FINA 3332 Week 6

TUESDAY THURSDAY
Discussion: Article Discussion: Articles
Time Value of Money: Time Value of Money:
Valuing Cash Flow Valuing Cash Flow
Streams, BDH, Chapter 4 Streams, BDH, Chapter 4
Applications Applications
Homework 3 to be posted

These notes should be used by enrolled students only.

May not be copied, duplicated, or posted on a publicly available website.
FINA 3332 Lecture 9 1
FINA 3332
Lecture 9 2/21/2017
Discussion: Article
Time Value of Money: Valuing Cash Flow Streams,
BDH, Chapter 4
Applications

These notes should be used by enrolled students only.

May not be copied, duplicated, or posted on a publicly available website.
FINA 3332 Lecture 9 2
 Discussion: Article

FINA 3332 Lecture 9 3

 Financing
Decision
(raising $)

Financial
Manager

Cash flow
Investment
Decision
(spending $)

FINA 3332 Lecture 9 4

 -- Brief Review (Last Class) --

FINA 3332 Lecture 9 5

 Valuing a Stream of Cash Flows
Present Value

FINA 3332 Lecture 9 6

 4.1 Valuing a Stream of Cash Flows
Applying the Rules of Valuing Cash Flows to a Cash Flow Stream
Stream of cash flows is a series of cash flows lasting several periods, often
represented by a timeline.
Rules to move cash flows across time (Chapter 3)

FINA 3332 Lecture 9 7

 4.1 Valuing a Stream of Cash Flows
How to calculate the Present Value of this cash flow stream?
2 steps:
First, compute the present value of each individual cash flow
Then, combine the present values

FINA 3332 Lecture 9 8

 4.1 Valuing a Stream of Cash Flows
Present Value of a Cash Flow Stream

1 2
= 0 + + 2
+ +
(1 + ) (1 + ) (1 + )

FINA 3332 Lecture 9 9

 4.1 Valuing a Stream of Cash Flows
Example, Textbook 4.1
Now, suppose that Uncle Henry gives you the money, and then deposits your
payments in the bank each year.
How much will he have four years from now?
SOLUTION
Method 2 (easier): Use the formula for the Future Value of Cash Flow Stream
with a Present Value of PV

FV= $24,890.65(1.06)4=$31,423.87 in 4 years

FINA 3332 Lecture 9 10

 Special Cases:
Annuities, perpetuities, growing annuities
and growing perpetuities

FINA 3332 Lecture 9 11

 Introduction: Special Cases
The formulas we have developed so far allow us to compute the present or
future value of any cash flow stream (general formula)
Now we will consider two particular types of cash flow streams:
Perpetuities
Annuities

FINA 3332 Lecture 9 12

 4.2 Perpetuities
A perpetuity is a stream of equal cash flows that occur at regular intervals
and last forever.
Timeline:

NOTE that the first cash flow does not occur immediately. It arrives at the
end of the first period

FINA 3332 Lecture 9 13

 4.2 Perpetuities
Present Value (PV) of a Perpetuity with payment C and interest rate r is given
by:

= + + +
(1 + ) (1 + )2 (1 + )3
Notice that all the cash flows are the same
Also, the first cash flow starts at time 1
There is a shortcut for this calculation. We can show that the value of a
perpetuity is simply the cash flow divided by the interest rate.
Present Value (PV) of a Perpetuity simplifies to:

FINA 3332 Lecture 9 14

 -- End of Review --

FINA 3332 Lecture 9 15

 Chapter 4

Time Value
of Money: Valuing
Cash Flow Streams
 Time Value of Money: Valuing Cash Flow
Streams
1. Valuing a Stream of Cash Flows
2. Perpetuities
3. Annuities
4. Growing Cash Flows
5. Solving for Variables Other Than Present Value or
Future Value

FINA 3332 Lecture 9 17

 Introduction: Special Cases
The formulas we have developed so far allow us to compute the present or
future value of any cash flow stream (general formula)
Now we will consider two particular types of cash flow streams:
Perpetuities
Annuities

FINA 3332 Lecture 9 18

 4.3 Annuities
An annuity is a stream of N equal cash flows paid at regular intervals.

The difference between an annuity and a perpetuity is that an annuity ends

after some fixed number of payments
Note that, just as with the perpetuity, we assume the first payment takes
place one period from today (date 1)

FINA 3332 Lecture 9 19

 4.3 Annuities
Present value of an Annuity
Present Value of an N-period annuity with payment C and interest rate r is:

= + + +
(1 + ) (1 + )2 (1 + )3 (1 + )

We can show that the above expression simplifies to:

FINA 3332 Lecture 9 20

 4.3 Annuities
Example, Textbook 4.4
Present Value of a Lottery Prize Annuity
You are the lucky winner of the $30 million state lottery.
You can take your prize money either as
(a) 30 payments of $1 million per year (starting today), or
(b) $15 million paid today.
If the interest rate is 8%, which option should you take?

FINA 3332 Lecture 9 21

 4.3 Annuities
Example, Textbook 4.4
Present Value of a Lottery Prize Annuity
Option (a) provides $30 million in prize money but paid over time. To evaluate it
correctly, we must convert it to a present value.

Note that because the first payment starts today, the last payment will occur in 29
years (for a total of 30 payments). This is an example of an annuity due.
The $1 million at date 0 is already stated in present value terms, but we need to
compute the present value of the remaining payments.
This case looks like a 29-year annuity of $1 million per year, so we can use the annuity
formula.

FINA 3332 Lecture 9 22

 4.3 Annuities
Example, Textbook 4.4
Present Value of a Lottery Prize Annuity
The first payment is already stated in PV terms, but we need to calculate the PV of
the remaining 29 payments using the PV(annuity) formula for a 29-year annuity of
$1 million per year:
1 1
= 1
(1 + )
1 1
29 $1 = $1 1
0.08 1.0829
= $1 11.158406 = $11,158,406
$11.16

FINA 3332 Lecture 9 23

 4.3 Annuities
Example, Textbook 4.4
Present Value of a Lottery Prize Annuity
To calculate the total present value of the cash flows, we sum up the PV of the
annuity with the cash flow at time 0 ($1 million).

Conclusion: Option (b) is more valuable, even though the total amount of money paid
is half of the amount paid in option (a). Why?

FINA 3332 Lecture 9 24

 4.3 Annuities
In-Class Application

FINA 3332 Lecture 9 25

 4.3 Annuities
Future Value of an Annuity
0 1 2 N

C C C

PV FV
1 1
= (1 + ) = 1 (1 + )=
(1 + )

FINA 3332 Lecture 9 26

 4.3 Annuities
Example, Textbook 4.5
Retirement Savings Plan Annuity
Ellen in 35 years old, and she has decided it is time to plan seriously for her
retirement.
She will make her first contribution in one year (when she is 36). At the end
of each year until she is 65, she will save $10,000 in a retirement account.
If the account earns 10% per year, how much will Ellen have saved at age 65?

FINA 3332 Lecture 9 27

 4.3 Annuities
Example, Textbook 4.5
Retirement Savings Plan Annuity
Ellens savings plan can be modeled as an annuity of $10,000 per year for 30
years.
In this case, it is helpful to keep track of both the dates and Ellens age

FINA 3332 Lecture 9 28

 4.3 Annuities
Example, Textbook 4.5
Retirement Savings Plan Annuity
Ellens savings plan can be modeled as an annuity of $10,000 per year for 30
years.

To determine the amount Ellen will have in the bank at age 65, well need to
compute the future value of this annuity.

FINA 3332 Lecture 9 29

 4.3 Annuities
Example, Textbook 4.5
Retirement Savings Plan Annuity

1
= (1 + ) 1

1
= $10,000 1.1030 1
0.10

= $10,000 164.49

= $1.645 65

FINA 3332 Lecture 9 30

 4.3 Annuities
Example, Textbook 4.5
Retirement Savings Plan Annuity
Conclusion: By investing $10,000 per year for 30 years (a total of $300,000)
and earning interest on those investments, the compounding will allow her
to retire with $1.645 million.

FINA 3332 Lecture 9 31

 4.3 Annuities
In-Class Application

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 4.3 Annuities
In-Class Application
Solution
Timeline:

FINA 3332 Lecture 9 33

 Personal Finance Application
[TO BE DISCUSSED NEXT CLASS]
Evaluate your monthly budget and decide which expense(s) you could eliminate
each month (e.g. 2 coffee drinks a week; one restaurant meal a week ; etc.)
Then, do the following:
1. Compute the amount you could save per year
2. Assume that you will deposit this amount at the end of each year at a
retirement account (e.g. IRA) for the next 10 years
3. Go to https://investor.vanguard.com/mutual-funds/target-retirement/#/
4. Find the appropriate target fund for your age and select the 10- or 5-year (or 3-
year if the others are not available) average annual return of this fund.
5. If you invest the amount you are saving every year on this fund, for the next 10
years, how much will you have when you reach 65?

FINA 3332 Lecture 9 34

 Application: Mortgage & Loan Balance
PROBLEM
When you purchased your house, you took out a 30-year annual-payment
mortgage with an interest rate of 6% per year. The annual payment on the
mortgage is $12,000. You have just made a payment and have now decided
to pay the mortgage off by repaying the outstanding balance. What is the
payoff amount if:
a) You have lived in the house for 12 years (so there are 18 years left on the
mortgage)?
b) You have lived in the house for 20 years (so there are 10 years left on the
mortgage)?

FINA 3332 Lecture 9 35

 Application: Mortgage & Loan Balance
Solution (a) a. Timeline:
Timeline 12 13 14 15 30
0 1 2 3 18

12,000 12,000 12,000 12,000

To pay off the mortgage, you must repay the remaining balance.
The remaining balance is equal to the present value of the remaining payments.
The remaining payments can be modeled as a 18-year annuity:
1 1
= 1
(1 + )
1 1
= $12,000 1 = $129,931.24
0.06 (1.06)18

FINA 3332 Lecture 9 36

 Application: Mortgage & Loan Balance
Solution (b)
Similarly to (a):
To pay off the mortgage, you must repay the remaining balance.
The remaining balance is equal to the present value of the remaining payments.
The remaining payments can be modeled as a 10-year annuity:

1 1
= 1
(1 + )

1 1
= $12,000 1 = $88,321.04
0.06 (1.06)10

FINA 3332 Lecture 9 37

 Next Class
News Articles
Finish Chapter 4 -- BRING A CALCULATOR (or Excel)

FINA 3332 Lecture 9 38