0% found this document useful (0 votes)
1 views81 pages

Finans 5

Chapter 5 focuses on Discounted Cash Flow Valuation, covering key concepts such as computing future and present values of multiple cash flows, loan payments, and understanding interest rates. It explains the differences between Annual Percentage Rate (APR) and Effective Rate (ER), and provides formulas for calculating these rates. The chapter also includes examples of valuing annuities and perpetuities, as well as practical applications of these concepts in investment decisions.

Uploaded by

dilaraarslan2003
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
0% found this document useful (0 votes)
1 views81 pages

Finans 5

Chapter 5 focuses on Discounted Cash Flow Valuation, covering key concepts such as computing future and present values of multiple cash flows, loan payments, and understanding interest rates. It explains the differences between Annual Percentage Rate (APR) and Effective Rate (ER), and provides formulas for calculating these rates. The chapter also includes examples of valuing annuities and perpetuities, as well as practical applications of these concepts in investment decisions.

Uploaded by

dilaraarslan2003
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 81

Chapter 5

Discounted Cash
Flow Valuation

0
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
51-1
NC-1

Key Concepts and Skills


• Be able to compute the future value of
multiple cash flows
• Be able to compute the present value of
multiple cash flows
• Be able to compute loan payments
• Be able to find the interest rate on a loan
• Understand how loans are amortized, or
“paid off”
• Understand how interest rates are
quoted
1
51-2
NC-2

Chapter Outline
• Future and Present Values of Multiple
Cash Flows
• Valuing Level Cash Flows: Annuities and
Perpetuities
• Comparing Rates: The Effect of
Compounding Periods
• Loan Types and Loan Amortization

2
51-3
NC-3

Annual Percentage Rate


• This is the annual rate that is quoted by
law
• By definition, APR = period rate times
the number of periods per year
• Consequently, to get the period rate we
rearrange the APR equation:
– Period rate = APR / number of periods per
year

3
51-4
NC-4

Effective Rate (ER)


• This is the actual rate paid (or received)
after accounting for compounding that
occurs during the year
• If you want to compare two alternative
investments with different compounding
periods, you need to compute the ER and
use that for comparison.
• You should NEVER divide the effective
rate by the number of periods per year – it
will NOT give you the period rate
4
51-5
NC-5

Computing APRs
• What is the APR if the monthly rate is
0.5%?

• What is the APR if the semiannual rate


is 5%?

• What is the monthly rate if the APR is


12% with monthly compounding?

5
51-6
NC-6

Things to Remember
• You ALWAYS need to make sure that the
interest rate and the time period match.
– If you are looking at annual periods, you need
an annual rate.
– If you are looking at monthly periods, you need
a monthly rate.
• If you have an APR based on monthly
compounding, you have to use monthly
periods for lump sums, or adjust the interest
rate appropriately if you have payments other
than monthly
6
51-7
NC-7

Computing ERs - Example


• Suppose you can earn 1% per month on $1
invested today.
– What is the APR?
• APR = ?
– How much are you effectively earning?
• FV = ?

• Rate = ?

7
51-8
NC-8

Computing ERs - Example


• Suppose if you put your $1 in another
account, and you earn 3% per quarter.
– What is the APR?
• APR = ?
– How much are you effectively earning?
• FV = ?

• Rate = ?

8
51-9
NC-9

ER - Formula
m×n
 APR 
ER  1   1
 m 

Remember that the APR is the quoted rate,


m is the number of compounds per year, and
n is the length of period for which we want
to calculate the effective rate in years

9
1-10
5 NC-10

ER – Formula with continuous


compounding
ER = 𝑒 APR×n − 1

Remember that the APR is the quoted rate


and n is the length of period for which we
want to calculate the effective rate in years

10
5 1-11
NC-11

Decisions, Decisions I
• You are looking at two savings accounts.
One pays 5.25%, with daily compounding.
The other pays 5.3% with semiannual
compounding. Which account should you
use?
– First account:
• EAR = ?

11
1-12
5 NC-12

Decisions, Decisions I
• You are looking at two savings accounts.
One pays 5.25%, with daily compounding.
The other pays 5.3% with semiannual
compounding. Which account should you
use?
– Second account:
• EAR = ?

• Which account should you choose and


why?
12
1-13
5 NC-13

Decisions, Decisions I Continued


• Let’s verify the choice. Suppose you invest
$100 in each account. One pays 5.25%, with
daily compounding. The other pays 5.3% with
semiannual compounding. How much will you
have in each account in one year?
– First Account:
• Daily rate = ?

• FV = ?

13
1-14
5 NC-14

Decisions, Decisions I Continued


• Let’s verify the choice. Suppose you invest
$100 in each account. One pays 5.25%, with
daily compounding. The other pays 5.3% with
semiannual compounding. How much will you
have in each account in one year?
– Second Account:
• Semiannual rate = ?

• FV = ?

14
1-15
5 NC-15

Computing APRs from ERs


• If you have an effective rate, how can you
compute the APR? Rearrange the ER
equation and you get:


APR  m  (1  ER)
1
m n
-1
 

15
1-16
5 NC-16

APR - Example
• Suppose you want to earn an effective
rate of 12% and you are looking at an
account that compounds on a monthly
basis. What APR must they pay?
APR = ?

APR  m  (1  ER)
1
m n
-1
 

16
1-17
5 NC-17
Present Value with Daily
Compounding
• You need $15,000 in 3 years for a new car.
If you can deposit money into an account
that pays an APR of 5.5% based on daily
compounding, how much would you need
to deposit?
• OPTION 1: work with daily periods
 Daily rate = 0.055 / 365 = 0.00015068493
 Number of days = 3(365) = 1,095
 FV=?
17
1-18
5 NC-18
Present Value with Daily
Compounding
• You need $15,000 in 3 years for a new car.
If you can deposit money into an account
that pays an APR of 5.5% based on daily
compounding, how much would you need
to deposit?
• OPTION 2: work with annual periods
 Calculate EAR = ?
 FV = ?

18
1-19
5 NC-19

Quick Quiz: Part 1


• What is the definition of an APR?
• What is the effective annual rate?
• Which rate should you use to compare
alternative investments or loans?
• Which rate do you need to use in the time
value of money calculations?

19
1-20
5 NC-20

Multiple Cash Flows – FV Example 1

• Suppose you invest $500 in a mutual fund


today and $600 in one year. If the fund
pays an APR of 8.71% with quarterly
compounding, how much will you have in
two years?
 FV2 = ?
 EAR = ?

20
1-21
5 NC-21

Example 1 Continued
• How much will you have in 5 years if you
make no further deposits?
• FV5 = ?
• First way:
 Work with original cash flows
 FV5 = ?

 Second way:
 Use value at year 2 , now it is PV2
 FV5 = ?
21
1-22
5 NC-22

Multiple Cash Flows – FV Example 2


• Suppose you plan to deposit $100 into an
account in one year and $300 into the
account in three years. How much will be
in the account in five years if the interest
rate is 7.72% with monthly compounding?
 FV5 = ?
 EAR = ?

22
1-23
5 NC-23

Example 2 Time Line


0 1 2 3 4 5

100 300

23
1-24
5 NC-24

Multiple Cash Flows – PV Example 1


• You are offered an investment that will pay
you $200 in one year, $400 in 2 years,
$600 in 3 years and $800 at the end of the
4th year. You can earn 11.66%
compounded semiannually on very similar
investments. What is the most you should
pay for this one?
• PV0 = ?
• EAR = ?
24
1-25
5 NC-25

Example 1 Time Line


0 1 2 3 4

200 400 600 800

25
1-26
5 NC-26
Multiple Cash Flows – PV Example 2
• You are considering an investment that
will pay you $1,000 in one year, $2,000
in two years, and $3,000 in three years.
If you want to earn 9.65% compounded
monthly on your money, how much
would you be willing to pay for this
investment today?
• PV0 = ?
• EAR = ?

26
1-27
5 NC-27

Example 2 Time Line


0 1 2 3

1,000 2,000 3,000

27
1-28
5 NC-28

Decisions, Decisions II
• Your broker calls you and tells you that
he has this great investment opportunity.
If you invest $100 today, you will receive
$40 in one year and $75 in two years. If
you require a 14.06% compounded
monthly return on investments of this
risk, should you take the investment?
• PV0 = ?
• EAR = ?

28
1-29
5 NC-29

Quick Quiz: Part 2

• Suppose you are looking at the following


possible cash flows: Year 1 CF = $100; Years
2 and 3 CFs = $200; Years 4 and 5 CFs =
$300. The required discount rate is 6.82 with
quarterly compounding%
• What is the value of the cash flows at year 5?
• What is the value of the cash flows today?
• What is the value of the cash flows at year 3?

29
1-30
5 NC-30

Annuities and Perpetuities Defined

• Annuity – finite series of equal payments


that occur at regular intervals
– If the first payment occurs at the end of the
period, it is called an ordinary annuity
– If the first payment occurs at the beginning of
the period, it is called an annuity due
• Perpetuity – infinite series of equal
payments

30
1-31
5 NC-31

Multiple Cash Flows – FV Example


• You think you will be able to deposit
$4,000 at the end of each of the next 3
years in a bank account paying 7.85%
compounded semiannually. You currently
have $7,000 in the account. How much
will you have in 3 years? In 4 years?
• FV3 = ?
• EAR = ?

31
1-32
5 NC-32

FV Example Time Line


0 1 2 3 4 5

7,000 4,000 4,000 4,000

32
1-33
5 NC-33

Annuities and Perpetuities –


Basic Formulas
• Perpetuity: PV = C / r
• Annuities:
1
1−
(1 + 𝑟)𝑛
𝑃𝑉𝐴 = 𝐶
𝑟

(1 + 𝑟)𝑛 − 1
𝐹𝑉𝐴 = 𝐶
𝑟

33
1-34
5 NC-34
Multiple Cash Flows – FV Example
• Find the value at year 3 of $7,000 that
you have in the account today.
– Today (year 0): FV3 = ?
– FV3 = ?
• Find the value at year 3 of $4,000
ordinary annuities that will be collected for
the next 3 years.
– FVA3 = ?
– FVA3 = ?
– Total FV3 = ?

34
1-35
5 NC-35
Future Values for Annuities
• Suppose you begin saving for your retirement
by depositing $1,000 every six months in a
Retirement Account. If the interest rate is
5.96% compounded quarterly, how much will
you have in 40 years?
• Effective rate = ?
• FVA40×2 = FVA80 = ?

35
1-36
5 NC-36
Future Values for Annuities
• Suppose you begin saving for your retirement
by depositing $500 every quarter in a
Retirement Account. If the interest rate is
5.96% compounded quarterly, how much will
you have in 40 years?
• Effective rate = ?
• FVA40×4 = FVA160 = ?

36
Future Values For Annuities –5 NC-37
1-37

Another Example
• Suppose you deposit $50 per month into
an account that has an APR of 9%, based
on monthly compounding. How much will
you have in the account in 35 years?
• Effective rate = ?
• FVA35×12 = FVA420 = ?

37
1-38
5 NC-38
Future Values For Annuities –
Another Example
• Suppose you deposit $150 per quarter into
an account that has an APR of 9%, based
on monthly compounding. How much will
you have in the account in 35 years?
• Effective rate= ?
• FVA35×4 = FVA140 = ?

38
1-39
5 NC-39
Future Values For Annuities –
Another Example
• Suppose you deposit $150 per quarter into
an account that has an APR of 11.88%,
based on monthly compounding. How
much will you have in the account in 35
years?
• Effective rate= ?
• FVA35×4 = FVA140 = ?

39
1-40
5 NC-40

Multiple Cash Flows – PV Example


• You are offered an investment that will
make three $5,000 payments. The first
payment will occur 3 years from today.
The second will occur in 5 years and
third will occur in 7 years from today. If
you can earn 10.48% compounded
monthly, what is the most this
investment is worth today?
• PV0 = ?
• Effective Rate = ?
40
1-41
5 NC-41

PV Example Time Line


0 1 2 3 4 5 6 7 8

PV0 5,000 5,000 5,000

41
1-42
5 NC-42

Saving For Retirement


• You are offered the opportunity to put
some money away for retirement. You
will receive five annual payments of
$25,000 each beginning in 40 years.
How much would you be willing to invest
today if you can earn an interest rate of
11.5% compounded quarterly?
• PV0 = ?
• EAR = ?
42
1-43
5 NC-43

Saving For Retirement Time Line


0 1 2 … 39 40 41 42 43 44

0 0 0 … 0 25K 25K 25K 25K 25K

43
1-44
5 NC-44

Annuity – Example
After carefully going over your budget, you
have determined you can afford to pay $632
per month towards a new sports car. You call
up your local bank to find out that the going
rate is 12% per year compounded monthly
for 4 year car loans. What is the maximum
amount you can pay for a car today?
PVA0 = ?
Effective rate = ?

44
1-45
5 NC-45

Annuity – Sweepstakes Example


Suppose you win the $10 million sweepstakes
of the Publishers Clearinghouse. The money
is paid in equal annual installments of
$333,333.33 over 30 years. If the appropriate
discount rate is 5%, how much is the
sweepstakes actually worth today?
PVA0 = ?
Effective rate = ?

45
1-46
5 NC-46

Buying a House
• You are ready to buy a house and you have
$20,000 for a down payment and closing
costs. Closing costs are estimated to be 4% of
the loan value. You have an annual salary of
$36,000 and the bank is willing to allow your
monthly mortgage payment to be equal to
28% of your monthly income. The interest rate
on the loan is 6% per year with monthly
compounding (.5% per month) for a 30-year
fixed rate loan. How much money will the
bank loan you? How much can you offer for
the house?
46
1-47
5 NC-47

Buying a House - Continued


• Bank loan
 Monthly income = ?
 Maximum payment = ?
 PVA0 = ?
• Total Price
 Closing costs = ?
 Down payment = ?
 Total Price = ?

47
1-48
5 NC-48

Quick Quiz: Part 3


• You know the payment amount for a loan
and you want to know how much was
borrowed. Do you compute a present
value or a future value?
• You want to receive $5,000 per month in
retirement. If you can earn 1% per month
and you expect to need the income for 25
years, how much do you need to have in
your account at retirement?

48
1-49
5 NC-49

Finding the Payment


• Suppose you want to borrow $20,000 for a
new car. You can borrow at 12% per year,
compounded monthly. If you take a 5-year
loan, what is your monthly payment?
• We know PVA0, t, r but you don’t know C,
so we will solve PVA equation for C.

49
1-50
5 NC-50

Finding the Payment –


Another Example
• Suppose you want to have $15,000 in a
bank account in 5 years. You plan to
make quarterly deposits into a bank
account paying 12% compounded
quarterly. The first deposit will be today
and the last one will be exactly 5 years
from today. How much should you
deposit every quarter?
50
1-51
5 NC-51

Finding the Number of Payments - PVA


• Suppose we know PVA0, C, r but you don’t
know t, so we will solve PVA equation for
t.
1
1−
(1+𝑟𝑝 )𝑡
• 𝑃𝑉𝐴 = 𝐶 ×
𝑟𝑝
𝑃𝑉𝐴 1
• × 𝑟𝑝 = 1 −
𝐶 (1+𝑟𝑝 )𝑡
𝑃𝑉𝐴 1
• 1− × 𝑟𝑝 =
𝐶 (1+𝑟𝑝 )𝑡
1
• 𝑃𝑉𝐴 = (1 + 𝑟𝑝 )𝑡
(1− ×𝑟𝑝 )
𝐶
51
1-52
5 NC-52

Finding the Number of Payments - PVA

1
• ln 𝑃𝑉𝐴 = 𝑡 × ln(1 + 𝑟𝑝 )
(1− ×𝑟𝑝 )
𝐶

1
ln 𝑃𝑉𝐴
(1− 𝐶 ×𝑟𝑝 )
• 𝑡=
ln(1+𝑟𝑝 )

52
1-53
5 NC-53

Finding the Number of Payments - FVA


• Suppose we know FVA0, C, r but you don’t
know t, so we will solve FVA equation for t.
(1+𝑟𝑝 )𝑡 −1
• 𝐹𝑉𝐴 = 𝐶 ×
𝑟𝑝

𝐹𝑉𝐴
• × 𝑟𝑝 = (1 + 𝑟𝑝 )𝑡 −1
𝐶

𝐹𝑉𝐴
• × 𝑟𝑝 + 1 = (1 + 𝑟𝑝 )𝑡
𝐶

53
1-54
5 NC-54

Finding the Number of Payments - FVA

𝐹𝑉𝐴
• ln × 𝑟𝑝 + 1 = 𝑡 × ln(1 + 𝑟𝑝 )
𝐶

𝐹𝑉𝐴
ln ×𝑟𝑝 +1
𝐶
• 𝑡=
ln(1+𝑟𝑝 )

54
1-55
5 NC-55

Finding the Number of Payments


• You ran a little short on your summer
vacation, so you put $1,000 on your credit
card. You can only afford to make the
minimum payment of $20 per month. The
interest rate on the credit card is 12% with
monthly compounding. How long will it
take you to pay off the $1000?

55
1-56
5 NC-56

Finding the Number of Payments

56
1-57
5 NC-57

Finding the Number of Payments –


Another Example
• Suppose you want to save $20,000 at 6%
compounding monthly and you are going
to make semiannual payments of $734.42.
How long is it before you can save this
amount?

57
1-58
5 NC-58

Finding the Number of Payments –


Another Example

58
1-59
5 NC-59

Annuity – Finding the Rate


• Trial and Error Process
– Choose an interest rate and compute the PV of
the CFs based on this rate
– Compare the computed PV with the actual
amount
– If the computed PV > actual amount, then the
interest rate is too low
– If the computed PV < actual amount, then the
interest rate is too high
– Adjust the rate and repeat the process until the
computed PV and the actual amount are equal
59
1-60
5 NC-60

Finding the Rate


• Suppose you borrow $10,000 from your
parents to buy a car. You agree to pay
$207.58 per month for 60 months. What is
the monthly interest rate?

60
1-61
5 NC-61

Annuity – Finding the Rate


• Let’s try r=12% per year = 1% per month
– PVA0 = ?
• Since PVA0 ><= 10,000 our r is too ______.
We should _______ it and recalculate the
PVA0. Let’s try r= ____ per year = ____ per
month
– PVA0 = ?
• Now PVA0 ><= 10,000, our r is too ____. We
should ____ it and recalculate the PVA0. We’ll
continue this process until PVA0 = 10,000. That
r is ____for our problem.
61
1-62
5 NC-62

Quick Quiz: Part 4


• You want to receive $5,000 per month for the
next 5 years. How much would you need to
deposit today if you can earn .75% per
month?
• What monthly rate would you need to earn if
you only have $200,000 to deposit?
• Suppose you have $200,000 to deposit and
can earn .75% per month.
– How many months could you receive the
$5,000 payment?
– How much could you receive every month for 5
years?
62
1-63
5 NC-63

Table 5.2

63
1-64
5 NC-64

Perpetuity
• Perpetuity formula:
𝐶𝑡+1
PVAt∞ =
𝑟−𝑔
Example: An investment offers perpetual cash flows of
$300 every 6 months starting two years from today. The
return you require on such an investment is 8% per year
compounded semiannually. What is the value of this
investment today.
PVA3∞ = ?

64
1-65
5 NC-65

Perpetuity
• Perpetuity formula:
𝐶𝑡+1
PVAt∞ =
𝑟−𝑔
Example: An investment offers perpetual cash flows of
$300 every 6 months starting two years from today. If
these CFs are growing at 1% in every 6-months and you
require a return of 8% per year compounded semiannually
on investments like this, determine the value of this
investment today.
PVA3∞ = 300/(0.04 – 0.01) = $10,000
PV0 = 10,000/(1+0.04)3 = $8,890

65
1-66
5 NC-66

Quick Quiz: Part 5


• You want to have $1 million to use for
retirement in 35 years. If you can earn 1%
per month, how much do you need to
deposit on a monthly basis if the first
payment is made in one month?
• What if the first payment is made today?

66
1-67
5 NC-67
Pure Discount Loans
• Suppose your friend needs to borrow
some money to support himself in college.
He will graduate next year and start
working immediately. He thinks that he
can pay a maximum of $1,000 in two
years from today for this loan. If the bank
wants to earn a return of 8% per year on
this loan, what is the maximum amount
your friend can borrow from this bank?
• PV0 = ?
67
1-68
5 NC-68

Interest-Only Loan - Example


• Consider a 5-year, interest-only loan
with a 7% interest rate. The principal
amount is $10,000. Interest is paid
annually.
– What would the stream of cash flows
be?
– CFs at t=1, 2, 3, 4 = Interest on the
loan = ?
– CF at t=5 = Interest + Principle = ?
68
1-69
5 NC-69
Amortized Loan with Fixed
Payment - Example
• Each payment covers the interest expense
plus, it reduces principal
• Consider a 4-year loan with annual
payments. The interest rate is 8% and the
principal amount is $5,000.
– What is the annual payment?
– PVA0 = C×PVIFA8%,4 Solve for C

69
1-70
5 NC-70

Amortization Table for Example


Year Beg. Total Interest Principal End.
Balance Payment Paid Paid Balance
1 5,000.00 1,509.60 400.00 1,109.60 3,890.40

2 3,890.40 1,509.60 311.23 1,198.37 2,692.03

3 2,692.03 1,509.60 215.36 1,294.24 1,397.79

4 1,397.79 1,509.60 111.82 1,397.78 .01

Totals 6,038.40 1,038.41 4,999.99

70
1-71
5 NC-71

Quick Quiz: Part 6


• What is a pure discount loan? What is a
good example of a pure discount loan?
• What is an interest-only loan? What is a
good example of an interest-only loan?
• What is an amortized loan? What is a
good example of an amortized loan?

71
1-72
5 NC-72

Comprehensive Problem
• An investment will provide you with $100 at the end of
each year for the next 10 years. What is the present
value of that annuity if the discount rate is 8% annually?
• What is the present value of the above if the payments
are received at the beginning of each year?
• If you deposit those payments into an account earning
8%, what will the future value be in 10 years?
• What will the future value be if you open the account with
$1,000 today, and then make the $100 deposits at the
end of each year?

72
1-73
5 NC-73

FV of an Ordinary Annuity
• You are saving for a new house and you
put $10,000 per year in an account paying
8%. If the first payment is made in exactly
1 year from today and you make a total of
3 payments, how much will you have at
the end of 3 years?

73
1-74
5 NC-74

Ordinary Annuity Time Line

0 1 2 3

10000 10000 10000

FVA3 = 32,464

74
1-75
5 NC-75

FV of an Annuity Due
• You are saving for a new house and you
put $10,000 per year in an account paying
8%. If the first payment is made today and
you will make a total of 3 payments, how
much will you have at the end of 3 years?

75
1-76
5 NC-76

Annuity Due Time Line


0 1 2 3

10000 10000 10000

FVA2 = 32,464

FV3 = 35,016.12

76
1-77
5 NC-77

PV of an Ordinary Annuity
• You are saving for a new house and you
put $10,000 per year in an account paying
8%. If the first payment is made in exactly
1 year from today and you make a total of
3 payments, what is the value of these
payments today?

77
1-78
5 NC-78

Ordinary Annuity Time Line

0 1 2 3

10000 10000 10000

PVA0 = 25,771

78
1-79
5 NC-79

PV of an Annuity Due
• You are saving for a new house and you
put $10,000 per year in an account paying
8%. If the first payment is made today and
you make a total of 3 payments, what is
the value of these payments today?

79
1-80
5 NC-80

Annuity Due Time Line


-1 0 1 2 3

10000 10000 10000

PVA-1 = 25,771

FV0 = 27,832.68

80

You might also like