Today's Lecture

TIP
If you do not understand
something,
ask me!
NPV
Present Value
Multi-Period
Useful formulae
Discount Rates
2
Another NPV Example
z What if the choice were trading $10 today
for $20 tomorrow.
z What are the market prices in this case
y Dollars today are always worth their face
value, that is, their price is 1
y The price of dollars tomorrow is given by the
interest rate
3
Present Value
z If the interest rate is 10%, what is $20
tomorrow worth today?
y The amount of money you could borrow
against this payment.
y Denote this amount of money as x:
x
x

4
Another Example (contd)
z NPV=18.18-10=8.18
z You should take this opportunity.
z This decision does not depend on how
you personally trade off money today vrs
money tomorrow. It is just like copper
and aluminum.
5
Review
z Competitive Markets
y Both buy and sell at the same price
z Law of One Price
y Two securities with exactly the same cash
flows must have exactly the same price
z NPV Rule
6
Definition: NET PRESENT
VALUE
z The additional value today of an investment
opportunity.
z Net-Present-Value Rule (or the no-brainer rule)
y Take on any investment with a positive NPV.
y Reject any investment that has a negative NPV.
z Why do peoples' preferences not affect this rule?
7
Example 1
z I have an offer to sell my bike for $500.
My brother also wants to buy the bike.
He will pay me $545, but he can only
make the payment in a year. If current
interest rates are 10%, which is the better
deal?
8
Present Value Formula:
r
C
r
C
PV
+

9
NET Present Value
Formula:
I
I
r
C
I PV NPV
+

10
Example 2
z Your buddy would like to start a business.
He needs $10,000. If you lend him the
money and the business is successful, he
will give you $12,000 in a year.
y If interest rates are 10% what should you do?
x What is the present value of $12,000?
x What is the net present value of this investment?
y Is 10% the correct rate to use?
x What would your answer be if rates were 25%?
11
Multiperiods
z The key to not making a mistake is the
TIMELINE:
1
$10,000
2
$10,000
0
$0
Date:
Cash Flow:
Year 1 Year 2
End Year 1 Begin Year 2
Today
12
Example 3 - The Multi-
Period Case
z Assume that the average college tuition
costs $20,000 dollars per annum (paid at
the end of the year). For a freshman just
starting college, what is the present value
of the cost of a four year degree when the
interest rate is 10%?
397 , 63
1 . 1
000 , 20
1 . 1
000 , 20
1 . 1
000 , 20
1 . 1
000 , 20
4 3 2

+ + + PV
13
Multiperiod PV Formula:
( ) ( )
( )
n C
r
C
r
C
r
C
r
C
PV
n
N
n
n
n
N
N
1
2
2 1

+
+ +
+
+
+
K
14
Net Present Value
z Just the Present Value minus the cost of
the investment:
z Formula:
( )
I
r
C
I PV NPV
N
n
n
n

1
15
Where are we?
z We understand the basic idea but ...
z it is a pain to add up these series --- is
there an easier way?
y YES!
16
Perpetuity
z A certain (constant) cashflow forever (e.g.
a consol bond).
z What is the present value of a perpetuity
with cashflow C forever?

1 n
n
17
Perpetuity Timeline
3
C
0
0
2
C
1
C
( ) ( ) ( ) ( )
2 3
1
1 1 1 1
n
n
C C C C
PV
r r r r

+ + +
+ + + +

L
18
Trick
z How much money would you have to put
in the bank to get a constant cashflow
stream forever?
z Formula:
r
C
PV
$105
$100
$5
3 0
$100
2 1
$105
$100
$5
$105
$100
$5
19
Example
z You made your fortune in the dot-com boom
(and got out in time!). As part of your legacy,
you want to endow an annual MBA graduation
party at your alma matter. You want it to be a
memorable, so you budget $30,000 per year for
the party. If the university earns 8% per year on
its investments, and if the first party is in one
years time, how much will you need to donate
to endow the party?
20
Solution
z PV = C / r = $30,000 / .08 = $375,000
today.
3
30,000
0
0
2
30,000
1
30,000
21
Example Contd
z Suppose instead the first party was
scheduled to be held 2 years from today
(the current entering class). How would
this change the amount of the donation
required?
22
Solution
z PV = $375,000 / 1.08 = $347,222 today.
3
30,000
0
0
2
30,000
1
375,000
23
Growing Perpetuity
z A stream of cashflows that grows at a constant
rate forever.
z What is the present value of growing
perpetuity?
where g is the growth rate
( ) ( )
( )

+
+

+
+
+
+
+
+
+
+

1
1
3
2
2
1
) 1 (
1
) 1 (
1
) 1 (
1
n
n
n
r
g C
r
g C
r
g C
r
C
PV K
24
Timeline
A growing perpetuity with first payment of
$100 that grows at a rate of 3% has the
following timeline:
3
$103
1.03
= $106.09
0
0
2
$100
1.03
= $103
4
$106.09
1.03
= $109.27
1
$100
25
The General Case
In general, a growing perpetuity with first
payment C and growth rate g will have
the following series of cash flows:
3
C (1+g)
2
0
0
2
C (1+g)
4
C (1+g)
3
1
C
26
Trick
z Write the growing perpetuity as a perpetuity
and apply the previous formula
z Definition:
z Now write the PV formula as
1 -
1
1
so
1
1
1
1
g
r
R
r
g
R +
+

+
+

+
( ) ( )
( )
( )
1
]
1

+
+
+
+
+
+
+
+
+

+
+
+
+
+
+
+
+

K
K
2
2
3
2
2
1
) 1 (
1
) 1 (
1
1
1
1
) 1 (
1
) 1 (
1
r
g C
r
g C
r r
C
r
g C
r
g C
r
C
PV
27
Trick (continued)
z so the PV formulae from the previous
slide becomes
( )
( )

+
+
+
+

+
+
+
+
+

1
1
1
1
1
1
1
) 1 (
1
1
1
n
n
n
n
n
R
C
r r
C
r
g C
r r
C
PV
28
Trick (continued)
z Now apply the perpetuity formula
z Substitute back for (1+R)
( )

,
_

+
+
+

+
+
+
+

R
C
r r
C
R
C
r r
C
PV
n
n
1
1
1
1
1
1
1
1
g r
C
g
r
C
r r
C
PV

+
+
+
+
+

29
Example 5
z Assuming the discount rate is 7% per
annum, how much would you pay to
receive $50, growing at 5%, annually,
forever?

g r
C
PV
30
Annuity
z Pays a constant payment for a fixed
number of years (periods).
z What is the present value of an N period
annuity?

N
n
n
1
31
Timeline
N
C
0
0
2
C
1
C
( ) ( ) ( ) ( ) ( )
2 3
1
1 1 1 1 1
N
N n
n
C C C C C
PV
r r r r r

+ + + +
+ + + + +

L
32
Trick
z Write an annuity as the difference between two
perpetuities.
z An N period annuity is equal to a perpetuity
minus another perpetuity whose first cashflow
arrives in period N+1.
( ) ( )
48 47 6 48 47 6
1 N at
begins that perpetuity
1
perpetuity
1
+

N n
n
n
n
r
C
r
C
PV
33
Trick (contd)
( ) ( ) ( )
( )
( )

,
_

,
_

+

+ +

N
N
n
n N
n
n
r
r
C
r
C
r
r
C
r
C
r r
C
PV
1 1
34
Example
z You are the lucky winner of the $30
Million State Lottery. You can take your
prize money either as
1. 30 payments of $1M per year (starting
today),
2. $15M paid today. If the interest rate is 8%,
which option should you take?
35
Timeline
0
1M
29
1M
2
1M
1
1M
36
Growing Annuity
z Pays a constantly growing cashflow for a
fixed number of years (N)
37
Timeline
z What is the present value?

+
+

N
n
n
n
1
1
N
C (1+g)
N1
0
0
2
C (1+g)
1
C
38
Trick
z same as before!
z Express as the difference between two
growing perpetuities.
z Derivation
y Let N be the number of period to maturity, C
be the first payment, and g be the growth rate
x What is the first payment of the perpetuity that
needs to to be subtracted off?
N
g C +
Subtract the two perpetuities:
( ) ( )
( ) ( ) ( )
( )

,
_

,
_

+
+

+
+

+
+
+
+

+
+

+
+

+
+

N
N
N
n
n
n
N
N
n
n
n
N n
n
n
n
n
n
r
g
g r
C
g r
C
r
g
g r
C
r
g C
r
g
r
g C
r
g C
r
g C
PV
1
1
1
1
1 N at begins that
perpetuity growing
1
1
perpetuity growing
1
1
4 4 8 4 4 7 6 4 48 4 47 6
40
Example
z Assume that a college education means an
additional $10,000/year in starting salary, and
that this difference grows at 3% per annum.
Assume a 7% annual discount rate and a 40 year
working life.
y On graduation day, what is the value of the degree?
y Assuming that college costs about $20,000/annum
(due in advance), what is the NPV of the investment
opportunity?
41
Working Backwards
z Sometimes you know the PV, but you do not
know the payment
z Example
y You are considering opening a business that requires
an initial investment of $100,000. Your bank manager
has agreed to lend you this money. The terms of the
loan are that you will make equal annual payments
for the next 10 years and will pay an interest rate of
8%. What is your annual payment?
42
Solution
10
-C
0
100,000
2
-C
1
-C
100,000 (annuity) 0
100,000 (annuity)
PV
PV


10
1 1
100, 000 1 6.71
0.08
1.08
C C
_


,
100,000
$14, 903
6.71
C
43
Internal Rate of Return
z Sometime you know the monthly
payment and the PV and you would like
to know what interest rate sets them equal
z You can also think of this as the return of
the investment
44
Example
z Assume you wanted to purchase a BMW
that cost $40,000. The dealer is willing to
let you have the car with zero down
payment, so long as you are willing to pay
off the car with 4 annual payments of
$15,000. What interest rate is the dealer
charging for this loan?
45
Timeline
3
-$15,000
0
$40,000
2
-$15,000
4
-$15,000
1
-$15,000
46
IRR
z The internal rate of return (IRR) is the
interest rate that sets the present value of
an investment opportunity equal to zero.
47
The Discount Rate
z The discount rate is the correct rate to use
to move a particular cash flow in time.
z We have not really addressed where this
comes from.
z A deep question that we will not fully
answer in this course.
48
Example
z Your cousin would like to buy your Acura.
Unfortunately, he is just a student and has very
little money. Instead of paying for the car, he
offers to pay you $100/month forever. If the
annual interest rate is 10%, how much is he
offering to pay for the car?
y What monthly interest rate would you demand on
your deposit at the bank so that you would be
indifferent between that and being paid 10%
annually?
49
Aside: Annual vrs Monthly
Compounding
z Say you deposit $1
y If you chose the annual interest deposit in one
year you will have
y If you chose the monthly interest deposit in
one year you will have
z So..
a
r +
( )
12
m
r +
( )
12
12
12
+
+ +
a m
a m
r r
r r
50
Example - Solution

r
C
PV
51
General Idea
z Given a discount rate of r
x
per x-years,
the equivalent discount rate r
y
per y-
years is given by compounding (1+r
x
) for
y/x periods:
1 + r
y
= (1 + r
x
)
y/x
.
52
Interest Rate Quotes
z When a bank quotes an interest rate for a
particular loan, it is usually not correct to
use this quote directly as the discount rate
z The discount rate often has to be
computed from the quoted rate based on
the conventions of the quote.
53
Annual Percentage Rate
(APR)
y This is the amount of interest you would
earn in one year assuming that you rollover
the loan but do not reinvest any interest
payment paid during the year, that is, the
loan is not compounded.
54
Example
z If a 3 month bond has a 8% APR, how
much interest will I earn over the life of
the bond?
y Since the APR quote does not include interest
on interest and since a 3 month bond can be
reinvested 4 times during the year, the bond
will earn 2% interest over its life.
55
Effective Annual Rate
(EAR)
y This is the amount of interest you would earn
in one year assuming that you rollover the
loan and reinvest all interest payments as
often as is allowed by the terms of the loan,
that is, the loan is compounded as often as
possible during the year.
56
Example
z If a 3 month bond has a 8% EAR, how much
interest will I earn over the life of the bond?
y Since the EAR quote does include interest on
interest and since a 3 month bond can be reinvested
4 times during the year,
( )
4
4

+
r
r
57
Example 6
z Using current rates, assume that the most
you can afford in monthly mortgage
payments is $1000. If you plan to use a 30
year fixed rate mortgage with an interest
rate of 7.75% and a 1% origination fee,
how large a mortgage can you afford?
58
Next Lecture
z Topics
y Bonds
z Reading
y Chapter 5: Appendix, Sec. 5.4-5.9
y BD Chapters 6 and 6X