Financial management: Lecture 3 Time value of money Some important concepts.
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Transcript of Financial management: Lecture 3 Time value of money Some important concepts.
Financial management: Lecture 3
Time value of money
Some important concepts
Financial management: Lecture 3
Today’s agenda Review of what we have learned in the last lecture Discuss the concept of the time value of money
• present value (PV)• discount rate (r)• net present value (NPV)
Learn how to draw cash flows of projects Learn how to calculate the present value of annuities Learn how to calculate the present value of
perpetuities Inflation, real interest rates and nominal interest
rates, and their relationship
Financial management: Lecture 3
What have we learned in the last lecture
Three types of business organization and their characteristics
Three types of financial managers The goal of corporation and agency problem The motivation for the study of the financial
market The seven functions of a financial market The cost of capital
Financial management: Lecture 3
Financial choices
Which would you rather receive today?
• TRL 1,000,000,000 ( one billion Turkish lira )
• USD 850 ( U.S. dollars ) Both payments are absolutely
guaranteed. What do we do?
Financial management: Lecture 3
Financial choices
We need to compare “apples to apples” - this means we need to get the TRL:USD exchange rate
From www.bloomberg.com we can see:
• USD 1 = TRL 1,594,500 Therefore TRL 1bn = USD 627
Financial management: Lecture 3
Financial choices with time
Which would you rather receive?• $1000 today
• $1200 in one year
Both payments have no risk, that is, • there is 100% probability that you will be paid
• there is 0% probability that you won’t be paid
Financial management: Lecture 3
Financial choices with time (2)
Why is it hard to compare ?• $1000 today
• $1200 in one year This is not an “apples to apples” comparison.
They have different units $100 today is different from $100 in one year Why?
• A cash flow is time-dated money• It has a money unit such as USD or TRL
• It has a date indicating when to receive money
Financial management: Lecture 3
Present value
In order to have an “apple to apple” comparison, we convert future payments to the present values• this is like converting money in TRL to money in USD
• Certainly, we can also convert the present value to the future value to compare payments we get today with payments we get in the future.
• Although these two ways are theoretically the same, but the present value way is more important and has more applications, as to be shown in stock and bond valuations.
Financial management: Lecture 3
Present value (2)
The formula for converting future cash flows or payments:
= present value at time zero = cash flow in the future (in year t)
= discount rate for the cash flow in year t
tt
t
r
CPV
)1(0
0PV
trtC
itC
Financial management: Lecture 3
Example 1
What is the present value of $100 received in one year (next year) if the discount rate is 7%?• Step 1: draw the cash flow diagram
• Step 2: think !
PV<?> $100
• Step 3: PV=100/(1.07)1=
Year one
$100
PV=?
Financial management: Lecture 3
Example 2
What is the present value of $100 received in year 5 if the discount rate is 7%?• Step 1: draw the cash flow diagram
• Step 2: think !
PV<?> $ 100
• Step 3: PV=100/(1.07)5 = Year 5
$100
PV=?
Financial management: Lecture 3
Example 3
What is the present value of $100 received in year 20 if the discount rate is 7%?• Step 1: draw the cash flow diagram
• Step 2: think !
PV<?> $ 100
• Step 3: PV=100/(1.07)20 =
Year 20
$100
PV=?
Financial management: Lecture 3
Present value of multiple cash flows For a cash flow received in year one and a
cash flow received in year two, different discount rates must be used.
The present value of these two cash flows is the sum of the present value of each cash flow, since two present value have the same unit: time zero USD.
2
221
11
2010210
)1()1(
)()(),(
rCrC
CPVCPVCCPV ttt
Financial management: Lecture 3
Example 4 John is given the following set of cash flows and
discount rates. What is the PV?
• Step 1: draw the cash flow diagram• Step 2: think ! PV<?> $200• Step 3: PV=100/(1.1)1 + 100/(1.09)2 =
%101 r
Year one
$100
PV=?
1001 C
%92 r1002 C
$100
Year two
Financial management: Lecture 3
Example 5 John is given the following set of cash flows and
discount rates. What is the PV?
• Step 1: draw the cash flow diagram• Step 2: think ! PV<?> $350• Step 3: PV=100/(1.1)1 + 200/(1.09)2 + 50/(1.07)3 =
503 C
1.01 r
Yr 1
$100
PV=?
1001 C
09.02 r2002 C
$50
Yr 3
07.03 r
Yr 2
$200
Financial management: Lecture 3
Projects
A “project” is a term that is used to describe the following activity:• spend some money today
• receive cash flows in the future A stylized way to draw project cash flows is
as follows:
Initial investment(negative cash flows)
Expected cash flows in year one (probably positive)
Expected cash flows in year two (probably positive)
Financial management: Lecture 3
Examples of projects An entrepreneur starts a company:
• initial investment is negative cash outflow.
• future net revenue is cash inflow . An investor buys a share of IBM stock
• cost is cash outflow; dividends are future cash inflows. A lottery ticket:
• investment cost: cash outflow of $1
• jackpot: cash inflow of $20,000,000 (with some very small probability…)
Thus projects can range from real investments, to financial investments, to gambles (the lottery ticket).
Financial management: Lecture 3
Firms or companies
A firm or company can be regarded as a set of projects.• capital budgeting is about choosing the best
projects in real asset investments.
How do we know one project is worth taking?
Financial management: Lecture 3
Net present value
A net present value (NPV) is the sum of the initial investment (usually made at time zero) and the PV of expected future cash flows.
T
tt
t
t
T
r
CC
CCPVCNPV
10
10
)1(
)(
Financial management: Lecture 3
NPV rule
If NPV > 0, the manager should go ahead to take the project; otherwise, the manager should not.
Financial management: Lecture 3
Example 6
Given the data for project A, what is the NPV?
• Step1: draw the cash flow graph
• Step 2: think! NPV<?>10
• Step 3: NPV=-50+50/(1.075)+10/(1.08)2 =
%0.810
%5.750
50
22
11
0
rC
rC
C
Yr 0
Yr 1 Yr 2
$10$50-$50
Financial management: Lecture 3
Example 1 John got his MBA from SFSU. When he was interviewed by a
big firm, the interviewer asked him the following question: A project costs 10 m and produces future cash flows, as shown
in the next slide, where cash flows depend on the state of the economy.
In a “boom economy” payoffs will be high• over the next three years, there is a 20% chance of a boom
• In a “normal economy” payoffs will be medium• over the next three years, there is a 50% chance of normal
In a “recession” payoffs will be low• over the next 3 years, there is a 30% chance of a recession
In all three states, the discount rate is 8% over all time horizons.
Tell me whether to take the project or not
Financial management: Lecture 3
Cash flows diagram in each state
Boom economy
Normal economy
Recession
-$10 m$8 m $3 m $3 m
-$10 m
-$10 m
$2 m$7 m
$0.9 m$1 m$6 m
$1.5 m
Financial management: Lecture 3
Example 1 (continues)
The interviewer then asked John:• Before you tell me the final decision, how do
you calculate the NPV?• Should you calculate the NPV at each economy or
take the average first and then calculate NPV
• Can your conclusion be generalized to any situations?
Financial management: Lecture 3
Calculate the NPV at each economy
In the boom economy, the NPV is• -10+ 8/1.08 + 3/1.082 + 3/1.083=$2.36
In the average economy, the NPV is• -10+ 7/1.08 + 2/1.082 + 1.5/1.083=-$0.613
In the bust economy, the NPV is • -10+ 6/1.08 + 1/1.082 + 0.9/1.083 =-$2.87The expected NPV is 0.2*2.36+0.5*(-.613)+0.3*(-2.87)=-$0.696
Financial management: Lecture 3
Calculate the expected cash flows at each time
At period 1, the expected cash flow is• C1=0.2*8+0.5*7+0.3*6=$6.9
At period 2, the expected cash flow is• C2=0.2*3+0.5*2+0.3*1=$1.9
At period 3, the expected cash flows is• C3=0.2*3+0.5*1.5+0.3*0.9=$1.62
The NPV is• NPV=-10+6.9/1.08+1.9/1.082+1.62/1.083
• =-$0.696
Financial management: Lecture 3
Perpetuities We are going to look at the PV of a perpetuity starting one year from
now. Definition: if a project makes a level, periodic payment into perpetuity,
it is called a perpetuity. Let’s suppose your friend promises to pay you $1 every year, starting
in one year. His future family will continue to pay you and your future family forever. The discount rate is assumed to be constant at 8.5%. How much is this promise worth?
PV???
C CC C C C
Yr1 Yr2 Yr3 Yr4 Yr5 Time=infinity
Financial management: Lecture 3
Perpetuities (continue)
Calculating the PV of the perpetuity could be hard
1
21
)1(
1
)1()1()1(
iir
C
r
C
r
C
r
CPV
Financial management: Lecture 3
Perpetuities (continue)
To calculate the PV of perpetuities, we can have some math exercise as follows:
rrr
S
SS
S
S
r
1)1/(11
)1/(11
1)1(
1
32
2
1
Financial management: Lecture 3
Perpetuities (continue)
Calculating the PV of the perpetuity could also be easy if you ask George
rC
SCCr
C
r
C
r
C
r
CPV
i
i
ii
..)1(
1
)1()1()1(
11
21
Financial management: Lecture 3
Calculate the PV of the perpetuity
Consider the perpetuity of one dollar every period your friend promises to pay you. The interest rate or discount rate is 8.5%.
Then PV =1/0.085=$11.765, not a big gift.
Financial management: Lecture 3
Perpetuity (continue)
What is the PV of a perpetuity of paying $C every year, starting from year t +1, with a constant discount rate of r ?
C CC C C C
t+1 t+2 t+3 t+4 T+5 Time=t+infYr0
)1()1()1( 21 r
C
r
C
r
CPV
tt
Financial management: Lecture 3
Perpetuity (continue)
What is the PV of a perpetuity of paying $C every year, starting from year t +1, with a constant discount rate of r ?
rr
Crr
C
rr
C
rrrr
C
r
C
r
C
r
CPV
tti
it
t
tt
)1(
1.
)1()1(
1
)1(
)1(
1
)1(
1
)1(
1
)1(
)1()1()1(
1
21
21
Financial management: Lecture 3
Perpetuity (alternative method)
What is the PV of a perpetuity that pays $C every year, starting in year t+1, at constant discount rate “r”?• Alternative method: we can think of PV of a perpetuity
starting year t+1. The normal formula gives us the value AS OF year “t”. We then need to discount this value to account for periods “1 to t”
That is
rr
C
r
VPV
V
ttt
rC
t
)1()1(
Financial management: Lecture 3
Annuities
Well, a project might not pay you forever. Instead, consider a project that promises to pay you $C every year, for the next “T” years. This is called an annuity.
Can you think of examples of annuities in the real world?
PV???
C CC C C C
Yr1 Yr2 Yr3 Yr4 Yr5 Time=T
Financial management: Lecture 3
Value the annuity
Think of it as the difference between two perpetuities• add the value of a perpetuity starting in yr 1
• subtract the value of perpetuity starting in yr T+1
rrrC
rr
C
r
CPV
TT )1(
11
)1(
Financial management: Lecture 3
Example for annuities
you win the million dollar lottery! but wait, you will actually get paid $50,000 per year for the next 20 years if the discount rate is a constant 7% and the first payment will be in one year, how much have you actually won (in PV-terms) ?
Financial management: Lecture 3
My solution
Using the formula for the annuity
71.700,529$07.0*07.1
1
07.0
1*000,50
20
PV
Financial management: Lecture 3
Example
You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?
Financial management: Lecture 3
Solution
10.774,12$
005.1005.
1
005.
1300Cost Lease 48
Cost
Financial management: Lecture 3
Lottery example
Paper reports: Today’s JACKPOT = $20mm !!• paid in 20 annual equal installments.
• payment are tax-free.
• odds of winning the lottery is 13mm:1
Should you invest $1 for a ticket?• assume the risk-adjusted discount rate is 8%
Financial management: Lecture 3
My solution
Should you invest ? Step1: calculate the PV
Step 2: get the expectation of the PV
Pass up this this wonderful opportunity
mm
mmmmmmPV
818.9$
)08.1(
0.1
)08.1(
0.1)08.1(
0.1202
1$76.0$
0*)13
11(818.9*
13
1][
mm
mmmm
PVE
Financial management: Lecture 3
Mortgage-style loans
Suppose you take a $20,000 3-yr car loan with “mortgage style payments”• annual payments
• interest rate is 7.5% “Mortgage style” loans have two main
features:• They require the borrower to make the same payment
every period (in this case, every year)
• The are fully amortizing (the loan is completely paid off by the end of the last period)
Financial management: Lecture 3
Mortgage-style loans
The best way to deal with mortgage-style loans is to make a “loan amortization schedule”
The schedule tells both the borrower and lender exactly:• what the loan balance is each period (in this case -
year)
• how much interest is due each year ? ( 7.5% )
• what the total payment is each period (year) Can you use what you have learned to figure
out this schedule?
Financial management: Lecture 3
My solution
year Beginningbalance
Interest payment
Principlepayment
Total payment
Ending balance
0
1
2
3
$20,000
13,809
7,154
$1,500 $6,191 $7,691 $13,809
1,036 6,655
537 7,154 7,691 0
7,691 7,154
Financial management: Lecture 3
Future value
The formula for converting the present value to future value:
= present value at time zero = future value in year i
= discount rate during the i years
iittit rPVFV )1(0
0tPV
itr
itFV
itC
Financial management: Lecture 3
Manhattan Island Sale
Peter Minuit bought Manhattan Island for $24 in 1629. Was this a good deal? Suppose the interest rate is 8%.
Financial management: Lecture 3
Manhattan Island Sale
Peter Minuit bought Manhattan Island for $24 in 1629. Was this a good deal?
trillion
FV
979.75$
)08.1(24$ 374
To answer, determine $24 is worth in the year 2003, compounded at 8%.
FYI - The value of Manhattan Island land is FYI - The value of Manhattan Island land is well below this figure.well below this figure.
Financial management: Lecture 3
Inflation
What is inflation? What is the real interest rate? What is the nominal interest rate?
Financial management: Lecture 3
Be consistent in how you handle inflation!! Use nominal interest rates to discount
nominal cash flows. Use real interest rates to discount real cash
flows. You will get the same results, whether you
use nominal or real figures
Inflation rule
Financial management: Lecture 3
Example
You own a lease that will cost you $8,000 next year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?
1 real interest rate = 1+nominal interest rate1+inflation rate
Financial management: Lecture 3
Inflation
Example - nominal figures
99.429,26$
78.59708741.82=8000x1.034
56.63768487.20=8000x1.033
92.68098240=8000x1.032
73.727280001
10% @ PVFlowCash Year
4
3
2
10.182.87413
10.120.84872
10.18240
1.108000
Financial management: Lecture 3
Inflation
Example - real figures
Year Cash Flow [email protected]%
1 = 7766.99
2 = 7766.99
= 7766.99
= 7766.99
80001.03
7766.991.068
82401.03
8487.201.03
8741.821.03
2
3
4
7272 73
6809 92
3 6376 56
4 5970 78
26 429 99
7766 991 068
7766 991 068
7766 991 068
2
3
4
.
.
.
.
..
..
..
= $ , .