2 - 1 chapter 2 discounted cash flow analysis time value of money financial mathematics future value...
TRANSCRIPT
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2 - 1CHAPTER 2
Discounted Cash Flow AnalysisTime Value of Money
Financial Mathematics
Future valuePresent valueRates of returnAmortizationAnnuities, ANDMany Examples
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MINICASE 2SIMPLE?
p. 88
Also note financial mathematics problems at end of TAB &
Notes on Excel and LOTUS.
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MINICASE 2
Why is financial mathematics (time value of money) so important in financial analysis?
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a.Time lines show timing of cash flows.
ALWAYS A GOOD IDEA TO DRAW A TIME LINE.
CF0 CF1 CF3CF2
0 1 2 3i%
Tick marks at ends of periods, so Time 0 is today; Time 1 is the end of Period 1, or the beginning of Period 2; and so on.
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Time line for a $100 lump sum due at the end of Year 2.
100
0 1 2 Years
i%
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Time line for an ordinary annuity of $100 for 3 years.
100 100100
0 1 2 3i%
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Time line for uneven CFs -$50 at t = 0 and $100, $75, and $50 at the end of
Years 1 through 3.
100 50 75
0 1 2 3i%
-50
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b(1) What’s the FV of an initial$100 after 3 years if i = 10%?
FV = ?
0 1 2 310%
100
Finding FVs is compounding.
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b(1) What’s the FV of an initial$100 after 3 years if i = 10%?
FV = ?
0 1 2 310%
100
Finding FVs is compounding.
110 ?
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After 1 year
FV1 = PV + INT1 = PV + PV(i)= PV(1 + i)= $100(1.10)= $110.00.
After 2 years
FV2 = FV1(1 + i)= PV(1 + i)2
= $100(1.10)2
= $121.00.
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FV3 = PV(1 + i)3
= 100(1.10)3
= $133.10.
In general,
FVn = PV(1 + i)n.
After 3 years
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Solve the equation with a regular calculator
Use tables
Use a financial calculator
Use a spreadsheet
Four Ways to Find FVs
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USING TABLES: See handout
3 PERIODS10 %= 1.3310times 100 = $133.10SAY GOOD-BYE TO USING TABLES!
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Financial Calculator Solution
Financial calculators solve this equation:
There are 4 variables. If 3 are known, the calculator will solve for the 4th.
FV PV inn 1 .
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3 10 -100 0N I/YR PV PMT FV
Here’s the setup to find FV:
Clearing automatically sets everything to 0, but for safety enter PMT = 0.
Set: P/YR = 1, END
133.10
INPUTS
OUTPUT
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b(2) What’s the PV of $100 due in 3 years if i = 10%?
Finding PVs is discounting, and it’s the reverse of compounding.
100
0 1 2 310%
PV = ?
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PV =
Solve FVn = PV(1 + i )n for PV:
PV = $100/( ) =
= $100(0.7513) = $75.13.
FVn
(1 + i)n
n
1.103
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Financial Calculator Solution
INPUTS
OUTPUT
3 10 0 100
N I/YR PV PMT FV
-75.13
Either PV or FV must be negative. HerePV = -75.13. Put in $75.13 today, take out $100 after 3 years.
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EXCEL SOLUTION
LOOK AT FUNCTION’S PAGE FOR EXCEL/LOTUS.
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Spreadsheet Solution
Use the FV function: see spreadsheet in Ch 02 Mini Case.xls. = FV(Rate, Nper, Pmt, PV) = FV(0.10, 3, 0, -100) = 133.10
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Spreadsheet Solution
Use the PV function: see spreadsheet. = PV(Rate, Nper, Pmt, FV) = PV(0.10, 3, 0, 100) = -75.13
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c. If sales grow at 20% per year, how long before sales double?
Solve for n: Time line ? FVn = PV(1 + i)n
2 = 1(1.20)n
(1.20)n = 2
n ln (1.20) = ln 2n(0.1823) = 0.6931 n = 0.6931/0.1823 = 3.8 years.
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INPUTS
OUTPUT
Graphical Illustration:
01 2 3 4
1
2
FV
3.8
Years
20 -1 0 2N I/YR PV PMT FV
3.8 Beware:Some Calculators round up.
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Spreadsheet Solution
Use the NPER function: see spreadsheet. = NPER(Rate, Pmt, PV, FV) = NPER(0.20, 0, -1, 2) = 3.8
Correction
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ADDITIONAL QUESTION
A FARMER CAN SPEND $60/ACRE TO PLANT PINE TREES ON SOME MARGINAL LAND. THE EXPECTED REAL RATE OF RETURN IS 4%, AND THE EXPECTED INFLATION RATE IS 6%. WHAT IS THE EXPECTED VALUE OF THE TIMBER AFTER 20 YEARS?
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ADDITIONAL QUESTION
Bill Veeck once bought the Chicago White Sox for $10 million and then sold it five years later for $20 million. In short, he doubled his money in five years. What compound rate of return did Veeck earn on his investment?
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RULE OF 72
A good approximation of the interest rate--or number of years--required to double your money.
n * krequired to double = 72
In this case,5 * krequired to double = 72
• k = 14.4 Correct answer was 14.87, so for ball-park
approximation, use Rule of 72.
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ADDITIONAL QUESTION
John Jacob Astor bought an acre of land in Eastside Manhattan in 1790 for $58. If average interest rate is 5%, did he make a good deal?
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d. What’s the difference between an ordinary annuity and an annuity due?
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d. What’s the difference between an ordinary annuity and an annuity due?
PMT PMTPMT
0 1 2 3i%
PMT PMT
0 1 2 3
i%
PMT
Annuity Due
Ordinary Annuity
36
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HINT
ANNUITY DUE OF n PERIODS IS EQUAL TO A REGULAR ANNUITY OF (n-1) PERIODS PLUS THE PMT.
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e(1). What’s the FV of a 3-year ordinary annuity of $100 at 10%?
100 100100
0 1 2 310%
FV =
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e(1). What’s the FV of a 3-year ordinary annuity of $100 at 10%?
100 100100
0 1 2 310%
110
121
FV = 331
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FV Annuity Formula
The future value of an annuity with n periods and an interest rate of i can be found with the following formula:
.33110.
100
0.10
1)0(1
i
1i)(1PMT
3
n
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Financial calculators solve this equation:
There are 5 variables. If 4 are known, the calculator will solve for the 5th.
.0i
1ni)(1PMTn
i1PVnFV
Financial Calculator Formula for Annuities
Correct but confusing!
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3 10 0 -100
331.00N I/YR PV PMT FV
Financial Calculator Solution
Have payments but no lump sum PV, so enter 0 for present value.
INPUTS
OUTPUT
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Spreadsheet Solution
Use the FV function: see spreadsheet. = FV(Rate, Nper, Pmt, Pv) = FV(0.10, 3, -100, 0) = 331.00
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e(2). What’s the PV of this ordinary annuity?
100 100100
0 1 2 310%
_____ = PV
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What’s the PV of this ordinary annuity?
100 100100
0 1 2 310%
90.91
82.64
75.13248.69 = PV
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3 10 100 0
-248.69
INPUTS
OUTPUTN I/YR PV PMT FV
Have payments but no lump sum FV,so enter 0 for future value.
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Spreadsheet Solution
Use the PV function: see spreadsheet. = PV(Rate, Nper, Pmt, Fv) = PV(0.10, 3, 100, 0) = -248.69
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e(3). Find the FV and PV if theannuity were an annuity due.
100 100
0 1 2 310%
100
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3 10 100 0
-273.55
INPUTS
OUTPUTN I/YR PV PMT FV
Could, on the 12C, switch from “End” to “Begin”; i.e. f Begin.
Then enter variables to find PVA3 = $273.55.
Then enter PV = 0 and press FV to findFV = $364.10.
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Another HINT
FV OF AN ANNUITY DUE OF n PERIODS IS EQUAL TO THE FV OF A REGULAR ANNUITY OF n PERIODS TIMES (1+k) (slide 30)
PV OF AN ANNUITY DUE OF n PERIODS IS EQUAL TO THE PV OF A REGULAR ANNUITY OF n PERIODS TIMES (1+k)
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HINT, illlustrated
The PV of this regular annuity was 248.69.
Multiply this by (1 + .10), and you get: 273.55, the PV of the annuity due.
This avoids the necessity of having to switch from end to begin.
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PV and FV of Annuity Due vs. Ordinary Annuity
PV of annuity due: = (PV of ordinary annuity) (1+i) = (248.69) (1+ 0.10) = 273.56
FV of annuity due:= (FV of ordinary annuity) (1+i)= (331.00) (1+ 0.10) = 364.1
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3 10 100 0
-273.55 N I/YR PV PMT FV
Switch from “End” to “Begin”.Then enter variables to find PVA3 = $273.55.
Then enter PV = 0 and press FV to findFV = $364.10.
INPUTS
OUTPUT
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Excel Function for Annuities Due
Change the formula to:
=PV(10%,3,-100,0,1)
The fourth term, 0, tells the function there are no other cash flows. The fifth term tells the function that it is an annuity due. A similar function gives the future value of an annuity due:
=FV(10%,3,-100,0,1)
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EXCEL SOLUTION
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300
3
(f) What is the PV of this uneven cashflow stream?
0
100
1
300
210%
-50
4
______ = PV
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300
3
(f) What is the PV of this uneven cashflow stream?
0
100
1
300
210%
-50
4
90.91247.93225.39
-34.15530.08 = PV
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Input in “CFLO” register:
CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50Enter I = 10%, then press NPV button
to get NPV = 530.09.
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CALCULATOR SOLUTION
0 g CF0
100 g CFj
300 g CFj
2 g Nj
50 CHS g CFj
10 if NPV
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EXCEL SOLUTION
REMEMBER EXCEL/LOTUS READS THE 1ST CASH FLOW AS OCCURING ONE PERIOD HENCE.
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Spreadsheet Solution
Excel Formula in cell A3:
=NPV(10%,B2:E2)
A B C D E
1 0 1 2 3 4
2 100 300 300 -50
3 530.09
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g. What interest rate would cause $100 to grow to $125.97 in 3 years?
3 -100 0 125.97
INPUTS
OUTPUT
N I/YR PV FVPMT
8.00%
$100 (1 + i )3 = $125.97.
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EXCEL SOLUTION
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h.Will the FV of a lump sum be larger or smaller if we compound more often, holding the stated i% constant? Why?
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h.Will the FV of a lump sum be larger or smaller if we compound more often, holding the stated i% constant? Why?
LARGER! If compounding is more frequent than once a year--forexample, semiannually, quarterly,or daily--interest is earned on interest more often.
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0 1 2 310%
0 1 2 3
5%
4 5 6
134.01
100 133.10
1 2 30
100
Annually: FV3 = 100(1.10)3 = 133.10.
Semiannually: FV6 = 100(1.05)6 = 134.01.
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Periodic rate = iPer = iNom/m, where m is number of compounding periods per year. m = 4 for quarterly, 12 for monthly, and 360 or 365 for daily compounding.
Examples:
8% quarterly: iPer = 8/4 = 2%.
8% daily (365): iPer = 8/365 = 0.021918%.
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Effective Annual Rate (EAR = EFF%):The annual rate which causes PV to grow to the same FV as under multiperiod compounding.
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An investment with monthly compounding is different from one with quarterly compounding. Must put on EAR% basis to compare rates of return.
Banks say “interest paid daily.” Same as compounded daily.
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h(3).How do we find EAR for a nominal rate of 10%, compounded
semiannually?
EFF% = 1 + i
m - 1Nom
m
= 1+ 0.10
2 - 1.0
= 1.05 - 1.0= 0.1025 = 10.25%.
2
2
Or use a financial calculator (not 12C)
![Page 65: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/65.jpg)
2 - 65EAR = (1+knom/m)m - 1
.10 ENT2 divide1 +2 Yx
1 -= .1025
(1 + EAR) = (1+knom/m)m
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CALCULATOR
WHAT IS EAR IF COMPOUNDING QUARTERLY?
COMPOUNDING DAILY?COMPOUNDING CONTINUOUSLY?
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EAR = EFF% of 10%
EARAnnual = 10%.
EARQ = (1 + 0.10/4)4 - 1 = 10.38%.
EARM = (1 + 0.10/12)12 - 1 = 10.47%.
EARD(360) = (1 + 0.10/360)360 - 1 = 10.52%.
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For multiple years, n
(1 + EAR) = (1 + Knom/m)m
(1 + EAR)n = (1 + Knom/m)mn
To multiply by a $ of dollars, PRIN
PRIN * (1 + EAR)n = PRIN * (1 + Knom/m)mn
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i. Can the effective rate ever beequal to the nominal rate?
Yes, but only if annual compounding is used, i.e., if m = 1.
If m > 1, EFF% will always be greater than the nominal rate.
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When is each rate used?
iNom: Written into contracts, quoted by banks and brokers. May be used in calculations or shown on time lines when compounding is annual.
OR USE EAR!
![Page 71: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/71.jpg)
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Used in calculations,shown on time lines.
If iNom has annual compounding,then iPer = iNom/1 = iNom.
Can always use EAR!
iPer:
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EAR = EFF%: Used to compare returns on investments with different compounding patterns.
Also used for calculations if dealing with annuities where paymentsdon’t match interest compounding periods.
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FV of $100 after 3 years under 10% semiannual compounding? Quarterly?
Daily?
= $100(1.05)6 = $134.01.FV3Q = $100(1.025)12 = $134.49.
FV = PV 1 .+ imnNom
mn
FV = $100 1 + 0.10
23S
2x3
![Page 74: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/74.jpg)
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ALTERNATE SOLUTION USING EAR
FOR SEMIANNUAL COMPOUNDING, EAR = 10.25%
FOR 3 YEARS: 100*(1.1025)3 = $134.01
FOR Quarterly COMPOUNDING and 3 years:
100*(1.1038)3 = $134.49
![Page 75: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/75.jpg)
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j(3). What’s the value at the end of Year 3 of the following CF stream if the
quoted interest rate is 10%, compounded semi-annually?
0 1
100
2 35%
4 5 6 6-mos. periods
100 100
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Payments occur annually, but compounding occurs each 6 months.
So we can’t use normal annuity valuation techniques.
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1st Method: Compound Each CF
0 1
100
2 35%
4 5 6
100 100.00110.25121.55331.80
FVA3 = 100(1.05)4 + 100(1.05)2 + 100= 331.80.
![Page 78: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/78.jpg)
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Could you find FV with afinancial calculator?
Yes, by following these steps:
a. Find the EAR for the quoted rate:
2nd Method: Treat as an AnnuityI.E. USE EAR
EAR = (1 + ) - 1 = 10.25%. 0.10
22
![Page 79: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/79.jpg)
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Or, to find EAR with a 17 OR 19b Calculator:
NOM% = 10 P/YR = 2 EFF% = 10.25
![Page 80: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/80.jpg)
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3 10.25 0 -100
INPUTS
OUTPUT
N I/YR PV FVPMT
331.80
b. The cash flow stream is an annual annuity whose EFF% = 10.25%.
c.
![Page 81: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/81.jpg)
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j(2) What’s the PV of this stream?
0
100
15%
2 3
100 100
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What’s the PV of this stream?
0
100
15%
2 3
100 100
90.7082.2774.62
247.59
![Page 83: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/83.jpg)
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Calculator solution
100 PMT3 n10.25 if NPV=247.59
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2 - 84What’s the FV of this stream under
quarterly compouning?
0
100
1 2 3
100 100
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EAR WORKSHEET
EAR worksheet
knom = 0.12 INPUTm = 8 INPUTEAR = 0.126493
EAR= 0.1255 INPUTm = 4 INPUTknom= 0.119992
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k. Amortization
Construct an amortization schedulefor a $1,000, 10% annual rate loanwith 3 equal payments.
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Step 1: Find the required payments.
PMT PMTPMT
0 1 2 310%
-1000
3 10 -1000 0
INPUTS
OUTPUT
N I/YR PV FVPMT
402.11
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ALGEBRA
PMT/(1+k) + PMT/(1+k)2 + PMT/(1+k)3 = 1000
PMT [1/(1+k) + 1/(1+k)2 + 1/(1+k)3] = 1000, or
PMT = 1000/ [1/(1+k) + 1/(1+k)2 + 1/(1+k)3]
![Page 89: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/89.jpg)
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Step 2: Find interest charge for Year 1.
INTt = Beg balt (i)INT1 = 1,000(0.10) = $100.
Step 3: Find repayment of principal in Year 1.
Repmt = PMT - INT = 402.11 - 100 = $302.11.
![Page 90: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/90.jpg)
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Step 4: Find ending balance after Year 1.
End bal = Beg bal - Repmt= 1,000 - 302.11 = $697.89.
Repeat these steps for Years 2 and 3to complete the amortization table.
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Interest declines. Tax implications.
BEG PRIN ENDYR BAL PMT INT REDUCTION BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000
![Page 92: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/92.jpg)
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0 1 2 3
402.11Interest
302.11
Level payments. Interest declines because outstanding balance declines. Lender earns10% on loan outstanding, which is falling.
Principal Payments
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Amortization tables are widely used--for home mortgages, auto loans, business loans, retirement plans, etc. They are very important!
Financial calculators (and spreadsheets) are great for setting up amortization tables.
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EXCEL SOLUTION
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NEW PROBLEM:
On January 1 you deposit $100 in an account that pays a nominal interest rate of 10%, with daily compounding (365 days).
How much will you have on October 1, or after 9 months (273 days)? (Days given.)
![Page 96: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/96.jpg)
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iPer = 10.0% / 365= 0.027397% per day.
FV=?
0 1 2 273
0.027397%
-100
Note: % in calculator, decimal in equation.
FV = $100 1.00027397 = $100 1.07765 = $107.77.
273273
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273 -100 0
107.77
INPUTS
OUTPUT
N I/YR PV FVPMT
iPer = iNom/m= 10.0/365= 0.027397% per day.
Enter i in one step.Leave data in calculator.
![Page 98: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/98.jpg)
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Now suppose you leave your money in the bank for 21 months, which is 1.75 years or 273 + 365 = 638 days.
How much will be in your account at maturity?
Answer: Override N = 273 with N = 638. FV = $119.10.
![Page 99: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/99.jpg)
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iPer = 0.027397% per day.
FV = 119.10
0 365 638 days
-100
FV = $100(1 + 0.10/365)638
= $100(1.00027397)638
= $100(1.1910)= $119.10.
![Page 100: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/100.jpg)
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ALTERNATIVE SOLUTION USING EAR
FIND EAR.10 ENTER365 DIVIDE1 +365 Yx [= (1 + EAR)]
.75 Yx [= (1 + EAR).75]
100 MULTIPLY = $107.79
![Page 101: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/101.jpg)
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MORE PRECISELY, instead of .75 exponent:Calculate [1+EAR] as above, then273 ENTER
365 DIVIDE [=(1+EAR)]
Yx [=(1+EAR)(273/365)]
100 MULTIPLY = $107.77
![Page 102: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/102.jpg)
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PROBLEM
SUPPOSE THAT YOU WERE TOLD THAT THE EFFECTIVE ANNUAL RATE WERE 10%, WITH DAILY COMPOUNDING. WHAT THE STATED, OR NOMINAL RATE BE IN THIS CASE?
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ALGEBRA
(1 + EAR) = (1 + knom /m)m
(1 + EAR)(1/m) = (1 + knom /m)
(1 + EAR)(1/m) - 1 = knom /m
m*[(1 + EAR)(1/m) - 1] = knom
![Page 104: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/104.jpg)
2 - 104m*[(1 + EAR)(1/m) - 1] = knom
Using the calculator, EAR = 10%, dailycompounding.
1.1 ENTER365 1/X Yx
1 -365 MULTIPLY= 9.53%
![Page 105: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/105.jpg)
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n. You are offered a note which pays $1,000 in 15 months (or 456 days) for $850. You have $850 in a bank which pays a 7.0% nominal rate, with 365 daily compounding, which is a daily rate of 0.019178% and an EAR of 7.25%. You plan to leave the money in the bank if you don’t buy the note. The note is riskless.
Should you buy it?
![Page 106: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/106.jpg)
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3 Ways to Solve:
1. Greatest future wealth: FV2. Greatest wealth today: PV3. Highest rate of return: Highest EFF%
iPer = 0.019178% per day.
1,000
0 365 456 days
-850
![Page 107: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/107.jpg)
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1. Greatest Future Wealth
Find FV of $850 left in bank for15 months and compare withnote’s FV = $1000.
FVBank = $850(1.00019178)456
= $927.67 in bank.
Buy the note: $1000 > $927.67.
![Page 108: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/108.jpg)
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456 -850 0
927.67
INPUTS
OUTPUT
N I/YR PV FVPMT
Calculator Solution to FV:
iPer = iNom/m= 7.0/365= 0.019178% per day.
Enter iPer in one step.
![Page 109: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/109.jpg)
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2. Greatest Present Wealth
Find PV of note, and comparewith its $850 cost:
PV = $1000/[(1.00019178)456]= $916.27.
![Page 110: 2 - 1 CHAPTER 2 Discounted Cash Flow Analysis Time Value of Money Financial Mathematics Future value Present value Rates of return Amortization Annuities,](https://reader035.vdocuments.us/reader035/viewer/2022081504/5519f9305503462e378b463e/html5/thumbnails/110.jpg)
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456 .019178 0 1000
-916.27
INPUTS
OUTPUT
N I/YR PV FVPMT
7/365 =
PV of note is greater than its $850 cost, so buy the note. Raises your wealth.
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Find the EFF% on note and compare with 7.25% bank pays, which is your opportunity cost of capital:
FVn = PV(1 + i)n
1000 = $850(1 + i)456
Now we must solve for i.
3. Rate of Return
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456 -850 0 1000
0.035646% per day
INPUTS
OUTPUT
N I/YR PV FVPMT
Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.
EAR = EFF% = (1.00035646)365 - 1 = 13.89%.
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Using interest conversion:
P/YR = 365NOM% = 0.035646(365) = 13.01 EFF% = 13.89
Since 13.89% > 7.25% opportunity cost,buy the note.
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ADDITIONAL PROBLEM #2
IT IS NOW JANUARY 1. YOU PLAN TO MAKE 5 DEPOSITS OF $100 EACH, ONE EVERY 6 MONTHS, WITH THE FIRST PAYMENT BEING MADE TODAY. IF THE BANK PAYS A NOMINAL INTEREST RATE OF 12 PERCENT, SEMIANNUAL COMPOUNDING, HOW MUCH WILL BE IN YOUR ACCOUNT AFTER 10 YEARS?
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ADDITIONAL PROBLEM #3 IT IS NOW JANUARY 1, 1997. YOU ARE
OFFERED A NOTE UNDER WHICH SOMEONE PROMISES TO MAKE 5 PAYMENTS OF $100 EACH, WITH THE FIRST PAYMENT ON JULY 1, 1997 AND SUBSEQUENT PAYMENTS ON EACH JULY 1 THEREAFTER THROUGH JULY 1, 2001, PLUS A FINAL PAYMENT OF $1000 TO BE MADE ON JANUARY 1, 2002. WITH A NOMINAL DISCOUNT RATE OF 10 PERCENT, QUARTERLY COMPOUNDING, WHAT IS THE PV OF THE NOTE?
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JOHNM PROBLEMS