You are on page 1of 15

Discounted Cash Flows

1

What is the percentage price increase? 110 Suppose instead the asset price fell from 110 to 99. What is the percentage price decrease? Percentage change = 99 . today’s price is Pt = 121.110 110 = .110 = 10% 2 .Percentage Changes Yesterday’s price on an asset was Pt-1 = 110.10% Percentage change = 121 .

and today’s price Pt What is the annual rate of return on the stock? It is the percentage change… rt = Pt-1 Pt -1 = Pt – Pt-1 Pt-1 Now suppose we observe monthly prices Pt-1 . r12 How do we obtain the annualized rate of return: rannualized = (Average[r1 . … . r2 . Pt The monthly rate of return rmonth t = Pt – Pt-1 Pt-1 Why might we want to convert to an annualized return? How do we convert this to an annualized rate of return? rannualized = (r1month + 1)12 -1 What if we have 12 monthly returns: r1 . r12] + 1)12 – 1 3 . … . r2 .Annual Rates of Return Suppose we observe last year’s stock price Pt-1 .

054 101 Net return = 5.67% 4 .10 r2 = –2.35% Annualized return: (1 – 0.70 Mar 1.4% Seven weekly closing levels on Gold in 2006: Feb 1.5 = 1.78% Feb 15. 06: 572. 06: 547.00% r5 = -3.50 Feb 8.5. What is the rate of return on the stock? Gross Return = Example 2: 106. Today’s price is $106. 06: 558.50 r3 = 2. 06: 561.Rate of Return Examples Example 1: Last year’s stock price was $101.59% r6 = 1.50 Feb 22.41% r4 = 1.35%)52 -1 = –16. 06: 571.82% Weekly returns: r1 = –2. 06: 559.50 Mar 8.70 Mar 15. 06: 549.67% Average weekly return: –0.

96% per annum with semi-annual compounding What does (ii) mean? compounding…divide the rate in half. You are offered the following two rates: (i) 5. and receive that amount of interest every half-year.0248)(1.02 5 .05) = $105 (ii) 100(1.00% per annum (ii) 4.0248) = $105.Compounded Rates of Return You have $100 to invest. By convention: given a quoted (annual) rate with semi-annual (i) 100(1.

02)10 = 121.02)2 = $104.04 – with monthly compounding: 100 (1 + 4%/12)12 = 104.Compounding Examples Example 1 Bank offers 4% per annum savings rate for your 1 year.10 6 .90 – with monthly compounding: 100 (1 + 4%/12)60 = 122.00 – with semi-annual compounding: 100 (1.04) = $104.07 The differences are small.04)5 = 121. $100 investment… – with no compounding: 100 (1.67 – with semi-annual compounding: 100 (1. But what about over 5 years? – with no compounding: 100 (1.

99% 5.: PV = 200. comp.059/2)2 – 1 = 5.000 (1.000 (1.606 5.9% per annum with semi-annual compounding – 5. comp.02% (b) Which requires the lowest investment today? 6% per annum: PV = 200.000 for child’s college education in 15 years.0295)-30 = $83.0585*15 = $83.More Compounding Examples Example 2 • • Put aside money today to have $200.164 7 .06)-15 = $83.85% per annum with continuous compounding (a) What is r (effective annual rate) in each case? r = 6% 6% per annum: 5.453 5. Three banks offer the following rates: – 6% per annum (no compounding) – 5.9% semi annual: PV = 200.85% cont.: r = e0.000 e-0.9% semi annual: r = (1+0.0585 – 1 = 6.85% cont.

you invest $100 as m   100 (1 + 0. continuous compounding Year-end cash = K ert 8 .04/m)m = 100 e0.Continuous Compounding Bank offers 4% per annum with continuous compounding.08 General Formula: Invest K dollars for t years at a rate of r% per annum.04 = 104.

Compounding Summary Accounting for different compounding periods: – m = # compounding periods per year – t = # of years – n = # of periods = m * t – R = Annual (or Nominal or Stated) interest rate – i = Periodic rate = R/m FV PV = (1 + R/m)m*t As m  = FV (1 + i)n (1 + R/m)m  eR For continuous compounding over t years: FV = PV eRt 9 .

PV(1 + 0. r = 6%.06)2 89.06 )2 = PV = = 100 100 (1. t = 2.00 FV (1 + r)t 10 Generalize: PV = .Present Value Example: Receive $100 in two years time. What is that worth today? FV = 100.

06) (1. + = 368.Multiple Cash Flows Example: identical annual payment of $50 each year for 10 years Annual discount rate = 6% Cash flows ($) 50 1 2 3 4 5 6 7 Time (years) 8 9 10 P = 50 50 50 50 + + + .06) (1.06)3 10 (1.06) 11 ..00 2 (1...

06) 50 0...06)3 + .06 + 50 (1.06)10 = 368 = [1 – (1. + 50 (1.06)2 + 50 (1..Multiple Cash Flows P = 50 (1.06) -10] = 368 Formula for identical cash flows C every year for t years with discount rate r: C [1 – (1 + r)-t ] r ‘Annuity’ formula (why is this a misnomer?) PV = How could you calculate the Future Value of a series of periodic cash flows? 12 .

.03) 20 0.. + 20 (1.03)10 = = [1 – (1.03)2 + 20 (1.60 + 20 (1.03) PV = C [1 – (1 + r/m) -t*m ] = r/m C [1 – ( 1+i ) –n ] i where i = r/m.03 170.03)3 -10] + .Multiple Cash Flows and Compounding Example: identical annual payment of $40 every six months for 5 years Annual discount rate = 6% with semi-annual compounding P = 20 (1.. n = t * m 13 .

The loan has a annual rate of 7.780.000. What is the fixed monthly payment required to pay off the loan? For this example.62% 12 n = 30 * 12 = 360 PV = 400.45% = 0.0062 [1 – (1.44 14 .000.Example: Mortgage Payments Suppose you take out a 30 year mortgage loan of $400.000 = C 0. fixed over the life of the loan. 400. we wish to solve for C given i = 7.0062)-360 ] Hence C = $2.45%. and compounded monthly.

Then the annual equivalent rate is: rann equiv = (1 + 5%/12)12 – 1 = 5. and on Jan 31 2008 is 102.12% 15 . for a quoted mortgage rate) as follows: rann equiv = (1 + rquoted /12 )12 – 1 Suppose the quoted mortgage rate is 5%.g.Annualizing vs Annual Equivalence We annualize a rate of return to facilitate comparisons in the performance of different assets: Example: (1 + rmonth)12 – 1 = rannual where rmonth = ( P1 – P0)/ P0 subscripts represent monthly data If the asset’s price on Dec 31 2007 is 100. then the annualized return (based on this data alone) is: rannual = 26.8% We convert an annual rate with multiple compounding periods into an annual equivalent rate (e. with monthly payments.