Chapters 4 Slide 1

Case 1

Slide 2

Case 1

Cash Flow

Slide 3 Compound Value: $2000 x 1.05 = $2,100 Net Present Value: $2000/1.05 = $1,905 Compound Value of $1905 $1905 x 1.05 = $2,000 Slide 4 Generalized Compound/Present Value Formulas

Generalized Compound Value Ct+T = Ct x (1+r)T Value in 1 year (T=1) = 2000(1+.05)1 = $2,100 Generalized Net Present Value Formula PV t = Ct+T / (1 + r)T

Present Value of amount paid/received in 1 year = 2000/(1+.05)1 = $1,905 If Leons offered two-year deferral and bank interest is 5% per annum Value in 2 years (T=2) = 2000(1+.05)2 = $2,205 Present Value = 2000/(1.05)2 = $1,814 Slide 6 What Rate is Enough?

Assume the total cost of a college education will be $50,000 when your child enters college in 18 years. You have $5,000 to invest today. What annual rate of interest must you earn on your investment to cover the cost of your childs education? Solve for r : Ct+T = Ct x (1 + r)T 50,000 = 5,000 x (1 + r)18 (1 + r)18 = 10 (1 + r) = 10(1/18) = 0.13646 = 13.646% per year

Slide 7 It is estimated that a firm has a pension liability that will require a payment of $1.5 M in 27 years. What amount must the firm invest today to meet this obligation if it will receives an annual return of 8% on its investment Ct+T T r Ct = $1.5 M = 27 = .08 = $1,500,000/(1.08)27 = $187,780

S lide 8 Ne t P re se nt V a lue / Discounte d Ca sh Flow Fa st Tra ck (Discount 10%) Initial Investm ent 0 (100) 1 New Revenues 1 60 0.909 (1/1.1) (100) 54.55 2 60 0.826 2 (1/1.1) 49.59 Scrap Value 3 40 0.751 3 (1/1.1) 30.05 Tim e Adjusted Cash Flow (NP V) 34.18

A ctual (Paym ent)/Receipt P resent Value Factor (10% )

Net P resent Value

S low Tra ck (Discount 10%)

Initial Investm ent 0 (100) 1

New Revenues 1 0 0.909 (1/1.1) 2 60 0.826 2 (1/1.1) 49.59 3 60 0.751 3 (1/1.1) 45.08

S crap V alue 4 40 0.683 4 (1/1.1) 27.32 Tim e Adjusted Cash Flow (NP V) 21.99

A ctual (Paym ent)/Receipt+ A51 P resent Value Factor (10% )

Net P resent Value Slide S low Tra ck (Discount 12%)

(100)

0.00

Initial Investm ent 0 (100) 1

New Revenues 1 0 0.893 (1/1.12) 2 60 0.797 2 (1/1.12) 47.83 3 60 0.712 3 (1/1.12) 42.71

S crap V alue 4 40 0.636 4 (1/1.12) 25.42 Tim e Adjusted Cash Flow (NP V) 15.96

A ctual (Paym ent)/Receipt P resent Value Factor (12% )

Net P resent Value

(100)

0.00

Slide 9 Some tips for computing NPV: Only add (subtract) cash flows from the same time period Use the Time Line Specify a cash flow for each time period (even when it is $0) Use an appropriate discount rate

The general formula for calculating NPV: NPV= - C0 + C1/(1+r) + C2/(1+r)2 + .. + CT/(1+r)T Slide 10 Perpetuity A stream of constant cash flows that lasts forever

Growing Perpetuity A stream of cash flows that grows at a constant rate forever

Annuity A stream of constant cash flows that lasts for a fixed number of periods

Growing Annuity A stream of cash flows that grows at a constant rate for a fixed number of periods

Slide 11. Perpetuity A Perpetuity is a constant stream of cash flows without end. PVt = Ct+1 / r

Simplification:

0 1 2 3 forever... |---------|--------|---------|--------- (r = 10%) $100 $100 $100 ...forever

PV0 = $100 / 0.1 = $1000

Slide 12. Growing Perpetuity A growing perpetuity is a stream of cash flows that grows at a constant rate (g) forever. Simplification: PVt = Ct+1 / (r - g)

0 1 2 3 forever |----------|---------|---------|------(r = 10%) $100 $102 $104.04 (g = 2%)

PV0 = $100 / (0.10 - 0.02) = $1250 Slide 13. Annuity An annuity is a stream of constant cash flows that lasts for a fixed number of periods. Simplification:

PV Annuity T = Ct+1 FV Annuity T = Ct+1 x (1 + r)T- 1 r 0 1 2 3 years |---------|--------|---------| (r = 10%) $100 $100 $100 PV0 = 100 x [1/.1 1/(.1(1.13)] = $249 FV3 = 100 x [(1.13 - 1)/.1] = $331

Slide 14.

Growing Annuity

A Growing Annuity is a stream of cash flows that grows at a constant rate over a fixed number of periods.

Simplification: PV Growth Annuity T = [1 - ()T] FV Growth Annuity T = PVGA t x (1+r)T

0 1 2 3 |---------|--------|---------| $100 $102 $104.04

PV0 = 100/0.08 x [1 - (1.02/1.10)3] = $253 FVT = $253 x 1.13 = $337 Slide 15

(r = 10%) (g = 2%)

Boris Karmalov, the number one draft choice of the Edmonton Oilers, has asked you to evaluate various contract offers made by the team. The team has offered him the following mutually exclusive deals (meaning he can choose only one). a) $4,000,000 payable immediately for a three year contract, with no further payments b) Annual payments of $1,500,000 for each of the three years starting immediately c) Annual payments of $1,600,000 for each of the three years starting one year from now d) A signing bonus of $500,000 immediately and a semi-annual payment of $700,000 over the next three years, starting in six months. Assuming the annual interest rate remains at 10% over the next three years, which contract should Boris sign? Year 0 1 2 3 Discount a) Rate 10% Payment Pres.Value 1 4,000,000 4,000,000 0.90909091 0.82644628 0.7513148 Total 4,000,000 1/1.1T
PV Annuity t = C t+1 x [ 1/r - (1 / (1 + r )]
2 = 1,500,000 + [1,500,000 x (1/.1 - (1/(.1(1.1) )))] = 1,500,000 + 2,603,306 = 4,103,306
t

b) Payment Pres.Value 1,500,000 1,500,000 1,500,000 1,363,636 1,500,000 1,239,669 4,103,306

Payment 1,600,000 1,600,000 1,600,000

c) Pres.Value 1,454,545 1,322,314 1,202,104 3,978,963

= 1,600,000 x (1/.1 - (1/(.1(1.1)3))) = 1,600,000 x 2.48685 = 3,978,963

Semi-Annual Periods 0 1 2 3 4 5 6

Discount Rate 5% 1 0.95238095 0.90702948 0.8638376 0.82270247 0.78352617 0.7462154

d) 500,000 700,000 700,000 700,000 700,000 700,000 700,000 500,000 666,667 634,921 604,686 575,892 548,468 522,351 4,052,984 500,000 700,000 x (1/.05 - (1/(.05(1.05)6))) = 3,552,984

Boris should select Option b) Total 4,052,984

Slide 15 Net Present Value

Question: You have just received a sizable inheritance, and wish to establish a fund for your sons college education. He will enter college in 5 years and will be taking a 4 year undergraduate degree. The current tuition and residents costs are $10,000 per year which is expected to increase by 4% per year. What funds should be set aside for his education now if these funds will earn a 7% investment return. Slide 16

Step 1. Tuition cost in 5 years $10000 x (1.04)5 = $12,167 Tuition

$10,000 $12,167 $12,654 $13,160 $13,686 0 1 2 3 4 5 6 7 8 !.!.!.!.!.!.!.!.!

Step 2. Present Value in year 4 of Growing Annuity paid at the beginning of the year 5 to 8 $12,167/(.07-.04) x [ 1 - (1.04/1.07)4]= $43,607 Present Value of Annuity (Year 4)
$43,607 $12,167 $12,654 $13,160 $13,686 0 1 2 3 4 5 6 7 8 !.!.!.!.!.!.!.!.!

Step 3. Current Present Value of the Growth Annuity $43,607/(1.07)4 = $33,267 Present Value of Annuity (Year 0)
$33,267 $43,607 0 1 2 3 4 5 6 7 8 !.!.!.!.!.!.!.!.!

Slide 17

Nominal Inte The stated periods

Slide 18
Slide 19
Compound/Present Value/Annuity/Effective Interest Rate Formulas Present Value: Compound Value: Perpetuity: Growing Perpetuity: Annuity: PV t FV T = CT / (1 + r)T = Ct x (1 + r)T

Perpetuity t = Ct+1 / r Growth Perpetuity t = Ct+1 / (r - g)

Present Value: PV Annuity T = Ct+1 x Future Value: FV Annuity T = Ct+1 x (1 + r) T- 1 r Growing Annuity: Present Value: [1 - ()T] Future Value: FVGA T = PVGA t x (1+r)T Where: t = initial period T = number of periods Ct = value in initial period Conversion of Nominal to Effective Interest Rate: e = [(1+r/T) T] - 1 e = effective annual rate r = nominal annual rate

1.

a)
T = number of compounding periods

W b

r = interest rate g = growth rate CT = value in period T

C alculatingaResidential Mortg e R (C ag ate anada) 1 All residential m ag are quoted as anom rate . ortg es inal com pounded sem i-annually 2 Therefore the effective rate is the stated rate . divided by 2then squared. For exam ple: 4 annual m ag (nom rate) % ortg e inal E ffective rate is: (1 .0 /2 -1= .0 0 = .0 % +4 ) 44 4 4 3 S . ince m ag are paid m ortg es onthly based on aconstant paym of principal and interest, this ent is an annuity but is based on the effec em th tiv on ly interest rate 4 The effective m . onthly rate is the rate that: > If com pounded 1 tim will g the effective 2 es ive annual rate, or >If com pounded 6tim will g the effective es ive sem i-annual rate What is the m onthly paym for a4 $ 0 ,0 0residential ent % 20 0 m ag am ortg e ortized over 2 years. 0 This am onthly annuity for 2 0m 4 onths (1 x 2 years) 2 0 The m onthly interest rate would be: (1+ /2 .04 ) (1+ 0 ) .04 4
(1/6) 2

-1= 0 3 5 = 3 5 % or .0 3 0 9 .3 0 9 -1= 0 3 5 = 3 5 % .0 3 0 9 .3 0 9
240

(1/12)

Monthly Paym =$ 0 ,0 0/(1 0 3 5 - (1 0 3 5 (1 3 0 9 ent 2 0 0 /.0 3 0 9 /.0 3 0 9 .00 3 5 = 1 0 .4 $ ,2 8 9

R v rs M rtg g P n e e e o a e la
Hm Eu Tdy o e q ity o a R e s M r a e(m x4 % ev r e o tg g a 0 ) N tE u e q ity R es M r a e ev r e o tg g Am Fe d in e s A p a a p r is l L a eg l C s g lo in T t l (B s fo r p y e t) o a a is r e a m n H m V lu in1 Y a s o e a e 0 er
Nominal Annual $ $ $ 200,000 (80,000) 120,000 80,000 400 600 1,495 $ $ 82,495 268,783 (1) Effective Monthly 0.486% 5.987%

R e s M r g g R te (2 ev r e o t a e a ) O t n1 p io : Lm Sm u p u

5.90%

Funds R eceived R everse Mortg g R ym a e epa ent H m E u yinT nY r o e q it e ea s

Home Value Rev. Mort. Repay. Net Equity

80,000 (147,555) (4 )

O tio 2 E u l M n lyP y e t p n : q a o th a m n s C sh R eived per Month a ec R ym Fa tor epa ent c Am ount D in1 Yea ue 0 rs R everse Mortg g ae H m E u inT nY a o e q ity e e rs

666.67

(5) (6) (7)

67 6 8 .4
$ 111,619

$
$

28 8 6 ,7 3 (1 7 5 ) 4 ,5 5
121,228

Value Rev. Mort. Repay. Net Equity

$ $
10

268,783 (111,619) 157,164

(1 $ 0 ,0 0x1 3 ) 20 0 .0 (2 (1 (.0 9 ) )-1 ) + 5 /2 (1 (.0 9 ) + 5 /2

(1/6) 2

C pound Interest om Annua E tive l ffec MonthlyE tive ffec C pound Interest om
1 0

-1

(3 $ 0 0 x1 3 ) 8 ,0 0 .0

10

(4 $ 2 9 x1 5 8 ) 8 ,4 5 .0 9 7 (5 $ 0 0 /1 0 ) 8 ,0 0 2 (6 $ 2 9 /1 0 ) 8 ,4 5 2

C pound Interest om

(7 $ 8 .4 x(((1 0 8 ) 67 6 .0 4 6

12 0

)-1 0 8 ) Future Va )/.0 4 6 lue of MonthlyAnnuity

BRICK "Don't Pay a Cent" Event: Cost Analysis

Components of Analysis 1 2 3 4 5 6 7 $2000 purchase interest free for 12 months Balance paid over 36 months Administration fee ($89.95) and HST payable upon purchase BRICK nominal rate on payment plan = 29.90% HSBC Credit Card nominal interest rate = 12.90% Bank nominal rate on 3 year unsecured loan = 7.25% Bank rate on 36 month GIC = 1.75% Loan Rates Nominal Annual Rates BRICK HSBC Bank Unsecured 29.90% 12.90% 7.25% Effective Annual Rate (monthly compound) BRICK HSBC Bank Unsecured BRICK HSBC Bank Unsecured Discount Rate GIC Nominal GIC Effective GIC Eff. Monthly Payment Due Immediately 1.75% 1.76% 0.146% Case 1 Pay Now [(1+(.0175/12)) 1.75/12 Case 2 Pay in full after 12 months Case 3 Convert balance after 12 months to Bank Loan $ $ $ 89.95 260.00 349.95 Case 4 Convert balance after 12 months to HSBC Credit Card $ $ $ 89.95 260.00 349.95 Case 5 Accept Brick repayment plan
12

34.36% 13.69% 7.50% 2.492% 1.075% 0.604%

[(1+(.2990/12)) [(1+(.1290/12)) [(1+(.0725/12)) 29.90%/12 12.90%/12 7.25%/12

12 12 12

] -1 ] -1 ] -1

Effective Monthly Rate

] -1

Payment Admin Fee HST Total

$ $ $ $

2,000.00 260.00 2,260.00

$ $ $

89.95 260.00 349.95

$ $ $

89.95 260.00 349.95

Repayment Costs Bank Unsecured Loan Balance Monthly Payment Annuity PV HSBC Credit Card Balance Monthly Payment Annuity PV BRICK Balance Monthly Payment Annuity PV

$ $ $

2,000.00 61.99 2000/[(1/.006045) - (1/(.006045(1.006045 2,172.35 61.99 x [(1/.00146) - (1/(.00146(1.00146

36 36

)))]

)))]

$ $ $

2,000.00 67.29 2000/[(1/.01075) - (1/(.01075(1.01075 36 )))] 2,358.26 67.29 x [(1/.00146) - (1/(.00146(1.00146 36 )))]

$ $ $

2,000.00 84.80 2000/[(1/.02492) - (1/(.02492(1.02492 36 )))] 2,971.78 84.80 x [(1/.00146) - (1/(.00146(1.00146 36 )))] Total Cost Analysis Case 2 Case 3 Pay in full after Convert balance 12 months after 12 months to Bank Loan $ 2,000.00 $ 2,172.35 0.9826 0.9826 $ 1,965.29 $ 2,134.65 2,260.00 $ 349.95 $ 349.95 2,260.00 $ 2,315.24 $ 2,484.60 $ 55.24 $ 224.60 100% 102% 110%

Case 1 Pay Now

PV 36 Month Annuity 12 Month Discount PV at Period 0 Payment at Period 0 TOTAL PAYMENT Diffference $ %

$ $

Case 4 Convert balance after 12 months to HSBC Credit Card $ 2,358.26 0.9826 $ 2,317.33 $ 349.95 $ 2,667.28 $ 407.28 118%

Case 5 Accept Brick repayment plan $ $ $ $ $ 2,971.78 0.9826 2,920.20 349.95 3,270.15 1,010.15 145%

1/1.00146

12

Website for Comparitive Credit Card Rates: http://www.fcac-acfc.gc.ca/eng/publications/CreditCardsYou/CreditCardComparisonTables-eng.asp

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