.
As we know,

Future Value = Present Value + Accumulated interest (4.1)

and

F = P ∗ (1 + r) (4.2)

This means
F
P = (4.3)
(1 + r)

1000
By this equation, the PV of our question is = $990.099. This is intuitive. Present value of $990 is as
1 + 0.1
good as getting $1000 in future.

4.2 Present Value for Multiple Time Period

Question : What is the present value of $1210 that you will inherit after two years? Interest rate is 10%.
Now we have two time periods. At end of time period 2, you have $1210 with you. Let’s time travel to end of
1210
time period one, that is at end of year 1. The present value at end of time period 1 is = $1100. Now
1 + 0.1
1210
(1+0.1)
what is the present value at start of time period 1, that is now? It is = $1000 This can also be stated
(1 + 0.1)
1210
as = $1000
(1 + 0.1)2

So, for n time periods,

 14

F
P = (4.4)
(1 + r)n

This division of future value by interest rate to get present value is called Discounting.
We can do the same calculation in Microsoft Excel using Function "PV"

PV Syntax : PV(rate, nper, pmt, [fv], [type])

• Rate : Required. The interest rate per period.
• Nper : Required. The total number of payment periods in an annuity.
• Pmt : Required. The payment made each period; it cannot change over the life of the annuity. Typically,
pmt contains principal and interest but no other fees or taxes. If pmt is omitted, you must include the fv
argument. Note that, since you are not making any payments at start or end of each period, this is zero for
our example.
• Fv : Optional. Optional. The future value, or a cash balance you want to attain after the last payment is
made. If fv is omitted, it is assumed to be 0. For our example, it is $1210.
• Type : Optional. The number 0 or 1 and indicates when payments are due. If type is omitted, it is assumed
to be 0. 0 means payment is due at end of the period and 1 means payment is due at start of each period.

4.3 Power of Discounting

Question : What are the present values of $ 1 billion received 50 years from now, now, for 5% and 15% rate of
return ?
Answer : We have done below calculation in excel (Fig 4.1).

Fig. 4.1. Power of Discounting

Rate Future Give Years Present Value

5% 1000000000 50 ($87,203,726.97)
15% 1000000000 50 ($922,800.84)

This means, if you have real ways to make a 15% return, year after year consistently, the seed money needed
now to achieve a huge amount in future is very less.

Problems

4.1. Time Value

$400 today is worth the SAME as $400 tomorrow.
(a) True
(b) False
Solution

4.2. Future to Present

At an interest rate of 11% it is better to have $250 today than $500 in 8 years.
15

(a) True
(b) False
Solution

4.3. Present to Future

Shawn wants to buy a new telescope. He estimates that it will take him one year to save the money and that the
telescope will cost $350. At an interest rate of 5%, how much does Shawn need to set aside today to purchase
the telescope in one year?
Solution

4.4. Save
Jeff has $1,000 that he invests in a safe financial instrument expected to return 3% annually. Marge has $500
and invests in a more risky venture that is expected to return 8% annually. Who has more after 25 years? And
how much does he/she have in FV terms?
(a) Marge; $3,424.24
(b) Marge; $36,552.97
(c) Jeff; $2,093.78
(d) Jeff; $36,459.26
Solution

4.5. Old Money

Don has just received a cash gift of $65,000 from his rich eccentric uncle. He wants to set it aside to pay for his
daughter Cynthia’s college education. Cynthia will begin college in 14 years and Don’s financial advisor says
that she can earn 7% interest on an investment in a special college fund. How much will Don have in the fund
when Cynthia begins college?
Solution
 Part II

Applications
5

Annuity

5.1 What is Annuity?

In previous chapters we learned about future value of a single payment at time 0. This is a very simple case. In
real life, people make investments periodically. Every year , month or so. Annuity is a case of payments across
multiple period. Basic structure of an annuity is that at end of period 0, you do not make any payment. At
end of every period after this, you make a payment (denoted as C or PMT) of equal amounts, for next n time
period. At end of nth time period, you collect all money including interest earned. Money paid in earlier periods
are compounded more due to the time value of money. See below table which shows the Period, the amount
paid and future value of the amount, where n is 3 years.

Year(End of period) Cash Flow (C) Years to End : n Future Value

0 0 3 0
1 C 2 C ∗ (1 + r)2
2 C 1 C ∗ (1 + r)
3 C 0 C
Table 5.1. Annuity - Total Future Value Calculations

This is another way of representing time line in a straight line. Now we can calculate the total value of Annuity
as in below formula.

F VAnnuity = 0 + C ∗ (1 + r)2 + C ∗ (1 + r) + C (5.1)

This can be rewritten as

F VAnnuity = C ∗ ((1 + r)2 + (1 + r) + 1) (5.2)

(1 + r)2 + (1 + r) + 1 is called Future Value Annuity Factor (FVAF). It is a function of interest rate (r) and
 

number of years (n).

F VAnnuity for n periods will be

F VAnnuity = C ∗ ((1 + r)n−1 + (1 + r)n−2 + ... + (1 + r)2 + (1 + r) + 1) (5.3)

FVAF for n periods is ((1 + r)n−1 + (1 + r)n−2 + ... + (1 + r)2 + (1 + r) + 1). This can be mathematically deducted
to following Formula.

1 
∗ (1 + r)n − 1

F V AF (r, n) = (5.4)
r
If your payment C is not constant, then F VAnnuity will be calculated by below formula. Here Cn is the payment
at end of nth period.
F VAnnuity = C1 ∗ (1 + r)n−1 + C2 ∗ (1 + r)n−2 + ... + Cn−2 ∗ (1 + r)2 + Cn − 1(1 + r) + Cn ) (5.5)

Please note that the what is described in above table is a commonly accepted structure of an annuity. However,
this structure can be altered. Some annuities may have a payment in year 0 and no payment in year n.
 20

5.2 Annuity Future Value Examples

Question 1 : What will be the value at your bank account if you deposit $1000 every year and you plan to
leave home at end of 5th year? Interest rate is 5%.

Year(End of period) Cash Flow (C) Years to End : n Future Value Result
0 0 5 0 0
1 1000 4 1000 ∗ (1 + 0.05)4 1215.50625
2 1000 3 1000 ∗ (1 + 0.05)3 1157.625
3 1000 2 1000 ∗ (1 + 0.05)2 1102.5
4 1000 1 1000 ∗ (1 + 0.05) 1050
5 1000 0 1000 1000
Table 5.2. Annuity - Example

Total at end of fifth year will be $5525.63125. If there is zero interest rate, saving at end of fifth year will be
5000. So the $525 is the savings from the compounding! You can also calculate this by using the excel function
FV.

= F V (0.05, 5, −1000, , 0) = $5525.63125 (5.6)

Here we marked yearly payment as negative (-1000) as you are parting with your money. End amount in the
account is positive as you can claim that money.
Question 2 : How much will be in your bank account 50 years from now, if you deposit $1000 every year at
an interest rate of 5% or 15%.
Now, in this example, both the number of years and compounding works together to give you big results.
Using Excel :

F V @5% = F V (0.05, 50, −1000, , 0) = $209, 347.99572 (5.7)

F V @15% = F V (0.15, 50, −1000, , 0) = $7, 217, 716.27723 (5.8)

As you can see, high interest rate over large number of years has produced a value way above original amount
invested!

5.3 Annuity - Present Value

Now, lets calculate present value of future payments to an Annuity in future. We will take the same 3 year
example.

Year(End of period) Cash Flow (C) Years to Discount : n Present Value at end of time Zero
0 0 0 0
C
1 C 1
(1 + r)
C
2 C 2
(1 + r)2
C
3 C 3
(1 + r)3
Table 5.3. Annuity - Total Present Value Calculations

Note that when you make a payment of 1000 at end of period 1, it has a PV at end of period 0 which is
C
.
(1 + r)
21

C C C
P VAnnuity = 0 + + 2
+ (5.9)
(1 + r) (1 + r) (1 + r)3

This is same as

h 1 1 1
P VAnnuity = C ∗ + 2
+ (5.10)
(1 + r) (1 + r) (1 + r)3

Present Value Annuity Factor (PVAF) is the factor by which payment(C) is multiplied to get PV.

P VAnnuity = C ∗ P resentV alueAnnuityF actor (5.11)

If we do the same calculations for n years,

C C C C
P VAnnuity = + 2
+ 3
+ ... + (5.12)
(1 + r) (1 + r) (1 + r) (1 + r)n

PVAF for n periods will be

1 1 1 1
P V AF = + 2
+ 3
+ ... + (5.13)
(1 + r) (1 + r) (1 + r) (1 + r)n

This can be summarized to

" #
1 1
P V AF = ∗ 1 − (5.14)
r (1 + r)n

If the payments are not equal amounts, PV will be

C1 C2 C3 Cn
P VAnnuity = + 2
+ 3
+ ... + (5.15)
(1 + r) (1 + r) (1 + r) (1 + r)n

5.4 Present Value of Annuity Examples

Question : How much money you must have in bank now, if you need to spend $3000 every year for next 4
years? Interest rate is 5
If the interest rate is zero ( i.e, money has no time value), we all know that you need to have $12000 (4 * 3000)
in your bank account. However, money in bank will accrue interest and hence you need not have $12000, right
now in bank. Interest, in due course of time will replenish a part of money needed. In excel you can calculate
this by PV(0.05,4,3000„0) = -$10,637.85. I have used positive sign for the money you get every year. Hence
the money you need to deposit now in bank comes out as negative. (You have to follow one consistent notation
for the money leaving you and reaching you. I have marked money that leaves me as negative and money I get
as positive.)
Question : You plan to attend an in-state college and your parents will take out a loan for $100000, to be
repaid in 5 years, at 6% interest. What are the yearly payments?
Just like last question, if there is no interest rate, the payment amount yearly will be 100000/5 = $20000.
However, since the money that bank gave you has a time value, you need to pay more. Excel has a function
PMT to find this payment yearly.
PMT Syntax : PMT(rate, nper, pv, [fv], [type])

Going by this : PMT(0.06, 5, 100000„ ,) : -$23,739.64.

6

Perpetuity

6.1 Perpetuity

Perpetuity , is a set of equal payments, that is paid forever, with or with out growth. You can see a pictorial
representation of it below (Fig6.1).

Fig. 6.1. Perpetuity

As you can see, you are getting a payment for every period. This may look a complex problem to calculate
present value of a perpetuity. However, if you notice, as you go in to more future periods, the present value
reduces more. Higher the interest rate and more in future the period is, the lower will be its contribution to
present value. Formal equation for present value of such a perpetuity is as below.

C C C C C
P VP erpetuity = + + + ... + + + ...∞ (6.1)
(1 + r) (1 + r)2 (1 + r)3 (1 + r)n (1 + r)n+1
C
PVP erpetuity = r

We can verify this by a simple example. Let’s assume that you have a perpetual payment of $100 for next 30
years. Interest rate is 10%. The Present value of such an annuity is PV(0.1,30,-100) = $942.69. Now let’s assume
that, this is a perpetuity. The PV will be 100/0.1 = $1000. You can see how close the values are.
There are various applications to perpetuity. Annuity is a case where you have a definite period. For e.g. a
Loan. In England there is a financial instrument called Consol, that pays you fixed amount every year and you
can buy it. But the most common example of perpetuity is Stock. Stocks is ownership in a company. Once you
buy a stock and based on company’s performance, you will get a specific payment every year (it could be equal
payments every year or not). This payment is called dividend. If the stock you own is a growth stock, you may
get dividend at an increasing rate. Say the rate at which annual payments increase is g ( g for growth), then
the formula for PV is
C
PVP erpetuity = (r−g)

This equation is applicable as long as growth rate of the stock is lesser than interest rate.

6.2 Other Equations

Below are some more formulas used for calculation of PV and FVs.
 24

Present Value of an Annuity growing at rate g:

" #
1 (1+g)n
PVAnnuity = C ∗ P AF (r, n, g) = C ∗ r−g ∗ 1− (1+r)n

Problems

6.1. Use vs Save

Bridgette’s grandparents opened a savings account for her and placed $600 in the account. The account pays
6.0% interest. Bridgette wants to be a singer and she has her heart set on a new karaoke machine. The machine
costs $150. How much less will the account be worth in 9 years if she buys the karaoke machine now versus
leaving the account untouched?
Soultion

6.2. Loan and Savings

Joe is getting ready to buy a car. He has $24,000 in investments earning 5.3% annually. The car also costs
$24,000. If he doesn’t pay cash for the car, Joe can get a loan at 3.1% interest for 4 years. The loan is structured
so that Joe pays one balloon payment at the end of 4 years. The balloon payment includes the principal plus
all interest accrued over 4 years. If Joe takes the loan will he have enough money available from his investments
to make the balloon payment? How much will he be short/have to spare?
Soultion

6.3. Break even

Ralph knows that he is going to have to replace his roof soon. If he has the roof replaced now, it will cost
$17,000. He could wait 5 years, but it will then cost him $28,000. At what rate will these options cost the same?
This is also known as the break-even point.
Soultion

6.4. Financial Decision

Jessica is in the market for a new car. She has narrowed her search down to 2 models. Model A costs $27,000
and Model B costs $17,000. With both cars she plans to pay cash and own them for 4 years before trading in for
a new car. Her research indicates that the trade in value for Model A after 4 years is 54% of the initial purchase
price, while the trade in value for Model B is 43%. Jessica has no emotional attachment to either model and
wants to make a strictly financial decision. The interest rate is 6%. For simplicity assume that operating and
maintenance costs for the models are identical every year. Which model is the better decision and how much
"cheaper" is it than the alternative?
Soultion

6.5. College Tuition

College tuition has been rising at a rate of 4% per year. Currently the average tuition of a state college is $11,700
per year. Andrea’s son Trevor will begin college in 10 years. Andrea’s portfolio is making 2% annually. How
much does Andrea need to have set aside today/now to pay for 4 years of college for Trevor? (Note: Tuition
will continue to change annually and Andrea’s portfolio balance will continue to accrue interest while Trevor is
in school. Also, tuition is due at the beginning of each year.)
Soultion

6.6. Increasing Maintenance Payments

Christine is a new homebuyer. She wants to make sure that she incorporates the cost of maintenance into her
decision. She estimates that routine repairs and maintenance on the home she is considering will be $1,700 in
the first year (one year from now). Due to the increasing age of the home, she expects that maintenance costs
will increase 2% annually. The interest rate is 6%. If she plans to be in the home for 10 years, what is the present
value of all future maintenance? (Note that maintenance costs will change annually, and starts one year from
now and she plans to do the last one before selling her house.)
Soultion
 Part III

Advanced Applications
7

Application 1 - Loans

7.1 Structure of a Loan

When you take a loan for, say 5 years, from a bank, Bank do not decide monthly payments just by multiplying
loan element with interest rate and number of years and adding it to loan amount and divide it to yearly equal
amounts. Instead it calculates the annual payments by considering time value of money.

Assume that you have taken a loan of $100,000 from a bank wit annual interest rate of 6%. If you do not
consider time value of money, it will be like below.
Annual interest for $100,000 = 6% * $100,000 = $6,000
Total interest for 5 years : 5 * $6,000 = $30,000

Total Amount to be paid back = $100,000 + $3,000 = $130,000.

Yearly payment = $130,000/5 = $26,000.

If you consider time value of money, the payment will be calculated as

PMT Syntax : PMT(rate, nper, pv, [fv], [type])

SO, PMT(0.06, 5, -100000) = $23,739.64.

See the structure of loan below (Fig7.1). Yo will see that you pay more interest initially as the principal is more.
You do not need to pay that much interest as you pay payback part of principal every year.

Fig. 7.1. Structure of Loan

 28

7.2 Some Interesting Questions

In this section, we will answer some interesting questions to the structure of a loan to understand the time value
of money.
Question 1 : What is the amount that you owe to the bank after paying second annual payment.

One way to find this is by calculating yearly amounts for each year as per the table in Fig7.1). However, if
you think about it, the payment is the amount that remains to be paid in 3 years with an annual payment
of 23739.64. Now the value of this amount at start of 3rd year is equivalent to a present value of annuity (
with interest rate 6% and annual equal installments of 23739.64. So this amount is PV(6%, 3, 23739.64) =
63456.34.
Question 2 : What is the interest component of annual payment in 3rd year.

Since we already calculated the total amount that we owe to the bank at start of year 3, the interest component
of that is 6% of the amount we owe. So it is 63456.34 * 6% = 3807.38.

7.3 Real World Twist

Question : You plan to attend the the college and you borrowed $100,000. What will be your monthly payments
if the annual interest rate is 6%?

Here 6% is the stated annual rate. If you are paying monthly this interest rate becomes 0.06/12 = 0.005.
Now the monthly payments can be calculated as PMT(0.06/12, 12*5 , 100000). This comes to $1,933.28. Recol-
lect from the previous examples that for a similar loan, for annual payments the yearly payment is $23,739.64.
Even if if you multiply $1,933.28 by 12, you will get $23,199.36. Why do we have difference? - This difference is
due to the monthly payment. as you pay monthly, net money you owe reduces monthly, it reduces the interest
you need to pay for say remaining 11 months in the year or 10 months in year and so on. IF you pay monthly,
time value of your prepayment makes your payment amount smaller than yearly payment.

See Fig7.2) to see the amortization table.

7.4 Effective Annual rate

In the above example of monthly payments the stated annual interest rate is 6%. Even in monthly payments,
we considered it to be same by dividing it by 12. However, the interest amount that you pay at end of month
one has more value than if you pay it at end of 12 months, due to time value of money. Effective interest rate
is the restive rate that you pay annually for monthly payments with a stated interest rate. It can be calculated
by the formula,

" #k
r
Effective Rate = 1 + −1 (7.1)
k

where r is the stated interest rate for a duration and k is the number of periods of payments in that stated
interest rate duration.

For 1 dollar you loaded, you pay monthly interest of r/k. For 12 monthly, this becomes raised to power of 12.
You take 1 dollar from it, you will get the effective interest rate.

In our case, this becomes , this becomes 0.06168, slightly more than 6%.
29

Fig. 7.2. Monthly Payments

8

Application 2 - Paying for Tuition

8.1 College Tuition

In this chapter, we are discussing second application, Tuition payments. The question of this application is as
below.
Question : College tuition has been rising at a rate of 2.50% per year. Currently the average tuition of a state
college is $10,000. Emilia’s daughter Jessica will begin college in 5 years. Emilia’s portfolio of savings is making
5% annually.How much does Emilia need to have set aside today to pay for four years of college for Jessica
This problem is a bit more complex than present value and future value problems handled in previous chapters.
A similar problem is solved, with rote calculations and goal seek functionality in problems at end of Part
2.
First step in solving this problem is to draw a time line. You start at Time zero. At end of time line 4 and
start of time period 5, you need to start paying for tuition (Tuition amounts are ganenerally paid at start of the
year). As of Today (start of time period 0) the tuition amount is $10000. This is increasing at 2.5% per year.
2.5 5
Tuition amount at start of year 5 will be $10000 * (1 + 100 ) = $11314.08.
For each subsequent year till start of year it it will be 11596.93, 11886.86, 12184.03. Present value of these 4
cash requirements at start of year 5, or end of year 4 is calculated using present value calculations. Since each
year’s amount is not same, we can not use PV function in Excel. We need to use another function NPV (Net
Present Value).

NPV Syntax : NPV(rate,value1,[value2],...)

For our case, Present value of these 4 cash requirements at start of year 5,or end of year 4 will be NPV(.05,
11314.08, 11596.93, 11886.86, 12184.03 ) = $41,586.22
Now $41,586.22 the amount needed at end of year 4 for Emili to send her daughter to college. How much does
she need to save today (start of year 0) and put in to her savings portfolio to have $41,586.22 at end of year 4?
That is PV(0.05, 4, , 41586.22) = $34,213.09.
See Fig8.1 to see how this calculation is done visually.

Fig. 8.1. Saving for Tuition Fee

 32

8.2 Check your calculations

You can check if the answer you obtained is correct by applying it to a payment structure. Fig8.2 explains how
the portfolio builds up till 5th year and then gets utilized while continuing to build up during college tuition
payment years.

Fig. 8.2. Saving for Tuition Fee

9

Application 3 - Financial Planning

9.1 Financial Planning

In this chapter, we are discussing third application, Financial Planning for retirement. The question of this
application is as below.
Question : Abebi, who has just celebrated her 25th birthday, plans to retire on her 55th birthday. She has just
set up a retirement fund to pay her an annual income starting on her retirement date, And to continue paying
for 20 more years. Abebi has committed to set aside equal investments at the end of each year for the next 29
years, starting on her 26th birthday. If the annual interest rate is 5%, how big should Abebi’s equal investments
be?
Answer : Time period zero in this question is 25th birthday of Abebi. She is going to make her first payment
in time period 1, which is her 25th birthday. She is going to retire on her 55th birthday, which is period 30. Her
last payment to retirement fund will be when she turns 54, that is period 29. This is the timeline of saving for
retirement.
Now there is another timeline running. That is when she lives in retirement. It starts at her 55th Birthday and
that is period 1, when she receives her first payment of $50,000. Now she continue to receives for 20 more years,
making it a total of 21 periods of payment. You can calculate present value of these 21 payments. And that will
be the present value at her 54th Birthday, one period before her retirement at 55th birthday. PV(0.05,21,50000),
which will be $641,057.64. Now this is the amount she need to have on her 54th birthday to retire on 55th
birthday.
Now, this is the total amount she need at end of her savings timeline ( which is equal payments from her
26th birthday to 54th birthday. So that is the future value of the savings timeline, with 29 periods ( 26 to 54).
Now equal yearly payment for this can be calculated using PMT function. PMT(0.05, 29, 0, -641057.64 ) =
$10,286.10. This is the amount Abebi need to save every year.
10

Application 4 - Making Complex Simple

10.1 Making Complex Simple

In this chapter, we are discussing fourth application, which is, again a case of education. The question of this
application is as below.
Question : You’ve invested $75,000 in a trust fund at 7.5% for your child’s education. Your child will draw
$12,000 per year from this fund for four years starting at the end of year seven. What will be the amount that
will be left over in this fund at end of year ten, after the child has withdrawn the fourth time?
Answer : One way of Answering this question is doing this in long way where you calculate the growth of trust
fund year by year and then subtracting the payment for education from end of 7th year onwards. However,
there is an easier way if we decouple the savings from trust fund and the expenses in eduction.
Lets first look at the savings in the trust fund. It grows year on year at 7.5% annually, compounded. If there is
no spend for eduction , at end of 10th year, you will have certain mount in it. It will be FV(0.075, 10, 0, -75000)
= $154,577.37.
Now consider the payments for education. You pay $12,000 every year from end of 7th year to end of 10th year.
If you consider value of this payment at end of 10th year, it will be FV(0.075, 4, 12000) = -$53,675.06.
At end of 10th year, if you subtract these two values you will get the next balance in the trust. 154,577.37 -
53,675.06 = 100, 902.30.Lookatthevalue.Evenaf terpaying4yearsof theeduction, youstillhavemorethan$100, 000lef tinthef un

10.2 Verify the Calculations

Let us now verify that our calculation is correct. We will enter year by year values of trust fund and eduction
payment and see the balance at end of 10th year.
See Fig10.1 to see how this calculation is done visually.

Problems

10.1. Purchasing First House

Melanie and Stephen Jackson are purchasing their first house. The house costs $340,000. They have put a 10%
down payment (that is, an amount that banks should require you to pay out-of-pocket), but will therefore
finance the rest. They are considering a fixed rate 15-year mortgage at a 7.00% APR with monthly payments.
How much will the Jacksons’ first monthly payment be?
Soultion

10.2. Financial Plannning

Abebi, who has just celebrated her 31st birthday, will retire on her 59th birthday, and she has just set up a
retirement plan to pay her income starting on her retirement day, and to continue paying for 19 more years.
Abebi’s goal is to receive $130,000 for each of these twenty years. In creating her retirement account, Abebi
has committed to set aside equal investments at the end of each year, for the next 27 years starting on her
 36

Fig. 10.1. Trust Fund and Education

32nd birthday. If the annual interest rate is 7%, how big should Abebi’s equal investments be? (Enter just the
number in dollars without the $ sign or a comma and round off decimals to the closest integer, i.e., rounding
$30.49 down to $30 and rounding $30.50 up to 31.)
Soultion

10.3. Buying a Car

Two years ago Abilia purchased a $12,000 car; she paid $2,000 down and borrowed the rest. She took a fixed
rate 60-month installment loan at a stated rate of 7.0% per year. Interest rates have fallen during the last two
years and she can refinance her car by borrowing the amount she still owes on the car at a new fixed rate of 4%
per year for 3 years. Should Abilia refinance her loan? How much will she save per month for the remainder of
the loan life if she decides to refinance?
Soultion

10.4. Refinance your Mortgage

You have been living in the house you bought 9 years ago for $350,000. At that time, you took out a loan for
80% of the house at a fixed rate 25-year loan at an annual stated rate of 9.5%. You have just paid off the 108th
monthly payment. Interest rates have meanwhile dropped steadily to 3.5% per year, and you think it is finally
time to refinance the remaining balance over the residual loan life. But there is a catch. The fee to refinance
your loan is $5,500. Should you refinance the remaining balance? How much would you save/lose if you decided
to refinance?
Soultion

10.5. Options for Buying a Car

You are interested in a new Ford Taurus. After visiting your Ford dealer, doing your research on the best leases
available, you have three options. (i) Purchase the car for cash and receive a $1,500 cash rebate from Dealer A.
The price of the car is $15,000. (ii) Lease the car from Dealer B. Under this option, you pay the dealer $450 now
and $175 a month for each of the next 36 months (the first $175 payment occurs 1 month from today). After
36 months you may buy the car for $9,000. (iii) Purchase the car from Dealer C who will lend you the entire
purchase price of the car for a zero interest 36-month loan with monthly payments. The car price is $15,000.
Suppose the market interest rate is 8%. What is the net cost today of the cheapest option? (Enter just the
number in dollars without the $ sign or a comma and round off decimals to the closest integer, i.e., rounding
$30.49 down to $30 and rounding $30.50 up to $31.)
Soultion
 Part IV

Special Application - Bonds

11

Special Application - Bonds

11.1 What is a Bond?

A bond, like the word suggest, binds an borrower to a lender in a financial contract. Borrower need money
and do not have enough of it. Lender is the person who has enough at that time and ready to lend it, with
an interest rate to account time value of money. A loan is a bond. A bond is an explicit IOU, a promise to
pay money in future in return of the money borrowed. Despite of having stock markets, loans are primary way
companies gather money for their actions. Bonds, due t explicit contract to pay back, are less risky compared
to stocks. However even bonds can be covering all kind of risks. Take an example of a very safe loan taken for
a safe activity, the interest rate will be lower. Activities of governments are sometimes financed using bonds
they release. There are corporate bonds raised by companies for their operation and they are “tradable” in stock
market. The loans taken by companies and individuals are not “tradable” in stock market.

11.2 Structure of Bonds

In this section we will not discuss the bonds taken or issues for individuals but will focus on bonds from entities
or institutions. One of the globally prevailing institution is government. Most of these institutions do these
issuing of bonds publicly. That means, there is an open market and people can buy or sell bonds, not only from
institutions, but also from each other.

Three important points about bonds are

• Two sources of payment : Payments back t lender from borrower happens in two ways in bonds.
1. Coupons : Coupons are periodic payments made by the borrower to lender coupon amount and fre-
quency are decided by borrower (government or company who issues the bond).The coupon is the
interest rate that the issuer pays to the holder. The name "coupon" arose because in the past, paper
bond certificates were issued which had coupons attached to them, one for each interest payment. On
the due dates the bondholder would hand in the coupon to a bank in exchange for the interest payment.
Interest can be paid at different frequencies: generally semi-annual, i.e. every 6 months, or annual.
2. Facevalue : Final payment at end of closing the bond.
• Finite or limited lifetime/maturity : The bonds , unless in soem special situations, do not last forever,
they have a fixed period with in which the borrower has to return money to lender.
• All kinds of risks : Based on who is issuing the bond ( financial situation of the issuer) and the nature of
activity financed by bond (risky or less risky activity), the bonds can have all kinds of risks.
Figure Fig11.1 exlains the structure of a bond. The “C” s are coupons and “F” is the face value paid at end. As
you can see, this is a special case of annuity and “P” is the present value of all coupon and maturity payments.
Interest rate will be decided by nature of borrower and bond.
 40

Fig. 11.1. Structure of Bonds

11.3 Government Bonds - Zero Coupon

One the most important entity which borrows a lot is the Government. Government borrows money for it’s
initiatives using bonds. The simplest and the most traded bond is “Treasury Bonds”. It is also called a “Trea-
sury Security” or a “Treasury Bill” . It is also a zero coupon bond. That means, the treasury bond do not
provide any coupon payment and provides the payment only at time of maturity. Generally treasury bonds
are provided with up to one year of maturity. There is one kind of treasury bond called “Strip” which has a
maturity more than one year. Interest compounding period for treasury bonds in real life are normally 6 months.

Question : Suppose a zero coupon bond pays $100,000 in exactly one year. What is the price of the bond, if
the interest on similar bonds is 5%?

Answer : This is a simple case of present value of a single payment in future. Since maturity period is one year
and 5% interest is annual, this price can be calculated as PV(5%, 1, , 100000) = $95,238.10.

P = M ∗ PV F (11.1)

or

M
P = (11.2)
(1 + r)n

Where
P : Price of bond.
M : Maturity value of bond.
PVF : Present alue Factor.
n : Number of periods.
r : Interest rate.

Price of such bonds are also called discount as the price we pay is the discounted value of maturity amount. In
real world, trading happens on these securities. That will bring other dimensions to it. We will discuss about
that in next section.

11.4 Government Bonds - Yield to Maturity

Generally zero coupon treasury bonds are the most fundamental security existing. Generally governments do
not default. (Do not take this as a rule. Governments can also default. Risk of default exists in any in-
vestment). If you hold a treasury bond till maturity, you are guaranteed to get the return amount. Generally
41

bond price is not just decided by existing exchange rate. An auctioneer tells you that you are going to get, say
a maturity value of $100,000 after, say one year. Public, who try to buy the investment will decide the price.
The ratio between the price paid and the return is the Yield To Maturity (YTM)

Question What is the YTM of a zero coupon bond with 5 years of maturity period, with a face value of
$100,000 and current price of $74,726.

M
P = (11.3)
(1 + r)n

100000
74726 = (11.4)
(1 + Y T M )5

YTM can be calculated in Microsoft Excel using RATE function.

RATE Syntax : RATE(nper, pmt, pv, [fv], [type], [guess])

Where

• Nper : Required. The total number of payment periods in an annuity.

• Pmt : Required. The payment made each period and cannot change over the life of the annuity. Typically,
pmt includes principal and interest but no other fees or taxes. If pmt is omitted, you must include the fv
argument.
• Pv : Required. The present value — the total amount that a series of future payments is worth now.
• Fv : Optional. The future value, or a cash balance you want to attain after the last payment is made. If fv
is omitted, it is assumed to be 0 (the future value of a loan, for example, is 0). If fv is omitted, you must
include the pmt argument.
• Type : Optional. The number 0 or 1 and indicates when payments are due. 0 or omitted means at the end
of the period and 1 means the beginning of the period
• Guess : Optional. Your guess for what the rate will be. If you omit guess, it is assumed to be 10 percent. If
RATE does not converge, try different values for guess. RATE usually converges if guess is between 0 and
1.
For our YTM question, the answer will be : RATE(5„ -74726,100000) = 0.06 which is 6%. Not that I entered
present value as negative. This is because both present price you pay for the bond and future return both be
positive. One is money going out (outflow) and other money coming in (inflow). In above calculation compound-
ing interval is 1 year. In real world, the compounding interval is 6 months. What will be YTM if compounding
interval is 6 months. It will be RATE(10„ -74726,100000). This will be 2.96%. This is slightly lower than half
of YTM 6% for one year , because the interest for 6 months also earns interest in next 6 months with in one year.

Generally YTM is inversely proportional to risk of the bond. The riskier the bond. the lesser you are ready too
pay for it. Bonds with short maturity by nature has lower risk and hence lower YTM.

11.5 Coupon Paying Bonds

Coupon paying bonds pays coupons at end of each period pre-decided. Generally coupon amount C is expressed
annually. If your coupons are paid aevery 6 months, you should use C/2 in your calculations. Coupons are
decided by borrower (or issuer of the bond). Interest rates are decided by market and stated annually.

Question: Suppose a government bond has a 3% coupon and a face value of $100,000 and 6 years of maturity.
What is the price of the bond, given similar bonds yields 4% ?
Answer :
3% coupon means coupon payment is 3 * 100000/100 = $3,000.
This is stated annual. So 6 months payment will be 3000/2 = $1,500. Maturity is 6 years. This will be 12 periods
 42

if coupon is paid once in six periods. Fig11.2 displays this bond payment structure. Interest rate applied for 6
month period will be 4%/2 = 2%. The price is a present value calculation with a periodic payment and future
−3000
value. This can be calculated as PV( 4%2 , 6 ∗ 2, 2 , −100000).

This will result in $94,712.33. Note that we used negative values for inflow here to get payment as a positive
value.

Fig. 11.2. Coupon Paying Bonds

11.6 Bond Price versus Interest Rates

Bonds payment interest rate is affected by the ongoing interest rate in market. For the time being, let us assume
both the interest rate used in the bond and general interest rate are same. This is true in the case of treasury
bonds with very low risk of default. See table 11.1 for the relation between interest rate and the price of bond.
As you can see, at 3% interest rate price of bond is same as maturity value of bond. This is called “selling at
par”. This is intuitive, as the coupons are paid at 3% and if interest rate is also at 3%, you maturity value and
price will be same. All the time value of money is paid through coupons in such a case.

Interest Rate Price of Bond

1% $111,618.93
2% $105,627.54
3% $100,000.00
4% $94,712.33
5% $89,742.24
6% $85,068.99
7% $80,673.33
8% $76,537.32
Table 11.1. Bond Price versus Interest Rates

As you can see the relation between interest rate and price of bond is inversely proportional. Fig11.3 depicts
this relation for more rates for above example.

11.7 Real World Bond Data

All the concepts we are discussing here are from real world institutions and financial concepts. There are various
sites which can give you this data. The one listed here is https://in.investing.com. This site gives us the
cuntry wise yield curves for bonds of any duration. As you can see, the yield is high for long duration bonds.
See Fig11.4 for India bond data. Bonds are generally rate by the quality of the investment in to various grades
( like AA, AAA etc...). A higher grade means it is less risky and hence the YTM of higher grade bond will be
lower, given all other conditions are equal with a low grade bond.
43

Fig. 11.3. Bond Price versus Interest Rates

Fig. 11.4. Investing.com data

Problems

Note : To be consistent with the real data and across questions in this assignment, all bond pricing questions
assume semi-annual compounding

11.1. Price of a Bond

A pure discount (or zero-coupon) government bond is issued today that promises to pay $10,000 in 25 years. If
the current interest rate on similar bonds is 4%, what is the price of the bond? Recall that the compounding
interval for bonds is 6 months.
Soultion

11.2. YTM
For two otherwise identical coupon bonds, the one with the higher rating will have a lower yield to maturity.
True or False?
Soultion
 44

11.3. Selling Premium

Coupon bonds are selling at a premium relative to the par value when the yield to maturity is higher than the
coupon rate. True or False?
Soultion

11.4. YTM Calculations

What is the yield to maturity (YTM) of a zero coupon bond with a face value of $1,000, current price of $800
and maturity of 6 years? Recall that the compounding interval is 6 months and the YTM, like all interest rates,
is reported on an annualized basis.
Soultion

11.5. Strips
The government in the U.S. issues zero-coupon bonds up to one year maturity, but STRIPS are "manufactured"
zero-coupon bonds with maturities up to 30 years. So, for example, a financial institution could first buy 250 30-
year coupon bonds issued by the government that each pay $4 of coupon every six months. The institution could
then sell the combined coupons totaling $1,000 as a separate zero-coupon bond for each maturity ranging from
6 months up to 30 years. This is a financial innovation that occurred decades ago in the face of volatile inflation
and an increased demand for long-term zero coupon government bonds. Given this information, analyze the
following statement: “The price of a long-term STRIP will typically be lower than that of a short-term STRIP.”
True or False?
Soultion
 Part V

Special Application - Stocks

12

Special Application - Stocks

What is a Stock? Stock is another form of Financing. Suppose you have a great idea which need money to
implement and obtain returns from the idea. One is borrowing. Other is by issuing stocks. Stocks are issued by
companies when they need to arrange money for their operation. See table 12.1 on how a company is structured.
With money you financed, you build real assets for the company. And the money financed is on other side as
liability - the debt that you borrowed and stocks that you issued.

Assets Liabilities
Real Assets Debt and Equities
Table 12.1. Stocks - What is it?

In a typical story, you have a great business idea. You put some money to test the idea. Once idea seems to work,
you need more money to now extend this idea to an enterprise. This is achieved by issuing stocks (equities) and
bonds ( debt). One important big picture is that stocks do not exist in isolation. They exist because an entity
which want to create value issues them. Once that entity ceases to create value, stocks losses all its value.

12.1 Stocks Versus Bonds

In short words, bond is a contract and stock is not. when you start a firm, you start with collecting money as
stocks (equities). Once , as a firm you have some equity and certain assets, you go to lenders and raise money
as bonds (or loans). Unless you have some repaying power , you don’t get a loan or bond. This is why equities
are issues first before issuing bonds when you start a company. Once you raised money and started running the
business, you made some revenue from the business. Now it is time for you to pay back. When you pay back,
bonds come first. Equity is paid only after bonds are paid. This is because, you are contractually obligated
to pay a bond. When a bond gets paid, it gets paid as interest or coupons. It also pays maturity amount at
end. Payment to stock holders are called dividend. Dividends are paid per share. Even a dividend payment
is volunteer. In cases of some companies, the money is reinvested in the company as ideas and do not pay
dividend. Even when you get divident ans a shareholder, you need to pay taxes and for you yororself, you need
to reinest this money. Often it is considered as less desirable and it is better company reinvest it and not pay
dividend. Another difference with bonds is that stocks do not have an end date. You assume to run company
perpetually. Bonds have clear maturity period. Another difference is risk. Betting on an idea with money which
is not contractually obligated to pay back is inherently more risky that a contracted lending.Moreover , when a
company makes money, the first liability to be paid is bonds and not stock. This makes stocks inherently more
risky and we expect higher returns for this risk, from stocks.

12.2 Stocks - Some Data

From 1926, there is recorded, detailed data become available from US stock exchanges. Table 12.2 gives the
information on the returns from various portfolios from 1926 till now. As you can see , small stocks, stocks
of small companies provide more returns. Risk premium is the amount of additional return you get above the
treasury bills for the risk you take. Treasury bills, as we discussed earlier considered risk free. As you notice,
 48

the more risky investments provide better returns. Also note the column standard deviation. Average return
is on an average the return made. Standard deviation shows the spread of return values. It means how much
varied the returns of say 67% of the people, from the average return. As you can notice, the variation is larger
for riskier portfolios.

Portfolio Average Return Average Risk Premium Standard Deviation

Small Stocks 21% 17% 42%
S&P500 12% 8% 21%
Corporate Bonds 7% 3% 7%
Government Bonds 6% 2% 9%
Treasury Bills 4% 3%
Table 12.2. US Stock and Bond Data

12.3 Pricing a Stock

In this section we will analyze how to price a stock. A stock can be thought in two ways. One each the perspective
from a company and an individual. For an individual it is a vehicle for investment. For a company it is a vehicle
for borrowing. For simplicity of the pricing, let’s assume that the company do not have any debt and has only
possible. is this really possible in real world? It is possible. There are many companies who do not have any debt.
This is often possible for companies which do not need a lot of upfront investment like manufacturing plants
etc... It is not possible that a company exists with only debt and no stock, though it is possible theoretically. One
problem is large debt is, when you grow fast, you need to pay your debts first and you can not default. Debt also
has some advantages. The dividend payment is not tax deductible, however , interest on debt is tax deductible
for your firm. How do you value a company which has a million shares. This means the company has a million
shares as stock trading in markets. If the price per share is $5 then the total value of the company is 5 Million
Dollars. What is the price in future? Lets call price today ( time zero) as P0 . Expected price one period from now
( period is generally one year) P1 . P2 will be price at end of year 2. There is no easy way to know P1 as you can
not generally predict how stock moves. Similar notation for dividends will be D1 and D2 etc... Note that there
is no D0 as dividend is paid only from end of first year. Just like Present value calculations, you can calculate
present value of a stock based on future price , if we know expected return. Let’s call this expected return r.
Now, There is no easy way to know expected return. Sometimes, we an assume that it will be similar to a similar
stock. By similar stock, I mean a stock in similar industry, same product or service and similar revenue. In real
life, even then the returns may not be same, as there are many variables which decides the price and no two com-
panies will be same on all of them. But for simplicity let’s assume r as the rate of return from a similar company.

Now, we can calculate price of a stock today as present value of price of stock 1 year from now present value of
dividend paid one year from now.

D1 + P1
P0 = (12.1)
(1 + r)

Now what is P1 ? It is present value of P2 and D2 at end of period 1.

D 2 + P2
P1 = (12.2)
(1 + r)

Substituting P1 value on formula for P0

D2 + P2
D1 +
(1 + r)
P0 = (12.3)
(1 + r)

If you consider for n periods

49

Dn + Pn
D5 + · · · +
(1 + r)
D4 +
(1 + r)
D3 +
(1 + r)
D2 +
(1 + r)
D1 +
(1 + r)
P0 = (12.4)
(1 + r)

This can be simplified as

D1 D2 D3 D4 Dn Pn
P0 = + + + + ... + + (12.5)
1 + r (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)n (1 + r)n

Note that., one big assumption that we made here is that return do not vary by year. This assumption generally
do not hold good in real world.
Now, if we assume enough periods in to future, by the properties of present value, constribution of Pn to P0
becomes minuscule. Now, the above formula can be rewritten as

D1 D2 D3 D4 Dn
P0 = + + + + ... + (12.6)
1 + r (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)n

This can be expressed as summation as shown below.

n
X Di
P0 = (12.7)
i=1
(1 + r)i

This model is called Dividend Discount Model. In this model current price of the stock is marked as a
discounted present value of the dividends paid over a period of time in future.

12.4 Pricing a Stock - Dividend and Growth Stocks - Questions

Formulas that we derived over section Pricing a Stock forms the basis of company and stock evaluations. In this
section, we will review some special cases using the same formulas.

Question 1 : Suppose the dividends remain approximately constant, what is price of the stock?

Answer : Basic assumption here is D1 ≈ D2 = D3 .... = D.

Now this becomes perpetuity discussed in chapter Perpetuity. Present value of a perpetuity with annual pay-
ments of D and a return or discount rate of r is D/r. If the company provides a dividend of $1, with a return
$1
rate of 5%, then the price of stock is 0.05 = $20.

You may argue that perpetual payment is often not realistic. Let’s assume that the payment of $1 is for 50
years at a return rate of 5%. Now the price of the stock becomes present value of an Annuity.

P = PV(0.05, 50, 1) ≈ 18.26.

Now what is the difference between perpetual dividend paying stock discussed before this and this 50 year
stock? It is $1.74. This difference is present value of a perpetuity of $1 obtained after 50 years.

PV of a perpetuity of $1 at discount rate of 5% = 20.

 50

Present vlaue of such a perpetuity starting after 50 years = PV(0.05, 50, , 20) = $1.74.

A stock which pays uniform dividend but do not grow is called a Dividend Stock. However, there is another
class of stocks where, due to good business of the company, the value of stock increases every years and hence
dividends. They are called Growth Stocks. See the question below.
Question 2 : If the dividend of the company is expected to grow at a rate of g, what is the price of the stock?

Answer : Here the price is increasing. D2 = D * (1+g).

D
Price of such a perpetually paying stock is P = (r−g)

Assume a company with same dividend as previous example $1. But this stock is expected to grow at a rate of
2.5%. Similar companies have a yearly return of 5%.

1
Price of stock = (0.05−0.025) = $40.

Note that, for all other parameters being same, growth stock is valued higher than the dividend stock.

12.5 Stocks - Real world Data

In this section, we will visit https://finance.yahoo.com for checking information on real world stocks. Yahoo
finance site lists data about markets and shares. As you can see in Fig12.1, it lists information about stock market
indices. A stock market is a institution where stocks are listed and traded. DOW, NASDAQ and SP500 are
various stock markets like that. The Market or exchange stock index is prepared as the average value of a given
number of top performing stocks. For example DOW Index is a collection of 30 top performing stocks.

Fig. 12.1. Market Indices - Yahoo Finance

We can go to a specific stock and see the specifics of individual stock by searching for them. I searched for
QUALCOMM Incorporated. This company’s stock prices surged as on the date this is written (Apr 17th , 2019)
as they settled all patent violation litigations with the consumer electronics giant, Apple Inc. The Main display
of the stock’s details is as in Fig12.2. Previous close is the price of the stock when the market closed on previous
working day. Open is the price at which the stock has opened this day. This depends on the transactions
requested. You will see there is a measurement called “Beta”. Beta is a measure of risk involved with a stock.
When you buy a stock, the risk is the price variance. It can vary up or down. Market’s risk, in Beta calculation,
is considered as 1. You can see the risk of this stock is lower than that. Note that Beta is an estimated value
and hence it can be close to real, only if the data used is extensive or calculation is rigorous. Volume of stocks
traded is number of stocks traded. Market cap is the price of stock multiplied by number of shares. PE ratio is
Price versus Earning ratio.
• Previous close : Price of the stock when the market closed on previous working day.
• Open : Price at which the stock has opened this day.This depends on the transactions requested at open.
• Beta : measure of risk involved with a stock in a portfolio. When you buy a stock, the risk is the price
variance. It can vary up or down. Market’s risk, in Beta calculation, is considered as 1. You can see the risk
of this stock is lower than that. Note that Beta is an estimated value and hence it can be close to real, only
if the data used is extensive or calculation is rigorous.
• Volume : Number of stocks traded. When volume falls very low, it means the people has lost faith in
market.
51

Fig. 12.2. QUALCOMM Incorporated - (Apr 17th , 2019)

• Market cap : Price of stock multiplied by number of shares.

• EPS : Earnings Per share. It is the portion of a company’s profit allocated to each share of common stock.
Earnings per share serve as an indicator of a company’s profitability. Generally EPS is the final amount of
earnings allocated to share. The way EPS is calculated depends on accounting.
(Net income−preferred dividends)
EPS = End - of - period common shares outstanding

• PE Ratio : The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its
current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes
known as the price multiple or the earnings multiple.
Market value per share
PE Ratio = Earnings Per share
• Dividend/Yield : This is dividend paid per share most recently. Yield is the ratio of dividend to price of
stock, expressed as percentage.
You can get more information about the company data from statistics link.

Problems

Note : To be consistent with the real data and across questions in this assignment, all bond pricing questions
assume semi-annual compounding

12.1. Bond Vs Stock

Bonds require issuers to repay the principal (or face value) and (where applicable) stipulated coupon payments
until contract maturity, while equity requires the firm to pay a certain dividend in perpetuity. True Or False?

Soultion

12.2. Valuing a Stock

Becky and Mandy are arguing about the best way to value the rapidly growing MySpaceBook.com. Mandy
argues that, since MySpaceBook.com is young and will plow most of its earnings back into the company that
the present value of all future earnings represents the best estimate of the stocks value. Becky disagrees. Who
is right?

Soultion
 52

12.3. Dividend Calculations

(One-period pricing. Recall that since stocks have really long lives, in the video we imagined owning a stock for
only one period. In this simple, yet powerful scenario, today’s stock price is the PV of next year’s dividend and
next year’s stock price. The formula was covered in class.) The stock for TM Consulting, and all-equity firm,
is currently trading at $32 per share, after just having paid a $1.70 per share dividend. Management has not
announced their specific dividend amount for next year, but they insist that they will pay a dividend. If analysts
project the stock price to be $34.40 after next year’s dividend is paid out, and the equity cost of capital (also
the discount rate for equity) is 13% for this firm, the expected dividend (for t = 1) must be?

Soultion

12.4. Dividend Calculations - 2

(One period stock pricing.) Nick’s Marine Company (NMC) currently has a stock price per share of $53. If
NMC’s cost of equity capital (the discount rate for equity) is 12.8% and capital gains rate (gain/loss in prices
relative to today’s price) for the next year is expected to be 10.6%, the dividend in the upcoming year (t = 1)
should be?
Soultion

12.5. Dividend Calculations - 3

Electricity for All (EFA) is preparing for their Initial Public Equity Offering (IPO). Being in a highly regulated
industry, and with no plans for expanding, EFA plans to payout all of its earnings as dividends that are expected
to the be same. If the expected rate of return on its equity is 8% and a fair IPO price is $112 per share, what
is EFA’s dividend per share? (Enter just the number in dollars without the $ sign or a comma and round off
decimals to the closest integer, i.e., rounding $30.49 down to $30 and rounding $30.50 up to $31.)
Soultion

12.6. Valuing a Stock - 2

Becky and Mandy are arguing about the valuation approach of a firm. Mandy argues that ignoring the present
value of future growth opportunities could grossly underestimate the value of a firm that is rapidly growing and
actively invests in research and development. Becky disagrees. Who is right?
Soultion
 Part VI

Wrap Up What Next?

13

Wrap Up What Next?

13.1 Lessons from this course

• Thinking: Finance is a way of thinking. Real world application is the key part of this thinking and it should
help you in real world.
• Understand: Finance helps us understand complex world better.
• Omnipresent: Finance is applicable everywhere.
• Unified nature : At bottom of it , be it personal or organizational finance, the tools, techniques are same.
Scale may vary. But concepts are same.

13.2 Personal Investing - Diversification

Given a choice, every individual likes to get more returns. You will put your money in higher return investments.
See the Fig13.1. If return is all you care, you will invest in small stocks. However, see the column standard de-
viation. It is a measure of, on an average how much variation in the return exists with in the small stocks (
and other investment portfolios). It is a measure of variation. Wider the standard deviation wider is the chance
that your return is farther away from the medium or average return. This means small stocks are risky. Risk
and returns go together.

Fig. 13.1. 1926-2008 American Portfolio Investment Experience

This is where the concept of diversification comes in. If you look only for return, the risk of losing your money
is high. But if you split your investments in to various investment oppertunities which are different from each
other, then chances of you losing money due to uncertainty or risk of one investment is reduced. Combine your
 56

stocks and make a portfolio. Pick good stocks , but not of same nature. See the Fig13.2. It shows the standard
deviation of stocks and S&P 500 portfolio over from 1989 to 2008. As you know, S&P 500 is an Index. It i a
portfolio of multiple stocks. Most of those individual stocks mentioned in Fig13.2 are part of this index. As you
can see the variation in S&P 500 is much less compared to individual stocks.

Fig. 13.2. 1989-2008 variations in stock prices

Why is this so? : More clarity on this comes from study of risk. There are two kind of risks. One is General
or common risk to the system in study. In our case of stocks, we can consider the system as market or the
economy. This is a common property of the system and all participants of the system (in our case, all stocks)
share equal part in this risk. Second is risks specific to a participant in the system. In our case, this is the risk
of a particular stock. When you make a portfolio of various different stocks, this specific risk of each stock may
cancel, up to an extent, with each other. This is what gives the you, lesser standard deviation in a portfolio
compared to individual stocks. In simple terms, in a portfolio, even if one stock price goes down, other stocks
may be increasing in value and it balances the risk. Markets has come up with pre-constructed stock portfolios
which investors can buy and sell. This is mutual funds. A fund manager manages the specific stocks with in the
portfolio. Value of portfolio goes up or down based on the value of stocks with in it. There are various portfolios
in existence with varied level of risks and varied level of diversification. You pick based on your risk quotient.
I.e. how much risk are you ready to take with your investment.
Solutions

Problems of Chapter 4

4.1 Time Value

Answer is (b). FALSE. A specific amount today is worth more than same amount tomorrow.

4.2 Future to Present

Answer is (b). If you calculate the future value of 200 at 11% interest, you will get 576.1344424 after 8
years.

4.3 Present to Future

350
Answer is $333. How? : = 333.33
(1 + 0.05)1

4.4 Save
Answer is : (a) Marge; $3,424.24.
Jeff Makes : 1000 ∗ (1 + 0.03)25 = 2093.77793 Marge Makes :500 ∗ (1 + 0.08)25 = 3424.237598

4.5 Old Money

Answer is : 167605
Calculation :65000 ∗ (1 + 0.07)70 = 167604.7198

Problems of Chapter 6

6.1 Use vs Save

Answer is : $253.42
Initial Amount ( If karaoke machine is not bought) : -600
Years : 9
Interest Rate : 6%
Value after 9 years : $1,013.69 : FV(.09,9,0, -600)

Initial Amount ( If karaoke machine is bought) : -450

Years : 9
Interest Rate : 6%
Value after 9 years : $760.27 : FV(.09,9,0, -450)

Difference : $253.42

6.2 Loan and Savings

Answer is : Yes, he will have money available in his savings to pay for the loan repayment. amount available
after repaying loan will be $2,389.71
 58

Investment : 24000
Interest : 5.30%

Cost of the Car: 24000

Interest rate 3.10%

Baloon Payment for loan at end of 4 years : $27,117.27 : FV(3.1%,4,0,-24000)

Amount from Investment at end of 4 years : $29,506.98 : FV(5.3%,4,0,-24000)

Difference : $2,389.71

6.3 Break even

Answer is : 10.49%

Cost of Replacing Roof now : 17000 Cost of Replacing Roof after 5 years : 28000 Present value of 5 year later
Roofing cost at break even point: $17,000.00 :=PV(Interest Rate,5,0,-28000)
By using goal seek functionality in Microsoft Excel, you get the interest rate for this break even to be 10.49

6.4 Financial Decision

Answer is : Model B, Amount cheaper is $4241.48

Interest rate : 6%

Model A Cost : 27000 Model A resale Value at end of 4 years : 54%

Model A resale Value at end of 4 years, in amount : 14580

Model B Cost : 17000 Model B resale Value at end of 4 years : 43%

Model B resale Value at end of 4 years, in amount : 7310

Present Value of Resale value for Car A $11,548.73 : PV(6%,4,0, -14580 )

Present Value of Resale value for Car B $5,790.20 : PV(6%,4,0, -7310)

Net amount that you pay for Car A $15,451.27

Net amount that you pay for Car B: $11,209.80

Difference : $4,241.48

6.5 College Tuition

Answer is : 58523.41

Fig. 13.3. Tuition Pay

59

6.6 Increasing Maintenance Payments

Answer is : 13571.09502

Present Value of an Annuity growing at rate g:

" #
1 (1+g)n
PVAnnuity = C ∗ P AF (r, n, g) = C ∗ r−g ∗ 1− (1+r)n

C : 1700
r : 6%
g : 2%
n : 10
Present Value Of Annuity Growing at 2% ( By above Formula) : 13571.09502

Problems of Chapter 10

10.1 Purchasing First House

Answer is : $2,750.41

Total cost of house : $340,000 Loan Amount : $340,000 * .9 = $306,000

Monthly payment can be calculated as : PMT(0.07/12, 12*15,306000) = $2,750.41

10.2 Financial Plannning

Answer is : $18,490.21

Present value (at the time of 58th Birthday) of yearly amount to be received from 59th birthday onwards for 20
years =PV(0.07,20, -130000) = $1,377,221.85
Amount to be set aside from 32nd birthday to 58th birthday for this : =PMT(0.07,27„1377221.85) = $18,490.21

10.3 Buying a Car

Answer is : Yes, and Abilia saves monthly on refinancing.

Loan amount : 12000-2000 = $10,000

Monthly Payment amount = PMT(0.07/12, 60, 10000) = $ Amount of installments left = 3*12 = 36.
Present value (at end of 2nd year of loan) of remaining =PV(0.07/12, 36, 198.01) = $6,412.91

Note this Step. Present value of all the payments you are making in future at $198.01, will be equivalent to the
principal amount remaining in your loan. You can do month by month payment table to see that this comes up
same. Or you can use below formula also to calculate the remaining amount

" # " #
(1 + r)n − 1
RP = LA ∗ (1 + r)n −P ∗ (13.1)
r

Where RP : Remiaing Principal Amount after n installments.

LA : Original Loan Amount.
P: Loan Payments.
r : Interest rate.
n : number o periods after which the remaining principal is being checked.
 60

Note : If you see the two parts of the equation, the first part is future value of loan amount after n installments.
Second part is future value of all the installments you paid including nth one. Subtracting first from second,
will give you the net principal remaining after n installments.
New monthly payment at 4% annual interest rate will be : PMT(0.04/12,36,6412.91 ) = $189.33

198.01 - 189.33 = $8.68

10.4 Refinance your Mortgage

Answer is : Yes, gain 112, 734.97

Annual Fixed Rate : 9.50%

Loan Amount : 280000
Number of Payments done : 108
Tenure : 25
Monthly Interest : 9.5%/12 = 0.79%
Payment Installment : =PMT(0.79,25*12, 280000) = $2,446.35
Remaining principal amount at end of 108 payments : = PV(0.79,(300-108),2,446.35 ) = $241,022.25
Fee for Refinance : $5,500
Total Amount for refinancing : $246,522.25
Refinance interest rate : 3.50%
Monthly rate = 3.5%/12 = 0.29%
New monthly payment amount : PMT(.29,(300-108),246,522.25 ) = $1678.69
Monthly difference = 2446.35 - 1678.69 = $767.67
Present value of next 192 payments differences : PV(0.29, (300-108), 767.67) = 112, 734.97

10.5 Options for Buying a Car

Answer is : $13,179

Option A : Present value of car = 15000- 1500= $13,500

Option B : Part 1 : Present value of $450 paid now : $450
Option B : Part 2 : Present value of $175 paid in next 36 monthly installments : =PV(0.08/12,36,-175) =
$5,584.57
Option B : Part 3 : Present value of $9,000 paid after 3 years : PV(0.08,3„-9000) = $7,144.49
Total present value of option B : $13,179.06
Option C : Monthly installment amount of a zero dollar loan : 15000/36 = $416.67
Option C : Present value of monthly payments at $416.67 at interest rate of 8% : PV(0.08/12,36,416.67) =
$13,296.59
Option B is the cheapest.

Problems of Chapter 11

11.1 Price of a Bond

Answer is : $3,715.28

Calculation is PV(0.04/2, 25*2, , 10000).

11.2 YTM
Answer is : True

A higher grade bond means the investment funded by the bond is more secure. This means the risk of default is
low. This means the price of that bond to buy, for a given maturity value, will be high. This means lower yield
to Maturity for the safer, high grade bond.
61

11.3 Selling Premium

Answer is : False

Par value is the price of a bond when the coupon rate is same as the rate of interest or Yield To Maturity(YTM).
At par value price of your bond will be same as maturity value. If YTM is higher than coupon rate, it means
the bond is riskier than at par value and the price you pay will be lower than maturity value. So it will not be
selling at premium to par value, but at discount to par value.

11.4 YTM Calculation

Answer is : 3.79

Calculated as RATE(6„800,-1000).

11.5 Strips
Answer is : True

A long term bond has more chances of fluctuations and hence gets a better YTM.Hence the Strips made from
a long term bond will be lower in price as it has higher YTM.

Problems of Chapter 12

12.1 Bond Vs Stock

Answer is : False. What is said about Bonds is true. Stocks, even though can pay dividend, it is not mandatory
to pay it. There are many companies which do not pay dividend on it’s stock.

12.2 Valuing a Stock

Answer is : Becky. Company reinvests most of it earnings to itself. However, it must be paying dividend also,
as it is not investing all of the earnings. so dividend also must be included in the evaluation of the stock price.

12.3 Dividend Calculations

Answer is : $2.74
Calculations :
Current Price P0 : $49
Stock Price Next Period : P1 = 54.10
Equity Cost of capital is basically the interest or discount rate for stock investment. : 16%
Refer Equation 12.2.
D1 = P0 * (1 + r) - P1
D1 = 49* (1+0.16) - 54.1 = $2.74

Note : Same way the P1 , price of stock in next period also can be calculated, if we know the current price and
next period dividend.

12.4 Dividend Calculations - 2

Answer is : $1.17
Calculations :
Current Price P0 : $53
Stock Price Next Period : P1 = 53 * (1+ 0.106) = 58.618
Equity Cost of capital is basically the interest or discount rate for stock investment. : 12.8%
Refer Equation 12.2.
D1 = P0 * (1 + r) - P1
D1 = 53 * (1+0.128) - 5458.618 = $1.17

Note : Same way the P1 , price of stock in next period also can be calculated, if we know the current price and
next period dividend.
 62

12.5 Dividend Calculations - 3

Answer is : $9
Calculations :
For a stock which pays dividend as perpetual payment, the price of Stock is D/r. So Dividend is Price of Stock
* Interest Rate. D = 1123 * 0.08 = 8.96 ≈ 9

12.6 Valuing a Stock - 2

Answer is : Mandy. If you ignore present value of future earnings , you will not be calculating the price
correct.