INTRODUCTION TO BUSINESS FINANCE

CHAPTER 8C
EVEN MORE TIME VALUE OF MONEY

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 Far-Future-Values of CFs Expected in the Future

Example for a single CF:

We will get CF1 = $100 in one year (T = 1).

Find:
How big will CF1 grow to at T= 4 years, if invested at 6%?
IE: What is future value of CF1 at T = 4 years?

Solution:
• CF Diagram
• Equation
• Numbers

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General Case: How to Compute Far-Future Values:

Key Idea:
Measure how much a set of Cash Flows will grow to at time Tfinal.

 Draw a Cash Flow Diagram.

 For each cash flow i, apply CFi, final = CFi, initial*(1+r)^ΔT
 ΔT is time elapsed between CFi, initial and CFi, final
 Add up the CFi, final’s
 CFfinal, tot = CF1, final + CF2, final +…

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Optional Summation Notation Formula for Far-Future Values:

Let:
 Tx = Final Time X = time when we want to evaluate CFs.
 Ti = Time when CF(i) is received/disbursed (Ti <= Tx).
 CF(i)Ti = amount of CF(i), when it first appears.
 Tx – Ti = amount of time elapsed between Tx and Ti.

Then:
CFfinal, tot = Σ CF(i)Ti * (1 + r)(Tx-Ti)
i = 1 to number of cash flows (n)
Ti = time of CF(i)

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 Multiple CF, Far-Future-Value Example
Real World Example 2013:
Centrus Energy (LEU, formerly USEC) uses electrical energy for its
gaseous diffusion (GD) uranium enrichment plant.
(FYI, GD uses 50x as much energy as centrifuge plants {!},
for achieving equal amounts of enrichment).

To lock in energy prices, LEU agrees to pay TVA $89MM in three years,
for 1,000MW of power delivered in year 4.
(it’s T0 or EOY 0 now).

This is a “forward contract” (~ to a futures contract),

used for hedging (and for speculation).

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LEU’s bank offers guaranteed 9% interest rate (r) in money market
account for next three years.

LEU CEO asks you:

 Will $25MM set aside at the end of each year for three years
grow to $89MM or more by EOY3?
 If not, what alternative(s) do you recommend?

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Solution:
 Draw CF Diagram.

 For each cash flow i, apply CFi, final = CFi, initial*(1+r)^ΔT

 Add up CFi, finals
CFfinal, tot = CF1, final + CF2, final + CF3, final
 Tell CEO:

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Alternate funding plan:

 Make 3 annual payments

into money market,
starting now.

 Produces $89.3MM

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 Compounding Periods
So far we’ve considered:

Annual compounding
 r % interest per year
 T a real number, units = years.

Need to be more flexible:

 quarterly, daily, continuous compounding
 “annual compounding, paid semi-annually”

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The good news:
Everything we’ve done re time value can be generalized to
longer/shorter compounding periods.

How to handle non-annual compounding periods?

Just change time units, consistently.

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Two important things for consistent time units:

1. Consider a quarterly compounding example:

Say “r % interest, compounded quarterly”
Means r % interest is paid every quarter.
r is called “native” interest rate for quarterly compounding.

2. For any compounding example:

T = 0 means now (End Of Period 0, or EOP 0).
T = 1 means one compounding period from now.
(End Of Period 1, or EOP 1).

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Native Interest Rate Examples:
 r = 5%, compounded annually, T measured in years.
(What we have done to-date).
 r = 6%, compounded monthly, T measured in months.
 r = 2%, compounded quarterly, T measured in quarters.
 etc.

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 Quarterly Compounding Period Example
Consider a 3-quarter mortgage:

 BigShark Lenders offers Mr. Small-Net-Worth

$30K to buy a $50K shack today.
(Mr. SNW pays $20K today).

 SNW agrees to pay BigShark back in 3 equal, quarterly payments,

with 10% interest compounded quarterly.

 How much is each quarterly payment?

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Solution:
Here, native r: r compunds quarterly, T measured in quarters.

This is still true:

PVTOT = CF0 = CF * Σ 1 / (1+r)Ti
i = 1,...number of future cash flows
Ti = Time of Cash Flow i, where T = 0 at PV

Just use our native r units.

r = ____________________________________________________.

T= 1 means _____________________________________________.

PVTot = CF0 =

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 Compounding Periods – EAIR
In Finance, we need to compare projects with various compounding periods
(Yearly vs Quarterly vs Monthly, etc).

Equivalent Annual Interest Rate (EAIR or EAR) lets us do this.

→ EAIR lets us make apples-to-apples comparisons of projects with
various compounding periods.

EAIR == interest generated per dollar over a year, irrespective of

compounding period.

EAIR = (1+r)(no. of compounding periods per year) - 1 89k)

Where r = native interest rate.

EAIR = “X% interest, compounded annually.”

= Same as annual r we’ve used to date.

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Examples using EAIR = (1+r)(no. of compounding periods per year) - 1

r = 10%, compounded annually

 EAIR = __________________________.

r = 10%, compounded quarterly

 EAIR = __________________________.

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 Compounding Periods – Nominal APR

Nominal Annual Percentage Rate (“Nominal APR,” or “APR”)

== r * (number of compounding periods per year)
Where r = native interest rate.

Note:
 “Nominal APR” is universally-agreed term.
 “APR” used to mean Nominal APR by some and EAIR by others.
 Our convention: APR = Nominal APR.

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APR Usage Examples:

If: r = 7%, compounded annually

Then: APR = 7% * 1 = 7%
Say: “Nominal APR = 7%, with annual compounding.”

If: r = 10%, compounded quarterly

Then: APR = 10% * 4 = 40%
Say: “APR = 40%, with quarterly compounding.”
(IE: r = 40% / 4 = 10% compounded quarterly).

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APR is common but usually not helpful.
 It does not capture effect of compounding.
 Usually underestimates EAIR.

To make APR useful:

1. Divide APR by no. compounding periods/year
to get r in native time units.
Example: APR = 24%, with monthly compounding
→ r = 24%/12 = 2% compounded monthly

2. Compute EAIR from r.

Same Example: EAIR = (1+r)^nper – 1 = ___________________.

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 Nominal APR – EAIR Example
Which money market offer is best?
 Bank 1: 5.0% compounded annually.
 Bank 2: 4.5% APR, with monthly compounding.

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EAIR Bank 1 =

EAIR Bank 2:
 APR = 4.5%
r=

 EAIR =

Bank ____ offers better deal.

(Bank _____ builds you a bigger pile of money / year).

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APR, native r and EAIR rules:

1. Always convert APRs to native r’s before using time value equations.
2. Whenever possible, solve problems in native r units.
3. Only use EAIR when you need it to solve a problem.

Why (Optional):
 Our fundamental time value formula, FV = PV*(1+r)^T works for any time units and any time
T, including non-integer times. For example, r = 2% compounded monthly and T=3.67 months.
 By contrast, the annuity formula and the annuity due formula (covered in the previous chapter)
assume we are working with native r, a consistent measure of time, and with uniform cash flows that
occur (only) at every compounding period. For example, r= 4% compounded quarterly, and a cash
flow of $10 occurs every quarter at the end of the next six quarters.
 The annuity formulas do not work for a series of uniform cash flows occurring at non integer
times, like (for example) every 0.5 years when r (or EAIR) is 2% compounded annually.

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 Important APR – EAIR Application:
Semi-Annual-Pay Bonds

Semi-Annual-Pay Bonds:
 Pay interest twice per year.
 Most Corporate and Treasury Bonds are this type.
 Are not “amortizing” contracts.
(Mortgages are example of amortizing loans).

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Example Cash Flow Diagram for 18 Month, Semi-Annual Bond:
A. Bond purchased at issuance, from Bondholder’s perspective.
(Illustrates entire bond contract).

Principal or Face Value

Interest Int Int

0 6 mo 12 mo 18 mo

Principal = Face Value

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B. Bond purchased in marketplace at 6 mo + 1 day after issuance,
from Bondholder’s perspective

Principal or Face Value

Int Int

6 mo 12 mo 18 mo

Price paid for bond (CF0) , probably not = Face Value

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Key Semi-Annual-Pay Bond Vocabulary
Principal or Face Value
= Amount borrowed per bond.
= Amount to be repaid at end of contract per bond.

Coupon == Total amount of interest paid per year per bond.

50% of this is paid every six months.
→ “Int” shown on diagrams = Coupon / 2.

Coupon Rate == Bond APR: “X% interest, compounded semi-annually.”

= Coupon / Principal, reported in %.

Yield to Maturity (YTM)

= EAIR = (1+r)^(2 periods per yr) – 1

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A. Solving Semi-Annual-Pay at Issuance Bond problems:

Remember:
Bondholder pays Principal to get contract
Principal = amount to be repaid at end of contract.

Can be asked to calculate:

a) Coupon = Coupon Rate * Face Value ($)
b) Coupon Rate = Coupon / Face Value = APR of the bond. (%)
c) Native r, in semi-annual compounding units.
= (Coupon Rate) / (2 periods per year)
This is only correct for At Issuance problems
d) YTM = EAIR = (1+r)^(2 periods per yr) – 1

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Example for Semi-Annual-Pay Bond at Issuance:
SimpleCo Issues one 7-year bond with $1,000 Face Value (per bond)
and a $100 Coupon.
(Coupon amount is paid semi-annually in blocks of $50 each).

Find, for a purchaser at issuance:

a) Coupon Rate of this bond,
b) r (native 6 month units),
c) Yield to Maturity (YTM)

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Solution:
a) Coupon Rate = APR = ___________________________
Coupon/Face Value = 1000/100 10%

b) r = APR/(2 periods per yr) = (Coupon Rate) / (2 periods/yr)

= _________________________
10%/2 = 5%

c) YTM = EAIR
= (1+r)^(2 periods per yr) – 1
= ____________________________________
(1+ 5%)^2-1 = 10.25% = 0.1025 10.25%.

Compare this to Coupon Rate (APR) of 10.0%.

YTM (EAIR) is higher cause APR does not include compounding.
APR = Coupon rate always underestimated the true annual interest rate

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 B. Solving Semi-Annual-Pay after Issuance Bond problems:

 Purchase price per bond (CF0) is determined in marketplace,

it’s not necessarily equal to Principal (Face Value).

Principal or Face Value

Int Int
All these contractual CFs unchanged

Contract timeline
6 mo 12 mo 18 mo
Marketplace purchaser's T= 0 1 2 semi annual periods
timeline

Price paid for bond (CF0), probably not = Face Value

Price paid determined in the marketplace.

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Implications:
 r based on current bond price and contract stipulations.
r <> Coupon Rate / 2.
 r is found from: Fundamental Discounting Eq. 74 introduced in CH 8b
CF0 = Σ CFi / (1+r)Ti
i = 1,...number of future cash flows
Ti = Time of Cash Flow i, where T = 0 at PV
Measure time in semi-annual units

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Can be asked to Calculate:
a) Coupon ($), Coupon Rate (%), or Semi-annual payment ($).
Same calculations as At Issuance. Use:
Coupon = Coupon Rate * Face Value
Coupon Rate = Coupon / Face Value = APR.
Semi annual payment = Coupon / 2.

b) r (semi annual, native units). Use CF diagram and this eq:

CF0 = Σ CFi / (1+r)Ti
i = 1,...number of future cash flows
Ti = Time of Cash Flow i, where T = 0 at CFo

c) YTM = EAIR. Use:

YTM = (1+r)(2 compounding periods per year) - 1
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Example for Semi-Annual-Pay Bond after Issuance
(Bond Trading in Marketplace)

On 1/1/20X1, SimpleCo Issued a bond maturing on 1/1/20X7 with

$1,000 Face Value and 10% Coupon Rate.
Today, on 1/2/20X6 the bond is trading at $950.0

Find, for purchaser of bond today:

a) Semi-annual interest payment.
b) An equation that can be solved for r (native semi-annual units).
c) Show the above equation produces
r = 7.796% compounded semi-annually
d) Yield to Maturity (YTM) for this purchaser.
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Solution:

Good to start with Cash Flow Diagram:

| |
|
___________________________________
|
|
|
|
|

a) Recall Coupon Rate = Coupon / Face Value.

→ Coupon = ______________________
Coupon rate *Face Value = 10% *1000 = $100
Total paid over one year, in two blobs of $50

Semi-annual interest payment = Coupon/2

= _______________________________
100/2 = 50

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b) CF0 = Σ CFi / (1+r)Ti → 74c Fundamental Discounting Eq

___________________________________________.
950 = 50(1+r)^1 + (50 + 1000)/(1+r)^2

c) Substituting r = 7.796% →

___________________________________________.
950 = 50(1+7.796%)^1 + (50 + 1000)/(1+7.796%)^2

d) YTM = EAIR = _______________________________.

(1 + 7.796)^2-1 = 0.162 = 16.2% 16.2%

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Solution:

Cash Flow Diagram:

50 50 + 1,000

6 mo 12 mo

950

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 Compounding Periods
Continuous Compounding
Continuous compounding satisfies:
 Compounding period  0
 No. periods / year  infinity

Taking these limits →

FV = PV * e(APR*T) ; T in years;
EAIR = e(APR) – 1.

Where e = 2.718...

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Example:
 What is value of $100 investment after two years, given 6% APR
compounded continuously?
FV = PV * e(APR*T)

112.75

 What is EAIR for this investment?

EAIR = e(APR) – 1.

6.18%

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 Bonus Section
More Semi-Annual Bond Problems

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A. Semi-Annual-Pay at Issuance Bond problems:
Bond purchased at issuance, from Bondholder’s perspective.
(Illustrates entire bond contract).

Principal or Face Value

Interest Int Int

0 6 mo 12 mo 18 mo

Principal = Face Value

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Example for Semi-Annual-Pay Bond at Issuance:
GoCo Issues one 8-year bond with $1,000 Face Value (per bond)
and a 6% Coupon Rate.

Find, for a purchaser at issuance, per bond:

a) Coupon
b) Amount of interest paid every 6 months ($)
c) APR of this bond,
d) r (native 6 month units),
e) Yield to Maturity (YTM)

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Solution:
a) Coupon = _________________________________________ = $60
b) $ paid every 6 months = _______________ = $30.
c) APR = ____________ = _______________________________
d) r = _____________________________________
= _____________________________________ = 3%
d) YTM = ____________________________________ = 6.09%
Compare this to Coupon Rate (APR) of 6.00%.

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B. Semi-Annual-Pay after Issuance Bond problems:

 Purchase price per bond (CF0) is determined in marketplace,

it’s not necessarily equal to Principal (Face Value).

Principal or Face Value

Int Int

6 mo 12 mo 18 mo

CFo = Price paid for bond, probably not = Face Value

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Key Implication:

 r is found from:
CF0 = Σ CFi / (1+r)Ti
i = 1,...number of future cash flows
Ti = Time of Cash Flow i, where T = 0 at PV
Measure time in semi-annual units

 r is NOT found from Coupon Rate / 2

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Example for Semi-Annual-Pay Bond after Issuance
Given the above CF Diagram with CF0, Int, Princ = 980, 40, 1000.
Write an algebraic equation that can be used to solve for r.

In general, CFo = __________________________________.

For given numbers, CFo = _________________________________ .

Solve for r by finding RHS = LHS.

Iterate (real world) or choose among multiple choice options (HW and exam).

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Example for Semi-Annual-Pay Bond after Issuance
(Bond Trading in Marketplace)
On 1/1/20X3, GoCo Issued a bond maturing on 1/1/20X6 with
$1,000 Face Value and $60 Coupon.
Today, on 1/2/20X5 the bond is trading at $990.0

Find, for purchaser of bond today:

a) Cash flow diagram.
b) Semi-annual interest payment.
c) An equation that can be solved for r (native semi-annual units).
d) Show the above equation produces
r = 3.526% compounded semi-annually
e) Yield to Maturity (YTM).
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Solution:

a) Cash Flow Diagram:

6 mo 12 mo

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b) Semi-annual interest payment = Coupon/2
= _______________________________

c) CF0 = Σ CFi / (1+r)Ti →

___________________________________________.

d) Substituting r = 3.526% →

___________________________________________.

e) YTM = EAIR = _______________________________.

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