Economics 122

FINANCIAL ECONOMI CS (LECTURE 3)

M. DE BUQUE - G ONZ ALES
AY2014 -201 5

S O U R C E : B R E A LY & M Y E R S , R O S S E T A L . , L O ( 2 0 0 8 )
Valuing an asset
 Valuing an asset usually involves valuing a sequence of cash flows
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 ≡ 𝑉
 Useful to always draw a timeline to have a clear picture of the timing of cash
flows

𝐶𝐹 𝐶𝐹 𝐶𝐹

t=0 t=1 t=2 t=T time

Valuing an asset
 How is value determined? How do you compute for 𝑉 ?
 If there is no uncertainty, we have a complete solution.
 If there is uncertainty, can only get an approximation.
Present value and discounting
Point to ponder: Cash flows at different dates are in different currencies
 Consider manipulating foreign currencies:
Php100 + USD100 = ???
 Need to convert into a common currency!
 Either currency can be used as a numeraire.
 Same idea for cash flows at different dates.
Present value and discounting
Point to ponder: Cash flows at different dates are in different currencies
 Cash flows at different dates cannot be combined
 Need to pick a numeraire date, typically t=0 or today
 Cash flows can then be converted to present value
𝐶𝐹 𝐶𝐹 𝐶𝐹

t=0 t=1 t=2 t=T

 Basic equation:
𝑉 𝐶𝐹 , 𝐶𝐹 , 𝐶𝐹 , … = 𝐶𝐹 + 𝐸𝑅 / × 𝐶𝐹 + 𝐸𝑅 / × 𝐶𝐹 + ⋯
Present value and discounting
 Net  present  value:  “Net”  of  the  initial  cost  or  investment,  usually  captured  by  
cash flow at time, 𝐶𝐹
𝑉 𝐶𝐹 , 𝐶𝐹 , 𝐶𝐹 , … = 𝐶𝐹 + 𝐸𝑅 / × 𝐶𝐹 + 𝐸𝑅 / × 𝐶𝐹 + ⋯
 If  there’s  an  initial  investment,  then  𝐶𝐹 < 0
 Note that any 𝐶𝐹 can be negative (i.e., a future cost)
NPV Example 1
 Suppose we have the following conversion rates:
𝐸𝑅 / = 0.90 and 𝐸𝑅 / = 0.80
 What would be the NPV of a project requiring a current investment of Php100
million and cash flows of Php50 million in year 1 and Php75 million in year 2?
𝑁𝑃𝑉 = −100 + 0.90 × 50 + 0.8 × 75 = 5
 Suppose someone wants to buy this project but pay for it 2years from now.
How much should you ask for it?
NPV Example 2
 Suppose we have the following conversion rates:
𝐸𝑅 / = 0.90 and 𝐸𝑅 / = 0.80
 What would be the NPV of a project requiring an investment of Php100 million
in year 2, with a cash flow of Php40 million immediately and Php50 million in
year 1?
𝑁𝑃𝑉 = 40 + 0.90 × 50 − 0.8 × 100 = 5
 Suppose someone wants to buy this project but pay for it 2 years from now.
How much should you ask for it?
Time value of money
 Implicit assumptions for NPV calculations
o Cash flows are known (magnitude, signs, timing)
o Conversion rates are known
o No frictions in conversion
 For the moment take this as truth (will come back to this issue later)
 We focus now on the conversion rates
o Where do they come from? How are they determined?
Time value of money
What  determines  the  growth  of,  let’s  say  $1,  over  T  years?
 A dollar today should be worth more than a dollar in the future. Why?
o Supply and demand
o Opportunity cost of capital, 𝑟
$1 in year 0 = $1(1 + 𝑟) in year 1
$1 in year 0 = $1(1 + 𝑟) in year 2
⋮
$1 in year 0 = $1(1 + 𝑟) in year T
 The value of a dollar today on the left-hand side of the equation
 The future value of a dollar today on the right-hand side
Time value of money
What determines the value today of a $1 in year T?
 A dollar in year T should be worth less than a dollar today. Why?
o Supply and demand
o Opportunity cost of capital, 𝑟
$
in year 0 = $1 in year 1
( )

$
in year 0 = $1 in year 2
( )
⋮
$
in year 0 = $1 in year T
( )

 The left-hand side are our conversion rates or discount factors.

Time value of money
 We now have an explicit expression for 𝑉 :
1 1
𝑉 = 𝐶𝐹 + × 𝐶𝐹 + × 𝐶𝐹 + ⋯
(1 + 𝑟) (1 + 𝑟)
𝐶𝐹 𝐶𝐹
𝑉 = 𝐶𝐹 + + +⋯
(1 + 𝑟) (1 + 𝑟)
 With this expression, any cash flow can be valued!
 Accept positive NPV projects, reject negative NPV projects
 All capital budgeting and corporate finance problems reduces to this expression
 However, this still requires many assumptions (perfect markets)
Special cash flows: Perpetuity
 A perpetuity pays constant cash flow C forever
 How much is this infinite cash flow worth?
𝐶 𝐶 𝐶
𝑃𝑉 = + + +⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝐶 𝐶 𝐶
1 + 𝑟 × 𝑃𝑉 = 𝐶 + + + +⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝑟 × 𝑃𝑉 = 𝐶
𝐶
𝑃𝑉 =
𝑟
Special cash flows: Perpetuity
 Growing perpetuity pays growing cash flow 𝐶(1 + 𝑔) forever
 How much is this infinite cash flow worth?
𝐶 𝐶(1 + 𝑔) 𝐶(1 + 𝑔)
𝑃𝑉 = + + +⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
(1 + 𝑟) 𝐶 𝐶 𝐶(1 + 𝑔) 𝐶(1 + 𝑔)
× 𝑃𝑉 = + + + +⋯
(1 + 𝑔) (1 + 𝑔) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
(1 + 𝑟) 𝐶
− 1 × 𝑃𝑉 =
(1 + 𝑔) (1 + 𝑔)
𝐶
𝑃𝑉 = ,𝑟 −𝑔 > 0
𝑟−𝑔
Special cash flows: Annuity
 Annuity pays constant cash flow C for T periods
 How much is this cash flow worth?
𝐶 𝐶 𝐶
𝑃𝑉 = + +⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝐶 𝐶 𝐶
1 + 𝑟 × 𝑃𝑉 = 𝐶 + + + ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝐶
𝑟 × 𝑃𝑉 = 𝐶 −
(1 + 𝑟)
𝐶 𝐶 1
𝑃𝑉 = −
𝑟 𝑟 1+𝑟
Special cash flows: Annuity
 Sometimes written as
𝐶 1
𝑃𝑉 = 1 −
𝑟 1+𝑟
1 1
=𝐶× 1−
𝑟 1+𝑟
1
= 𝐶 × 1 − 𝑃𝑉𝐹(𝑟, 𝑇)
𝑟
= 𝐶 × 𝐴𝐷𝐹(𝑟, 𝑇)
Special cash flows: Annuity
 Annuity pays constant cash flow C for T periods
 Related to perpetuity formula

Perpetuity
t=0 1 2 … T T+1 …
Minus

Date-T Perpetuity …

Equals
…
T-period Annuity
Examples
 You just won the lottery and it pays $100,000 a year for 20 years. Are you a
millionaire? Suppose 𝑟 = 10%.
100,000 1
𝑃𝑉 = 1− = 851,356
0.10 1 + 0.10
 What if the payments last 50 years?
100,000 1
𝑃𝑉 = 1− = 991,481
0.10 1 + 0.10
 What if the payments last forever?
100,000
𝑃𝑉 = = 1,000,000
0.10
Examples
 Suppose we were examining an asset that promised to pay $500 at the end of each of
the next three years. The cash flows from this asset are in the form of a three-year,
$500 ordinary annuity. If we wanted to earn 10% on our money, how much would we
offer for this annuity?
.
◦ 𝐴n𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = $500 ∗ = $500 ∗ 2.48685 = $1,243.43
.

 After carefully going over your budget, you have determined you can afford to pay
$632 per month toward a new sports car. You call up your local bank and find out that
the going rate is 1% per month for 48 months. How much can you borrow?
.
◦ 𝐴n𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = $632 ∗ = $632 ∗ 37.974 = $24,000
.
Examples
 Finding the payment: Suppose you wish to start up a new business that specializes in
the latest of health food trends, frozen yak milk. To produce and market your product,
the Yakee Doodle Dandy, you need to borrow $100,000. Because it strikes you as
unlikely that this particular fad will be long-lived, you propose to pay off the loan
quickly by making five equal annual payments. If the interest rate is 18%, what will the
payments be?
C = $? C = $? C = $? C = $? C = $?

$100,000
t=0 t=1 t=2 t=3 t=4 t=5

$ , $ , $ ,
◦ $100,000 = 𝐶 × 𝐴𝐷𝐹 => C= = = = = $31,978
.
. . .
◦ Answer: $31,978
Examples
 Finding the number of payments: You ran a little short on your spring break 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 1.5% per month.
How long will you need to pay off the $1,000?
$1000 = $20 × 1−
. .
$1,000 1
× 0.015 = 1 −
$20 1 + 0.015
1
= 1 − 0.75 = 0.25
1.015
1.015 = 4
𝑇 × ln 1.015 = ln 4
.
𝑇= = 93 months
.
◦ Answer: About 93 months (or 7.75 years)
Examples
 Finding the rate: For example, an insurance company offers to pay you $1,000 per year
for 10 years if you pay $6,710 up front. What rate is implicit in this 10-year annuity?
$1,000 1
$6,710 = 1−
𝑟 1+𝑟
1 1
6.71 = 1 −
𝑟 1+𝑟

◦ How do you solve for r?

◦ Hard to compute this (use trial and error).
◦ Answer: 8%
Special cash flows: Annuity
 Future value for annuity cash flows:
𝐹𝑉 = 𝐶 + 𝐶(1 + 𝑟) + 𝐶(1 + 𝑟) + ⋯ + 𝐶(1 + 𝑟)
1 + 𝑟 𝐹𝑉 = 𝐶 1 + 𝑟 + 𝐶(1 + 𝑟) + ⋯ + 𝐶(1 + 𝑟)
𝑟 × 𝐹𝑉 = 𝐶(1 + 𝑟) − 𝐶
𝐶
𝐹𝑉 = (1 + 𝑟) −1
𝑟
Special cash flows: Annuity
 Sometimes written as
𝐶
𝐹𝑉 = (1 + 𝑟) −1
𝑟
1
= 𝐶 × (1 + 𝑟) −1
𝑟
= 𝐶 × 𝐹𝑉𝐹 𝑟, 𝑇 − 1
 Example: Suppose you plan to contribute $2,000 every year into a
retirement account paying 8%. If you retire in 30 years, how much will
you have?
.
◦ 𝐹𝑉 = $2000 ∗ = $2000 ∗ 113.2832 = $226,566.4
.
Cash flow timing – some notes
Note: In cash flow timing (i.e., in working present and future value problems), cash flow
timing is critically important.
◦ In almost all such calculations, it is implicitly assumed that the cash flows occur at the
end of each period.
Note on Annuity Due
◦ An annuity for which the cash flows occur at the beginning of the period is called an
annuity due.
◦ The relationship between the value of an annuity due and an ordinary annuity with
the same number of payments is just:
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑑𝑢𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 ∗ (1 + 𝑟)
◦ This works for both present and future values, so calculating the value of an annuity
due involves two steps: (1) calculate the present or future value as though it were an
ordinary annuity and (2) multiply your answer by (1 + r).
Compounding
 Interest may be charged more frequently than annually.
o Bank accounts – daily
o Mortgages, leases – monthly
o Bonds – semi-annually
 Annual percentage rate: The interest rate charged per period multiplied by the
number of periods per year. The quoted or stated rate.
o By law, the APR is simply equal to the interest rate per period multiplied by the
number of periods in a year.
o Ex. If interest rate is 1% per month, then APR is 12%.
Compounding
 The effective annual rate (EAR) may differ from APR.
o Ex. If interest rate is 1% per month, APR is 12% but EAR is 12.68%.
 Typical accounting conventions
o Let 𝑟 denote APR
o Let 𝑛 denote periods of compounding (e.g., 12 if monthly)
o 𝑟 /𝑛 is per-period rate for each period
 EAR is where 1 + 𝑟 = 1+𝑟 /𝑛 , and therefore:

𝑟 = 1+𝑟 /𝑛 −1
APR = n[(1+EAR)^(1/n) - 1 ]
Examples
 If a bank is charging 1.2% per month on car loans, then the APR that must be
reported is 1.2% × 12 = 14.4%. So, an APR is in fact a quoted, or stated, rate.
What is the EAR on such a loan?
.144
𝑟 = 1+ − 1 = 1.012 − 1 = 15.39%
12
 A typical credit card agreement quotes an interest rate of 18 percent APR.
Monthly payments are required. What is the actual interest rate you pay on
such a credit card?
.
𝑟 = 1+ − 1 = 1.015 − 1 = 19.56%
Continuous compounding
Continuous compounding: As 𝑛 approaches zero, the relation of EAR to the
APR denoted by 𝑟 is given by the exponential function/s:
◦1+𝑟 = exp 𝑟 =𝑒
◦𝑟 =𝑒 −1
◦ 𝑟 = ln(1 + 𝑟 ), which is the continuously compounded rate.
Example: A bank offers you two alternative interest schedules for a savings
account of $100,000 locked in for 3 years: (a) a monthly rate of 1%; (b) an
annually, continuously compounded rate (𝑟 ) of 12%. Which alternative
should you choose?
◦ For monthly rate = 1%, 𝑟 = [1 + 0.01] = 12.68%
◦ For 𝑟 = 12%, 𝑟 = 𝑒 . − 1 = 12.75%
◦ You should therefore choose the continuously compounded rate for its
higher EAR.
5-29
Inflation
 What is inflation?
o Change in real purchasing power over time
o Different from time value of money. (How?)
o Inflation can be problematic in some cases.
o How doe we quantify its effects?
 If we take into account inflation, the real return would be:
1+𝑟 × $1 = (1 + 𝑟 )(1 + 𝜋) × $1
1+𝑟
1+𝑟 =
(1 + 𝜋)
1+𝑟
𝑟 = −1 ≈ 𝑟 −𝜋
(1 + 𝜋)
 Think about it: Is the approximation overstated or understated?
if inflation > 0,
understated
otherwise