Professional Documents
Culture Documents
Investment Appraisal
Maths of Finance
Present and Future Values
Pat McAllister
INVESTMENT APPRAISAL:
INTEREST
• Interest is a reward or rent paid to a lender or
investor who has provided an asset (capital,
principal) to another party – the borrower
– bank lending e.g. a mortgage
– a share in a company
– government or corporate borrowing, bonds
– property investment
• Interest may appear as “income” “profit”
“dividend” or “rent” depending on the asset / deal
• What determines interest rates? The Fisher model:
– Time Preference or Impatience
– Expected or Anticipated Inflation
– The Risk Associated with the Investment
• Other assets: opportunity cost, cost of capital
INVESTMENT APPRAISAL:
SIMPLE INTEREST
• Place £100 into an account paying 8% interest.
After one year it will contain the original £100 plus
£8 interest. 100 * (1 + 0.08) = £108.
• In the second year, it earns a further 8% on the
original sum invested. 100 * (1 + 2 * 0.08) = £116
• In general C (1 + ni) = A where
C = initial capital invested
I = interest rate
n = term
A = final accumulated amount
• e.g invest £100 for 5 years at 8%
• A = 100 (1 + 5 * .08) = 100 * 1.4 = £140
• What would a rational investor do, however?
INVESTMENT APPRAISAL:
COMPOUND INTEREST
• The rational investor withdraws the £108 at the
end of year one and reinvests it at 8%
• At year two, she has £108 (1 + .08) = £116.64
• The extra £0.64 is interest earned on earlier
interest, or COMPOUND interest
Deposit £100 earning 10% compound interest.
At end Year 1 100 (1.1) = 110.00
end Year 2 100 (1.1) (1.1) = 121.00
or 100 (1.1)2
end Year 3 100 (1.1) (1.1) (1.1) = 133.10
or 100 (1.1)3
And so on………….
In general: An = C(1 + i)n
An is the Future Value of C at i% interest.
INVESTMENT APPRAISAL:
COMPOUND INTEREST
( 1 i)n
• C = 1000 (1.12)-3 = 1000 (0.7118) = £711.80
• £711.80 is the Present Value of £1,000 received in
three years time, discounted at 12%
• £100 received today is more valuable than £100
received in four years. Why?
– Inflation erodes spending power (inflation)
– Could invest the £100 and let it grow (opp. Cost)
– Will we actually receive the £100 later? (risk)
– WE WANT IT NOW NOW NOW (impatience)
– Could pay off other debt (cost of capital)
INVESTMENT APPRAISAL:
DISCOUNTING
• Discounting pulls back all future cashflows to a
common base period – today.
• In Property Valuation (1 + i)-n is the Present Value
of £1 - written PV£1 n
• In actuarial notation, this is written i v
• This is a useful, universal notation. It is NOT a
formula
In summary:
C0 0 n An
Discounting (1+i) -n
INVESTMENT APPRAISAL:
INTEREST RATE CHANGES
• Suppose an investment earns 8% for three years
then 10% for two years (assuming compound
interest). Future value is:
An = C (1.08) (1.08) (1.08) (1.1) (1.1)
= C (1.08)3 (1.1)2 = C (1.2597) (1.21)
= C (1.5243)
• What would the “average” rate be over the whole
period?
An = C(1 + i*)n So (1 + i*)5 = 1.5243
So (1 + i*) = (1.5243)(1/5)
So i* = (1.5243) (1/5) -1
= 0.088 or 8.8%
Check: (1.088)5 = 1.5246 (rounding error only).
INVESTMENT APPRAISAL:
INTEREST PAID LESS THAN ANNUALLY
• What is Annual Rate of Interest Charged at 2% per
month?
• (1+.02)12 – 1 = 26.8% per annum NOT 24% NB
• However, what is “10% per annum credited
quarterly”? In fact, this is 2.5% per quarter.
• (1.025)4-1 = 10.38% (and not 10%)
• Distinguish between NOMINAL & EFFECTIVE rates
– the published APR is an Effective Rate
• In general, where i(p) is the nominal rate payable
(“convertible”) p’thly (so p = 12 is monthly, p = 4
quarterly) then the annual effective rate is given
by: ( p)
i p
i [1 ] 1
p
INVESTMENT APPRAISAL:
INTEREST PAID LESS THAN ANNUALLY
• So a loan repayable monthly at a nominal 14.5%
has an effective rate of:
.145 12
[1 ] 1 .155 15.5%
12
• Remember that i(p) is not a formula, it is a number
– the p is the number of times that interest is
added in the year.
• For commercial property, in the UK rent is payable
quarterly. In many other countries, it is paid
monthly.
• This means it is important to be able to carry out
calculations that are not annual in nature.
INVESTMENT APPRAISAL:
INFLATION
• Suppose inflation is running at ƒ% per annum.
Then the purchasing power of £X received in one
year is X(1+ ƒ)-1 or X / (1 + ƒ). So £100 received
one year hence with inflation running at 3.5% is
worth 100 / (1.035) = 96.62.
• Now, if an investment pays j% per annum
compound interest, with inflation running at ƒ%
per annum, then the real accumulated values for
years 1,2,n will be, respectively:
2 n
(1 j ) (1 j ) (1 j )
(1 f ) (1 f ) (1 f )
INVESTMENT APPRAISAL:
INFLATION
• There must, thus, be a real interest rate i% such
that: (1 j )
(1 i)
(1 f )
• Hence:
(1 j ) j f
i 1...
(1 f ) (1 f )
ANNUITIES
INVESTMENT APPRAISAL
ANNUITIES
0 1 2 8 9 10
0 1 2 6 7 8
1
• The first payment is worth £1000
10%
2
• The second payment is worth £1000 10% and so on
8
• The year eight payment £1000 10%
1 2 8
• In total, we have: 1000 10% 1000 10% ...1000 10%
1 2 8
• Which is: 1000[ 10% 10% ... 10% ]
INVESTMENT APPRAISAL
PRESENT VALUES, ORDINARY ANNUITIES
• Generalising the square bracket for n years and i%
a n| i % [ 1
i%
2
i% ... n
i% ]
• This is the Present Value of an Ordinary Annuity
or, in UK valuer speak, the Years Purchase
• As before, this is a geometric progression, which
simplifies to the most important valuation formula
you will meet: n
a n| i % 1 vi
i
• In our example, n = 8 and i = 10%
• S0: present value =£1000 a 8| 10%
8
• 1000 1 1.1 = 1000 (5.3349) = £5,335
0 .1
INVESTMENT APPRAISAL
PRESENT VALUES, ORDINARY ANNUITIES
• Note that the total payments received are £8,000 but
the present value to us is only £5,300.
• The lower value reflects the impact of anticipated
inflation, time impatience, alternative investment
opportunities, borrowing costs and the risk
associated with this type of cashflow
• You can acquire a property lease, making an annual
profit of £1000. The lease has six years to run and
alternative investments have returns of 12%. How
much should you pay?
• £1,000 a 6| 12% = £1,000 (4.1114) = £4,111.41
0 5 6 7 8 9 10
• That is .1
2000 5
2000(.1638) 327.59
(1.1) 1
• 1 / s n| i %
is the Annual Sinking Fund or ASF in
valuation terminology. It is the amount of annual
investment at i% required to produce £1 after n
years. You can then multiply it by whatever the
required end amount is.
• In UK traditional valuation, this is used extensively
in the leasehold valuation process
INVESTMENT APPRAISAL
ANNUITIES DUE: PAYMENT IN ADVANCE
• Invest £1 at the start of each of the next n years:
£1 £1 £1 £1 £1
0 1 2 n-2 n-1 n
s n| i % = (1+i) s n| i %
INVESTMENT APPRAISAL
ANNUITIES DUE
• £200 invested at the start of each of the next ten
years earning 8% interest will be worth:
200 s
10| 8%
(1.08)10 1
that is 200(1.08) .08 or 200 (1.08) 14.4866
= £3,129.10
• Exactly the same principle applies to discounting /
calculating present values.
• Each payment is received one year earlier, so it is
discounted one year less.
• Therefore the Present Value of an Annuity Due is:
an| i % = (1+i) a n| i %
INVESTMENT APPRAISAL
ANNUITIES DUE
• The present value of £10,000 received at the start of
the next 15 years discounted at 8% is:
15| 8% = 10,000(1.08)a 15| 8%
10,000 a
a n |i% = 1 n| i %
so a
1
= (1+i) =
(1 i )
i i i
• An investment that pays £2,000 at the start of each
year in perpetuity, discounted at 8% has a present
value of 2000 (1.08)/.08 = 2000 (13.50) = £27,000
THINGS GET GRIM
QUARTERLY IN ADVANCE
The “effective” rental value must take into account the early arrival of income.
Suppose our annual discount rate is i%. Then the quarterly rate is j = (1+i) ¼-1.
1
R4
s 4| j % =
1
R (1+j)s 4| j %
4
s 4| j % = [(1+j)4 –1] / j
And so
s 4| j % = i / [(1+i) ¼ -1]
s 4| j % s 4| j %
= (1+j) = (1+i)¼ {i / [(1+i) ¼ -1]}
This now produces an effective annual in arrears rent, which we can present value using
a n |i%
.
1 1
s 4| j % a n | i %
R 4 (1+j) = R4 (1+i)¼ {i / [(1+i) ¼ -1]} * [1 – (1+i)-n] / i]
4
R 1
4
[1 (1 i ) ]
INVESTMENT APPRAISAL
QUARTERLY IN ADVANCE
1
4
4[1 (1 i ) ]
• For example, £2,000 received QinA for six years,
discounted at 12% has a present value of:
6
1 (1.12)
2000 1
2000(4.4154) 8,830.79
4
4(1 (1.12) )
• For a perpetuity, the numerator becomes 1
• For other periods, change the 4s to the appropriate
number e.g. monthly, change the 4s to 12s
IS THERE NO END TO THIS SUFFERING?
CONTINUOUS INCOME
• Suppose income is received “continuously”. Then
the present value:
n
1 v
a n| i % =
i
log e (1 i )
• What is the value of turnover at £10,000p.a.
received continuously for six years, discounting at
10%?
6
1 (110
. ) .4355
10,000 = 10,000 = 10,000 (4.5693) = £45,693
loge (110
. ) .0953
1
Year 1 is worth:
(1 i )
(1 g )
Year 2 is worth: (1 i ) 2 and so on until
(1 g ) n 1
Year n: (1 i ) n
Ia n | i % = 1 (1 g ) (1 g ) n 1
Thus (1 i ) + (1 i ) 2 + …. + (1 i ) n
This is yet another geometric series. Avoiding the algebra, this reduces to:
1 g n
1 ( )
Ia n | i % 1 i
= i g
IF ONLY TO BAFFLE YOU ….
INCREASING ANNUITIES
• Now where n tends to infinity (that is, for a
perpetuity), the numerator tends to 1 (assuming
that i > g), leaving:
1
Ia n | i % =
i g
• In equity markets this is the Gordon Dividend
Growth model: i is the required return, g is the
expected growth in dividends and d = i - g is the
dividend yield.
• The same principle applies to property. The initial
yield k = e - g where k is the initial yield, e is the
equated yield (required return) and g is the
expected rental growth. However, we need to
correct for the rent review period.
INVESTMENT APPRAISAL
INCREASING ANNUITIES
• An investment pays £10,000 per annum in
perpetuity: the income is expected to increase at 3%
per annum and the investor wishes to make a return
of 9% from this type of investment. What should she
pay?
1
10,000 10,000(16.6667 )
.09 .03
£166,667.