CLASS NOTES WEEK III

READING ASSIGNMENT BMA 3

Alex Kane

1

IPCOR421 Finance

PV revisited
• We know that the PV of a future CF in t=1 is:
PV=C(1)/(1+r) = DF(1)*C(1)

• We will stick to the notation that C(t) is cash flow at time t and, for now, assume t measures years. • Thus C(2) denotes CF in year 2 and so on • What is the PV of C(2)? • We follow the same procedure as before, and ask: What is the price of a 2-year T-bill?

Alex Kane

2

IPCOR421  Finance

A 2-year Strip (of a T-bond)
• The U.S. Treasury doesn’t sell a two year claim to \$10,000. Beyond one year maturity, T-bonds and notes bear semi-annual interest coupons • However, financial institutions engage in “stripping.” This is the act of putting T-bonds in escrow and issuing separately claims to Zero Coupon Treasuries called Strips • Thus, you can purchase the equivalent of a 2year (and up) T-bill, or simply observe its price
Alex Kane 3 IPCOR421  Finance

The 2-year DF and market interest rate
• Suppose we observe a 2-year strip
C(2)=\$10,000 Price = \$9100

• We can compute:
DF(2) = 9100/10000 = 0.91 = PV(2-year safe \$)

• We can also compute the rate
r(2) = (10000–9100)/9100 = 0.0989 (9.89%)

• But, r(2) is the total rate for a two-year investment
Alex Kane 4 IPCOR421  Finance

The annual rate embedded in r(2) and DF(2)
• Suppose we invest \$1 in the 2-year strip. What annual rate will be earned? Denote it by r2 • Compounding r for two years, a \$1 investment will yield
1 + r(2) = 1.0989 = (1+r2)*(1+r2)= (1+r2)^2 1+r2 = 1.0989^(1/2) = 1.0483 (r2=4.83%)

• Equivalently:
1+r2 = 1/DF(2)^0.5 = 1/0.91^0.5 = 1.0483
Alex Kane 5 IPCOR421  Finance

Why do we see several levels of r?
• The strips of various maturities are safe in terms of default, that is, you are guaranteed to earn the promised rate • But, there are other risks involved: uncertain future inflation makes the true (real) value of the earned dollars uncertain. Also, if interest rates go up after one year, you will be better off investing in a 1-year claim and then another and so on • We commonly observe different annual rates in different maturities. We must match the maturity of rates to the maturity of the CF we discount • For now we assume the rate is same for all maturities
Alex Kane 6 IPCOR421  Finance

PV and NPV of projects
• A project involves investment, C(0), and future CF: C(1), C(2),…,C(T) ; T is the project horizon Some of the C(t) can be zero or negative C(T) includes scrap value, termination costs or resale value -- the net C(T) also can be positive or negative (e.g., reclamation of land - environmental obligation) • PV is additive: PV(sum) = sum (PV) PV[C(1)+C(2)+…+C(T)] = PV[C(1)] + … + PV[C(T)] = Σ PV[C(t)] = Σ [C(t) / (1+r)^t] • As before: NPV = C(0) + PV = C(0) + Σ [C(t) /(1+r)^t]
Alex Kane 7 IPCOR421  Finance

Annuities and perpetuities
\$1 Perpetuity \$1 0 1 \$1 2 \$1 3 4 5 Time line

Definition:  CF is same each equal­length period
\$1, three­period annuity \$1 0
Alex Kane

\$1 2

\$1 3 Time line
8 IPCOR421  Finance

1

Simple CF: Annuities and perpetuities
• A cash flow of equal payments spread over equal periods (not necessarily years) is called “annuity” • An annuity that continues to infinity is called “perpetuity” • If the annuity payments are \$C/period, the PV of the annuity is: PV(annuity) = C* Σ 1/(1+r)^t = C * PVA • PVA = PV(\$1 annuity) = Σ 1/(1+r)^t • The first term in the summation is 1/(1+r) • Each subsequent term is multiplied by 1/(1+r), called the “common factor,” • This is a geometric progression • here, the common factor is same as the first term and <1
Alex Kane 9 IPCOR421  Finance

PV of perpetuities
• In a geometric progression, the first term is denoted by “a” and the common factor by “q” • The sum of T terms of such progression is:
S(T) = a*(1–q^T)/(1–q) When q<1, then the sum of an infinite progression is S(∞) = a/(1–q), because q^T goes to zero With an annuity, the common factor is: q = 1/(1+r) <1 Also, the first term is the PV of the first payment which is: 1/(1+r) < 1 Therefore: a/(1–q) = 1/(1+r) / {1– [1/(1+r)] } = 1/r In sum: PV(perpetuity of \$C/year) = C/r
Alex Kane 10 IPCOR421  Finance

PV of annuities (1)
Perpetuity as of t = 0 \$1 0 1 \$1 2 \$1 3 Perpetuity as of t = 3 \$1 \$1 \$1 Time line

3 \$1 0
Alex Kane

\$1 2

\$1 3

4 5 6 A three­period annuity Time line
11

Time line

1

Notice: PV(annuity) = difference  between PV(perpetuities)
IPCOR421  Finance

PV of annuities (II)
• • • • • PV(perpetuity as of t=0) = C/r PV(perpetuity as of t=T) = (C/r)/(1+r)^T PV(annuity from 0 to T) = C/r – (C/r)/(1+r)^T = (C/r ) *[1–1/(1+r)^T] The value of an annuity is less than the value of a perpetuity, and gets closer to it as T (its length) grows Example:
(1) at 10%, PV( \$1 perpetuity) = 1/0.1 = \$10 (2) PVA(r=0.1,T=3) = (1/0.1)*(1–1/1.1^3) = 10*0.2487=\$2.49 In Excel, T is denoted by NPER
Alex Kane 12 IPCOR421  Finance

Example of annuity vs. perpetuity
• Suppose the annuity is of \$1000 and the required rate is either 4% or 16%
– Using the formula we have T (years) PV (4%) 1 961.54 20 13590.33 80 23915.39 perpetuity 25000.00 PV(16%) 862.07 5928.84 6249.96 6250.00

• Notice the effect of the rate on the value of the annuity and its convergence to the value of a perpetuity
Alex Kane 13 IPCOR421  Finance

Growth annuities and perpetuities
• In economics, time series where numbers grow at a constant (or close to it) rate are common • For CF, instead of a constant C, we have:
C(1), C(2)=C(1)*(1+g), C(3)=C(1)*(1+g)^2, …, C(T)=C(1)*(1+g)^(T–1)

• The PV of a growth annuity is of a similar form to an annuity. We replace C by C*=C(1)/(1+g) and the rate r by r*=(r–g)/(1+g) [ useful in Excel ] • With this substitution we can use the formulas for annuity/perpetuity for growth as well • Then PV(growth perpetuity) = C*/r* = C(1)/(r-g)
Alex Kane 14 IPCOR421  Finance

Example of a growth annuity
• Suppose shareholders (SH) expect next year’s dividend at C(1)= \$3/share, with growth of g = 7%/year. The required rate is r = 0.12 • To use annuity formula we substitute:
C* = C(1)/(1+g) = 3/1.07 = 2.8037 r* = (r–g)/(1+g) = 0.05/1.07 = 0.04673

• When this goes on forever, the value is
PV = C(1)/(r–g) = 3 / (0.12–0.07) = \$60

• If the stream ends at T=7, then:
PV = (C*/r*)*[1–1/(1+r*)^T] = (2.8037/0.04673)*(1–1/1.04673^7) = \$16.42
Alex Kane 15 IPCOR421  Finance

Annual compounding
• With annual compounding you do not earn interest on CF within the year • Your interest is calculated (and credited) at the end of each year, based on investment value at the beginning of the year • Most contracts allow for compounding over shorter periods

Alex Kane

16

IPCOR421  Finance

Compounding period in general
• When a compounding period is specified in a contract (for example, a mortgage contract calls for a compounding period of one month), interest is calculated and credited at the end of each such period (a month for mortgages) based on the investment value at the beginning of that period

Alex Kane

17

IPCOR421  Finance

Compounding convention
• A compounding period is specified • Accordingly, there are n compounding periods per year. For example: with monthly compounding, n=12 • An annual rate is specified and called: APR (Annual Percentage Rate), example: r = 0.07 • The compounding period rate is: APR/n = (monthly) 0.07/12 = 0.05833 • APR/n is used for each compounding period
Alex Kane 18 IPCOR421  Finance

The Effective Annual Rate (EAR)
• EAR = the annual rate actually earned on \$1 with the contract APR, over the compounding periods (n) • By definition
1+EAR = (1+r/n)^n With the previous example: EAR = (1+0.07/12)^12 – 1 = 0.0723 (7.23%)

• It is obvious that, given an annual rate (APR), EAR is greater the shorter the compounding period (and a larger n). You earn interest on interest more frequently • Is there a limit to this increase? Put differently, when n grows, does EAR grows without bound?
Alex Kane 19 IPCOR421  Finance

Continuous Compounding
• 1+EAR = (1+r/n)^n, will grows as n grows, but cannot exceed the limit:
Limit(n–>∞) of (1+r/n)^n = exp(r)

• Example: with APR=0.07, and continuous compounding, EAR= exp(0.07)–1 = 0.0725 (7.25%) • It appears that continuous compounding is an artificial construct, but is isn’t • For example, since information flows to the market continuously, values of financial assets compound continuously, although we observes them from transactions only infrequently
Alex Kane 20 IPCOR421  Finance

Compounding frequency and the EAR
• Example: semi-annual monthly weekly daily Cont.
n= 2 12 52 365 ∞ EAR(r=5%)= 5.0625 5.1162 5.1246 5.1268 5.1271 EAR(r=15%)=15.5625 16.0754 16.1583 16.1798 16.1834

• Obviously, one cannot profit from setting up a contract with more frequent compounding • Market conditions determine the appropriate EAR and the compounding interval is chosen for convenience
Alex Kane 21 IPCOR421  Finance

Note on terminology
• Consumer law requires that the EAR be clearly shown in any contract • Over time, some confusion took over and now frequently APR is listed as the EAR • You will find from your own experience that ignorance about compounding still is widespread

Alex Kane

22

IPCOR421  Finance

Mortgages: monthly compounding
• Consider a \$100,000, 30-year mortgage
payments are to be made every month and your obligation is compounded n=12 times a year Suppose APR is 9% the monthly rate is then r(month) = APR/n = 0.09/12 = 0.0075 (0.75%)

• A dollar you owe in the beginning of the year becomes:
(1+APR/n)^n = (1+0.0075)^12 = 1. 0938 = 1+EAR EAR = 0.0938 (9.38%) the Annual Effective Rate
Alex Kane 23 IPCOR421  Finance

Mortgage payments
• It is required that PV of payments equal the mortgage value. Using Excel’s function, PV:
PV(rate=0.075, nper=360, PMT, FV=0,0) = 100,000 PMT is the annuity amount needed to get the right PV Excel allows for a “balloon” payment (FV) at the end, here FV=zero. [The last argument, when set to 1, allows for PMT at beginning of month] PV = (C/r)*(1–1/(1+r)^T) = (C/0.075)*(1–1/1.075^360) Excel’s function, PMT, easily produces the monthly payment: PMT(rate=0.0075,nper=360,PV= –100000,0) = \$804.62
Alex Kane 24 IPCOR421  Finance

Inflation and real rates
• Suppose a one-year T-bill yields 7%, so a \$10,000 bill will cost 10000/1.07 = \$9345.79 • Suppose inflation over the next year is: i = 0.04 (4%) • An average \$1-item will cost you \$1.04 next year • Therefore, when you get your money, the purchasing power will be only 10000/1.04, or: Amount/(1+inflation rate) • Hence, your real rate (rr) is taken from
1+rr = (10000/9345.79)/(1+i) = (1+r)/(1+i) rr = (r – i)/(1+i). r is now referred to as the nominal rate

• The approximation rr = r –i is good only when inflation is low. With continous compounding: ccrr=ccr – cci (exactly)
Alex Kane 25 IPCOR421  Finance

Real and nominal CF
• The real value of a CF at t, RC(t), is found by discounting it at the rate of inflation RC(t) = C(t)/(1+i)^t • Conversely, the nominal CF, C(t), with purchasing power of C(0), is obtained by compounding at the rate of inflation C(t) = C(0)*(1+i)^t • Examples: With i=4%, looking t=10 years forward. (1) The purchasing power of C(t) = \$10,000 will be only RC(t) = \$6,755.64 (2) To maintain a \$50,000 standard of living we’ll need C(t) = \$74,012.21 This type of calculations is critical for personal finance!
Alex Kane 26 IPCOR421  Finance

PV of projects with inflation
• The PV of a project can be computed in two equivalent ways:
(1) PV(nominal CF) discounted at the nominal rate (2) PV(real CF) discounted at the real rate

• It is necessary to be consistent in the calculation. You choose one of the identical versions according to convenience and to what fits the presentation you may have to make

Alex Kane

27

IPCOR421  Finance

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