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Chapter 6

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11 views4 pages

Chapter 6

Uploaded by

burnsburner29
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We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 6

Lump sums

Formula vs POV vs Calculator


 PV = FV/ (1+r)^n

Example: You need $100000 in 18 years for your child's university fees. You will earn 8 percent
per year. How much do you need to invest as a lump sum today to achieve this?
 $100000/ (1+0.08)^18
o $25024

Leverage - Debt
 Example 1:
o No mortgage, house price - $1000000, no mortgage, equity = $1000000
 House price increases by 5 percent and equity increases, therefore profit
on selling the house increases by $50000
Example 2:
 House price - $1000000, mortgage $900000, equity = $100000
 House price increase by 50 percent and equity increases, therefore profit
on selling the house increases by $50000

Future Value of Annuity Formula


 Annuity equals a stream of cash flows over a time period
o FV = amount * (1+r)^n - 1/r
o Amount = amount of annuity cash flow ($)
o R = interest rate
o N = # of periods

Example: You decide to save $12000 per year for 40 years. You expect to earn 8 percent per
year. What amount will you have in 40 years?
FV = $12000 * (1+0.08)^40 - 1/ 0.08
FV = $3108678 → assume inflation is 3%
PV = 3108678/(1.03)^40 = 952986

Present Value: Ordinary Annuity vs Annuity Due


 An ordinary annuity is a cashflow at the end of the period
o mortgage
 Annuity due is the cashflow at the beginning of the period
o Lease

 PV ordinary annuity = amount * [1 - 1/(1+r)^n/r]


 PV annuity due = amount * [1 - 1/(1+r)^n/r] * (1 + r)
Example: You take a $500000 mortgage to buy a house. You will repay it over 25 years. The
interest rate is 2 percent. What will be your monthly payment?
 PV ordinary annuity = amount * [1 - 1/(1+r)^n/r]
o $500000, r = 0.02/12, n = 25 * 12 = 300
o $500000 = amount * 235.9301
 Amount = $2119/month
The interest rate goes up 6 percent and you keep payments the same
 Max mortgage you can afford is $362476

Example: You lease a car for $100000 at a lease rate of 3% for 5 years. Payments are due at the
beginning of the month. What are your payments?
 $100000, r = 0.03/12, n = 5 * 12 = 60
 $100000 = amount * 55.79149
o Amount = $1792

Perpetuity
 Equal cashflow for infinity
o PV = amount/r

Example: You receive $100/year forever. You invest at 10 percent/per year. What is the value of
perpetuity?
 PV = 100/0.1 = $1000

Credit Ratings
- Default Risk
o Issuer of bond cannot repay it
- Interest Rate Risk
o If interest rate increases unexpectedly then bond price will fall
o Lose money if you sell bond
- AAA – Countries (Microsoft & J&J)
- AA – Countries/provinces
- A – Canadian Banks
- BBB – Investment Goods (Pension funds can invest in AAA, AA, A)
- BB – Not Investment Goods (Pension funds must sell bonds)
o Mass sales
o Price Falls
- B – High Yield (Junk Bonds)
- C – Default
- D – Bankrupt
o Had financial problems that caused a downgrade (Includes BB, B, C, D)
 Example: Net Income

Bond Valuation
- Par
o Trades at face value ($1000)
o Coupon Rate = Current Market price
 Interest is paid by bond
- Premium
o Trades at a price > Face value
 Coupon Rate > Current market rate
- Discount
o Trades at a price < Face value
 Market Price
 Coupon Rate < Current market rate

- When bonds are issued, they are valued at par


- When bonds mature, they are valued at par
- During the life of a bond, they trade at either a premium or a discount (Depending on the
current market)

PV of Face Value = Amount/(1+r) ^n

PV of interest coupon = Amount * [1-1/(1+r) ^n/r]

Value of the bond = PV of face value + PV of interest coupon

Multiple Year Cash Flow


- Lump sum cash flow (Ex. 1)
- Annuity cash flow (Ex. Equal cash flow)
- What if you have multiple cash flows that are different?
o Genes of PV of lump sums

Example: You have a machine that will produce the following cashflows
Year 1 + $500000
Year 2 + $525000
Year 3 + $475000
Year 4 + $450000
- The different years are the FV
- The amount is individual PV of lump sums

If the inflation rate is 3%, what is the present value of these cash flows?
PV = FV/(1+n)^n
PV = $500000/(1+0.03) ^1 + $525000/ (1 + 0.03) ^2 + ….
PV = $1819811
Bonds Overview
- Debt and Equity (Costs)
o Pros of debt
 Does not dilute ownership
 Debt is cheaper than equity
 Tax deductible
o Cons of Debt
 Bankruptcy Risk

- Bond vs. Bank loan


o Bank loan  Private company
o Bonds (Public Market) and Bank Loan  Public company

- Process to issue
o BCE ($300 million bonds)  Invest bank  Institutional Investors (Pension
funds, mutual funds, trust)  Individual Investors

- Bid/ Ask spread and liquidity


o Bid  Highest bid for bond
o Ask  Lowest selling price
- Example
o Apple stock = $157.00 (last trade)
o $156.95 (Bid)
o $157.05 (Ask)

- Bonds have higher bid and ask spread


o Could be up to 1%
- Less liquid  Don’t trade as much

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