FIN 502 Business Finance
Lecture 2: Time Value of Money,
Interest Rates, and Inflation
Professor Ran Duchin
Foster School of Business
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Review of Last Class: Agency
Problems
Managers are hired to increase shareholders’ value by
implementing profitable investment projects
Advantage: managerial expertise
Disadvantage: potential conflict of interest
These conflicts are called agency problems, because
managers act as agents on behalf of shareholders
Agency problems are costly:
Direct costs: corporate perks, such as jets, expensive trips,
unnecessary luxury
Indirect costs: sub-optimal investment decisions, such as
empire-building
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Case Illustration: Agency
Problems at Yahoo
Feb 1, 2008
Microsoft offers to acquire all outstanding shares of Yahoo for
$31 per share, a 62% premium over the market price
Feb 9, 2008
Yahoo board of directors rejects the offer, claiming that it
understates firm value
May 2-3, 2008
Negotiations at final stage; Microsoft raises its bid to $33, but
Yahoo board and management continue to resist
May 3, 2008
Microsoft withdraws its offer, and the price of Yahoo
immediately plummets by 15% in one day
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Thank you, Mr. Jerry Yang
Nov 12, 2008
Yahoo stock closes at $10.34, a multi-year low
Yahoo lost $32.7 billion in value compared to the Microsoft bid
Nov 17, 2008
Yahoo CEO, Jerry Yang, is forced to step down under the
pressure from shareholders; Yahoo stock jumps by 8.7%
January 13, 2009
Carol Bartz is appointed the new CEO
July 30, 2009
Yahoo and Microsoft establish a strategic partnership in online
advertising and internet search
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Yahoo Stock Price: Jan 1, 2008 – Sep 18, 2009
MSFT bid MSFT bid withdrawn CEO steps down
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Roadmap for This Class
Jump Start:
We learned about time value of money and discounted cash
flows: annuities and perpetuities
We learned about compounded interest
We identified key terminology for interest rate quotes:
APR and EAR
Today’s class:
Interest Rates and Inflation
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Recall: The Time Value of Money
The fundamental rule:
A dollar today is worth more than a dollar tomorrow!
The discount rate is a kind of “exchange rate”: r = 7% means:
$1.07 tomorrow is worth $1.00 today, or
$1 tomorrow is worth $0.934 today.
Trade off value today with value in the future by
investing/saving/lending, or borrowing.
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A Quick Example…
What is the following project’s NPV?
C0 = -$11
CF1 = $6
CF2 = $7
Discount Rate = 9%
Solve the problem twice: once with formulas and once with the
calculator TVM menu.
Today: How are the cash flows and discount rate affected by
inflation?
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Inflation: Nominal and Real Dollars
Inflation is the loss in purchasing power of a currency
Holding constant the quality of goods, inflation is measured by a
percentage increase in the price of a representative basket of
goods and services
In the U.S. the consumer price index (CPI) measures the change in
purchasing power of dollars
The percentage change in the consumer price index is the rate of
inflation
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Consumer Price Index
The CPI is calculated as the total price of a group of goods that a
typical consumer would purchase (e.g. food, gasoline, etc.)
If this group of goods costs $100 last year and the same goods cost
$105 this year, then inflation is 5%. Prices have risen by 5%. The
purchasing power of a dollar has decreased
Say your income grows by 10% a year, but inflation is 5% a year:
Rate of Real value Nominal income Real
Year CPI
inflation of $1.00 (growth = 10%) income
0 100.00 $1.00 $10,000 $10,000
1 105.00 5.0% $0.9524 $11,000 $10,476
2 110.25 5.0% $0.9070 $12,100 $10,975
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CPI
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Inflation
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Nominal and Real Interest Rates
Coffee costs you $1 today. If inflation is expected to be 5%, you can
expect a coffee to cost you $1.05 next year
If you invest $100 (=100 coffees) at a nominal rate of 8%, you will
receive $108 (actual dollars you receive) in one year
However, prices have increased, so each dollar is worth less. With
$108, you can buy ($108/$1.05) = 102.86 coffees.
Therefore, we say that in one year you will receive $102.86 real
dollars. That is, after adjusting for the increase in general prices,
your real return is only 2.86%
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Nominal and Real Interest Rates
Nominal interest rate – quoted rate unadjusted for inflation
Real interest rate – nominal rate adjusted for inflation
This rate reflects percentage changes in the amount of goods
and services that money can buy
(1 + rnominal) = (1 + rreal)(1 + inflation)
r real = (1 + rnominal) / (1 + inflation) – 1
Approximation: rreal ≈ rnominal – inflation
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The Relation Between Nominal
Rates and Inflation
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Example 1: Nominal and Real
Interest Rates
You are choosing between two 1-year investments: one in
Germany and another one in Brazil. The investment in
Germany yields a 7% annual return, and the inflation in
Germany is expected to be 2%. The investment in Brazil
promises a 13% annual return, and the inflation in Brazil is
expected to be 8%.
Which investment delivers a higher real rate of return?
r real, Germany = (1 + 0.07) / (1 + 0.02) – 1 = 4.90%
r real, Brazil = (1 + 0.13) / (1 + 0.08) – 1 = 4.63%
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Example 2: Nominal and Real
Interest Rates
You have been able to save 80% of the funds you need to
purchase a new car. You decide to invest your savings at
8% per year today to save for the remaining amount.
However, prices of cars are also expected to grow by 3%
per year due to inflation. In how many years will you be
able to afford the purchase of a new vehicle?
Real rate = (1.08) / (1.03) – 1 = 4.85%
Funds in possession (PV) = 0.8
Funds needed (FV) = 1
N = 4.71
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Example 3: Nominal and Real
Interest Rates
You are comparing two rates. One is quoted as a nominal APR of
12%, compounded monthly. The other is quoted as a real APR of
8%, compounded quarterly. If the inflation rate is 4% (APR,
compounded annually), which is the higher rate?
First rate:
0.12
𝑟 0.01 → 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐸𝐴𝑅 1 0.01 1 0.1268 12.68%
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Second rate:
0.08
𝑟𝑒𝑎𝑙 𝑟 0.02 → 𝑟𝑒𝑎𝑙 𝐸𝐴𝑅 1 0.02 1 0.0824 8.24%
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𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐸𝐴𝑅 1 𝑟𝑒𝑎𝑙 𝐸𝐴𝑅 1 𝑖𝑛𝑓 1 1.0824 1.04 1
0.1257 12.57%
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Inflation and Cash Flows
There are two ways to account for inflation in cash flows:
1. Use nominal cash flows and discount them at the nominal rate
Nominal cash flows – unadjusted cash flows expressed in dollars of the
year when they occur
Nominal rate – market rate that contains a premium for inflation
2. Use real cash flows and discount them at the real interest rate
Real cash flows – cash flows adjusted (i.e. reduced) for inflation
If inflation is positive:
nominal cash flows > real cash flows
nominal discount rate > real discount rate
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Which Method Should We Use?
Unless explicitly stated otherwise, all cash flows and discount rates
in finance are expressed in nominal terms
All accounting and most financial data are in nominal terms, i.e.
unadjusted for inflation and in dollars of the year when they occur
Therefore, in the dominant majority of cases, cash flow analysis is
based on nominal cash flows and nominal rates of return
Using real cash flows and interest rates involves an extra step for
inflation adjustment, but both methods yield the same PV values
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Back to the Earlier Example
What is the present value of the nominal and real incomes when
inflation is 5% a year and the nominal discount rate is 8% a year?
Nominal income
Year Real income
(growth = 10%)
0 $10,000 $10,000
1 $11,000 $10,476
2 $12,100 $10,975
PV = 10,000 + 11,000/1.08 + 12,100/1.082 = 30,558.99
rreal = (1 + rnominal) / (1 + inflation) = 1.08 / 1.05 – 1 = 2.857%
PV = 10,000 + 10,476/1.02857 + 10,975/1.028572 = 30,558.99
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Example 4: Perpetuity
Widgets, Inc. just signed an exclusive contract with
Guinness to supply Guinness forever. The contract
calls for Widgets to receive $2 million next year. After
that, the payment will be indexed to inflation (meaning
it will be increased by the amount of inflation), which
is expected to be 3% per year. If the nominal discount
rate is 11%, what is the present value of the revenues
from this contract?
PV = 2M/(.11-.03) = 25M
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Mini-Case
Hyperinflation in Zimbabwe:
The nation of broke billionaires
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No Country for Farming Men:
Zimbabwe in 2000-2008
In 2000, the government initiates the "Fast Track Land
Reform“ seeking to destroy commercial farmers, who
support the political opposition
Thousands of farmers evicted and their lands expropriated
Previously a net exporter of farm produce, Zimbabwe is
suffocated by hunger
Production falls every year between 2000 and 2008, and
government spending rises to 56% of GDP
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Printing the Solution
With a decline in production, tax revenues
evaporate
Government finances spending by printing money
Inflation soars to 231,000,000% in mid-2008
By the fall of 2008, prices double every 24 hours
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One Way to Make History
Highest Inflation Rates in World History
Country, Year Highest Monthly Equivalent Daily Time for Prices to
Inflation Inflation Double
Hungary, 1946 1.30 x 1016% 195% 15.6 hours
Zimbabwe, 2008 79,600,000,000% 98.0% 24.7 hours
Yugoslavia, 1994 313,000,000% 64.6% 1.4 days
Germany, 1923 29,500% 20.9% 3.7 days
Greece, 1944 11,300% 17.1% 4.5 days
China, 1949 4,210% 13.4% 5.6 days
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Zimbabwean Dollar is Extinct
July 1, 2009: Zimbabwean Dollar officially ceased to exist
Sept 2009: the use of the U.S. Dollar brought inflation
down close to zero (actually, to -3%)
Zimbabwe is now pegged to the U.S. Dollar and allows
trade in several other currencies, such as the Euro
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Takeaways
Government regulation:
Lack of property rights
State ownership
Uncontrolled spending
Hyperinflation:
Causes
Remedies
Consequences
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Summary
Nominal and real rates
r real = (1 + rnominal) / (1 + inflation) – 1
Approximation: rreal ≈ rnominal – inflation
Nominal cash flows discounted at the nominal discount rate
Real cash flows discounted at the real rate
Both approaches yield the same PV, but the first one is more
common since most information is in nominal terms
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