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Fins5514 L02 2023 PDF
Fins5514 L02 2023 PDF
Fins5514 L02 2023 PDF
Financing Decisions
2-2
Basic Definitions
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2-3
Time lines
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• On a time line:
– Time 0 is today,
– Time 1 is one period from today or the end of Period 1
and the start of Period 2, and so on.
• Information on a time line is written as:
– Cash flows are written above the tick marks
– Unknown cash flows are denoted with a question mark
– Interest rates are written above the line and between
the tick marks.
• Here there is a cash outflow of $100 at time 0 (note
the minus sign),
• The interest rate is 10% in period 1 (t=0 to t=1) and
5% in both period 2 and period 3.
• There are no cash flows at times 1 and 2. There is a
cash flow at time 3 exists but the value is unknown
2-6
Future Values: General Formula
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FV = PV(1 + r)t
– FV = future value
– PV = present value
– r = period interest rate, expressed as a decimal
– T = number of periods
2-7
Effects of Compounding
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• Simple interest
– assumes that interest rate paid is a flat percentage of the
principal (P) each period
• Compound interest
– interest is earned/paid on the principal plus any
accumulated interest determined since the start of the
deposit/loan.
• Consider the previous example
– FV with simple interest = 1000 + 50 + 50 = 1100
– FV with compound interest = 1102.50
– The extra 2.50 comes from the interest of .05(50) = 2.50
earned on the first interest payment
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Future Values – Example 2
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2-9
Future Values – Example 3
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2-10
Present Values
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PV = FV / (1 + r)t
2-12
Present Values – Example 2
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_
2-13
Present Value – Important Relationship I
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2-14
Present Value – Important Relationship II
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2-15
Discount Rate
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_
FV = PV(1 + r)t
r = (FV / PV)1/t – 1
2-16
Discount Rate – Example 1
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2-17
Discount Rate – Example 2
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2-18
Finding the Number of Periods
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FV = PV(1 + r)t
2-19
Number of Periods – Example 1
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2-20
Multiple Cash Flows –Future Value Example 1
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• Find the value at year 3 of each cash flow and add them
together.
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cash flow 7000 4000 4000 4000
|______|_____|_____|_____|
period 0 1 2 3 4
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Multiple Cash Flows – FV Example 2
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2-23
Multiple Cash Flows – Example 2 Continued
2-24
Multiple Cash Flows – Present Value Example 3
2-25
2-24
2-24
Annuities and Perpetuities Defined
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2-27
Ordinary annuity
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2-28
Annuities Basic Formulas
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• Annuities:
1
1 − t
(1 + r )
PV = C
r
(1 + r ) t
− 1
FV = C
r
2-29
To get the formulas :
• Assume an annuity of $1 for n periods, where the
periodical compound interest rate is r.
Cash flow $1 $1 $1 $1 ... $1 $1
|___|___|___|___|___|____________|___|
Period 0 1 2 3 4 n-1 n
( 1 + r )n - 1
FV = 1[ ]
r
• Using a similar technique we find that the present
value of a series of cash flows of $1 for n periods, at a
rate of r
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Annuity – Sweepstakes Example
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2-32
Buying a House
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Buying a House – Continued
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• Bank loan
Monthly income = 36,000 / 12 = 3,000
Maximum payment = .28(3,000) = 840
PV = 840[1 – 1/1.005360] / .005 = 140,105
• Total Price
Closing costs = .04(140,105) = 5,604
Down payment = 20,000 – 5604 = 14,396
Total Price = 140,105 + 14,396 = 154,501
2-34
Finding the Payment
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2-35
Finding the Number of Payments
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2-36
Future Values for Annuities
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2-37
Annuity due
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• You are saving for a new house and you put $10,000
per year in an account paying 8%. The first payment
is made today. How much will you have at the end
of 3 years?
2-39
2-38
x (1 + r)
2-38
Annuity Due- PV
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2-42
Methods
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• Method 1
– Let b be the delay period and assume that the annuity is
an ordinary annuity
– Calculate the present value of the annuity at the beginning
of period b. To calculate the PV of this stream at time zero
(today) discount the above annuity to time 0, by dividing
by (1+r)b-1
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2-41
• Method 2
– Take the present value of annuity paid for n years and
subtract an annuity paid over b-1 periods
2-44
Deferred Annuity example
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2-45
Perpetuities
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PV = C / r
2-46
Perpetuity – Example
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……
C C×(1+g) C ×(1+g)2
C C ×(1+ g) C ×(1+ g) 2
PV = + 2
+ 3
+L
(1+ r) (1+ r) (1+ r)
• The formula for the present value of a growing
perpetuity is (if g<r):
C
PVGrowing Perpetuity =
r -g 62
Growing perpetuity - example
• The expected dividend of Company XYZ next year is
$1.30 and dividends are expected to grow at 5%
forever. If the discount rate is 10%, what is the present
value of this dividend stream?
0 1 2 3
…
$1.30 $1.30×(1.05) $1.30 ×(1.05)2
$1.30
PV = = $26.00
0.10 − 0.05
63
Growing Annuity
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L
C C×(1+g) C ×(1+g)2 C×(1+g)T-1
C C ×(1+ g) C ×(1+ g) T −1
PV = + +L+
(1+ r) (1+ r) 2
(1+ r)T
• The formula for the present value of a growing annuity is:
PV =
C (1+ g)T
1−
r−g (1+ r)
64
Growing annuity - example
• A retirement plan offers to pay $20,000 the first year, and to
increase the annual payment by 3% each year until the person
dies. Assume the person will die in 40 years. What is the present
value at retirement if the discount rate is 10%?
0 1 2 40
L
$20,000 $20,000×(1.03) $20,000×(1.03)39
40
$20,000 1− (1.03)
PV = = $265,121.57
0.10 − 0.03 (1.10 )
65
Effective Annual Rate (EAR)
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2-53
Annual Percentage Rate
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2-56
Computing EARs – Example
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2-57
EAR – Formula
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m
APR
EAR = 1 + −1
m
2-58
Decisions, Decisions II
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Decisions, Decisions II Continued
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Computing APRs from EARs
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APR – Example
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= 12 (1 + .12) / −1
= .1138655152 or 11.39%
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Computing Payments with APRs
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2-63
Future Values with Monthly Compounding
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2-64
Continuous Compounding
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2-65
Loans and Amortization
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2-66
Pure Discount Loans
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2-67
Interest Only Loans
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2-68
Amortized Loans
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2-69