Stocks Versus Flows: Held by A Firm or Consumer at A Given Point in Time

I.E.
1
Stocks versus Flows
• A Stock is an amount of units of a good or an amount of dollars
held by a firm or consumer at a given point in time.
– Example: inventory such as 400 bicycles on September 30, 2002
– Example: current savings such as $10,000 today
• A Flow is an annual amount of units of a good or service
produced by a firm or consumed by a consumer.
– Example: production such as 3000 bicycles per year
– Example: consumption such as 1460 popsicles per year (4 per day)
• A Flow is an annual amount of dollars received or paid.
– Example: income such as $50,000 per year
– Example: mortgage payments such as $10,000 per year
• Wealth is a stock and income is a flow.
• Capital is a stock and investment is a flow.
Copyright © 2002 by Martin K. Perry
I.E.2
Stocks versus Flows in Accounting
• Publicly-held corporations are required to submit Accounting
Statements on their Stocks of assets and liabilities, and their
Flows of revenues and costs.
• The Balance Sheet is a accounting statement of the current value
of the assets and liabilities as of a particular date (end of the
calendar or fiscal year).
– Assets include tangible assets such as plant, equipment, and inventory
– Assets include intangible assets such as patents and copyrights
– Assets also include financial assets such as cash, investment funds
– Liabilities include bonds, loans, and other contractual liabilities
• The Income Statement (revenues and costs and Cash Flow
Statement (cash) are accounting statements of the flows that
occurred during a specific time period (quarter or a year).
– Revenues include the cash from the sale and delivery of goods and services
– Revenues include income from financial assets
– Costs include the expenses for salaries, wages, inputs, energy, maintenance
– Asset purchases are NOT current costs, but depreciation of assets is a cost
I.E.3
Methods of Accounting Fraud
• Section 10(b) of the Securities Exchange Act (1934)
– Securities Exchange Commission (SEC) regulates securities markets
– Rule 10b-5 (1942): Manipulative and Deceptive Practices
• (2) Unlawful to make any untrue statement of an material fact
• (3) Unlawful to engage in any fraudulent act, practice, or course of conduct
• Balance Sheet Fraud
– Over-Value Assets
• Financial assets (bonds) which have no market price (Banks, subprime bonds)
• Contractual assets using optimistic predictions on prices (Enron, oil and gas)
– Under-Value Liabilities: legal liabilities of product defects
• Income Statement Fraud
– Inflate Revenues
• Back-dating sales into the previous accounting period
• Channel Stuffing by forcing distributors to take excess goods (Coke, syrup)
• Premature recognition of revenues from long-term contracts (Xerox, copiers)
– Deflate Costs
• Report operating expenses as capital expenses (Worldcom, access charges)
I.E.4
Examples of Income Statement Fraud
• Revenue Recognition: SEC Guidelines
– Goods: Delivery to the buyer, and price assured in the future.
– Services: Revenue must be allocated equally over the term of the contract.
• Coca-Cola (1999): Channel Stuffing
– October 13, 1999: Press Release that sales trends are “very encouraging”.
– December 3, 1999: Stock Price rose from $47 (10/21/99) to $69 per share.
– December 6, 1999: CEO suddenly resigns.
– January 2000: Reports $45 m loss in fourth quarter, Stock Price tumbles.
– Coke had inflated its quarterly revenues since late 1998 by forcing its
bottlers to purchase excess inventories of syrup ($600 million).
• Xerox (1997): Premature Recognition of Lease Revenue
– Lease includes the copier, and service on the copier over contract life.
– The annual payments from the lease includes both goods and services.
– Starting in 1997, Xerox allocates a larger fraction of the total lease
payments over the life of the contract to the sale of the copier, reporting
that allocation as revenue in the quarter that the lease in signed.
– Revenue reported for future quarters is lower (less than lease payments).
I.E.5
Time Value of Money
• The Time Value of Money means that a dollar in one year is not
equivalent to a dollar in another year.
• In general, consumers and firms prefer to receive a dollar now
rather than in the future
– If you have a dollar now, you can keep it in your pocket or a bank in order
to have a dollar in the future.
– With economic growth there exist investment opportunities such that
consumers or firms can invest a dollar now and earn more than a dollar in
the future.
• Caveat: inflation in the prices of goods erodes the value of a dollar, but there are
typically investments which earn returns in excess of the rate of inflation
• The Time Value of Money affects investment decisions by firms
and consumers.
– Investment involves spending dollars now, but earning dollars in the future
– Examples: research and development by firms, education by consumers
• Problem: How do you compare stocks and flows?
I.E.6
Future Value of a Stock of Money Invested Now
• Future Value answers the question: If you invest $1000 NOW,
how much money would you have at some FUTURE year?
– Future Value of $1000 NOW at the rate of interest r
• FV(dollar amount NOW , interest rate ; future year) is a function
that converts the dollar amount NOW into the Future Value of
that dollar amount in the specified future year.
– FV($1000, r ; 0) = $1000 because 0 year (Y0) is NOW
– FV($1000, r ; 1) = $1000 + r · ($1000) = (1+r)·($1000)
• principal + interest in Y1
– FV($1000, r ; 2) = $1000 + r · ($1000) + r · ($1000) + r · r · ($1000)
• principal + interest in Y1 + interest in Y2 + interest in Y2 on interest from Y1
– FV($1000, r ; 2) = [1 + 2·r + r2] · ($1000) = (1+r)2 · ($1000)
• FV($1000,r; n) = (1+r)n · ($1000)
– Future Value of $1000 now after earning interest at the rate r for n years
• COMPOUNDING is the term used to describe the process of
earning interest on the interest in calculating the Future Value
I.E.7
Future Value of a Stock of Money Invested Now
• Sale of Manhattan in 1626 for $24
– Who got the best deal: Dutch or Native Americans
• FV($24, r ; 382 years) = (1+r)382 · ($24) (as of 2008)
– FV($24, 2.5% ; 382 years) = $300 thousand
– FV($24, 5.0% ; 382 years) = $3 billion
– FV($24, 7.5% ; 382 years) = $24 trillion
– FV($24, 10.0% ; 382 years) = $156 million billion
• Gift of $5000 by Henry Rutgers in December 1825

– What is the future value of that gift?
• FV($5000, r ; 182 years) = (1+r)182 · ($5000) (as of 2008)
– FV($5000, 2.5% ; 182 years) = $447 thousand
– FV($5000, 5.0% ; 182 years) = $36 million
– FV($5000, 7.5% ; 182 years) = $2.6 billion
– FV($5000, 10.0% ; 182 years) = $170 billion
I.E.8
Future Value of a Flow of Money Invested in Past
• Saving for College Expenses, Goal = $100,000
– Save x dollars each year, for ten years, at interest rate r?
– FV(x,r;10) + FV(x,r;9) + … + FV(x,r;1) = $100,000
• Factor x and solve: x · [ (1+r)10 + (1+r)9 + … + (1+r) ] = $100,000
• At r = 5%: x = $100,000 / [13.2] = $7576
• At r = 10%: x = $100,000 / [17.5] = $5714
• Saving for Retirement, Goal $5,000,000
– Save what fraction x < 1 of your salary, at interest rate r?
• Starting salary $50,000, annual raise of 5%, work for 40 years
– FV(x·S1,r;39) + FV(x·S2,r;38) + … + FV(x·S40,r;0) = $100,000
• x · $50,000 · [ (1+r)40 + (1+r)39·(1.05)1 + (1+r)38·(1.05)2 + … +
(1+r)1·(1.05)39 ] = $5,000,000
• At r = 5%: x = 100 / [281.6] = 35.5% {easy to calculate, why?}
• At r = 10%: x = 100 / [841] = 11.9% {messy to calculate}

I.E.9
Present Value of a Stock of Money in the Future
• Present Value Question: If you wanted to have $1000 at some
FUTURE YEAR, how much would you have to invest NOW?
– Present Value Now of $1000 received in the future at the rate of interest r
• PV(dollar amount then , interest rate , future year) is a function
that converts the dollar amount receive in the specific future year
into the Present Value of that dollar amount NOW.
– PV($1000, r ; 0) = $1000 because year 0 (Y0) is NOW
– PV($1000, r ; 1) = ($1000)/(1+r) PV invested, generates $1000.
• (1+r) · PV($1000, r ; 1) = $1000 OR FV( PV($1000,r;1) , r ; 1) = $1000
– PV($1000, r ; 2) = ($1000)/(1+r)2 PV invested, generates $1000.
• (1+r)2 · PV($1000, r ; 2) = $1000 OR FV( PV($1000,r;2) , r ; 2) = $1000
• PV($1000, r ; n) = ($1000) / (1+r)n {< $1000 because r > 0}
– Present Value of $1000 received n years from now at interest rate r.
• DISCOUNTING (back to the present) is the term used to describe
the process of calculating the Present Value, by dividing by (1+r)n.
– Higher interest rate r implies MORE discounting of future dollars
I.E.10
Examples of Future Value and Present Value for a
Stock of $1000
• Suppose the interest rate is 10% (r = .10)
• FUTURE VALUE of $1000 in year Yn = ($1000) times (1+r)n
• Y0 Y1 Y2 Y3 Y4
• $1000 $1100
• $1000 $1210
• $1000 $1331
• $1000 $1464.10
• PRESENT VALUE of $1000 in year Yn = ($1000) divided by (1+r)n
• Y0 Y1 Y2 Y3 Y4
• $909 $1000
• $826 $1000
• $751 $1000
• $683 $1000

I.E.11
STOCK TABLE
Present Value of $1000 Received ONCE
in a Given Number of Years from NOW
• STOCK: Year in which $1000 is Received ONCE
• Present Value of this STOCK at Different Interest Rates
• PV($1000, r ; n) = ($1000) / (1+r)n
• year PV(5%) PV(10%) PV(15%) PV(20%)

• 0 1000 1000 1000 1000
• 1 952 909 870 833
• 2 907 826 756 694
• 3 864 751 658 579
• 4 823 683 572 482
• 5 784 621 497 402
• 10 614 386 247 162
• 15 481 239 123 65
• 20 377 149 61 26
I.E.12
Intuition for the Present Value of a Stock
• For any given interest rate, the Present Value declines when the
money is received further in the future. What is the intuition?
– Since a $1000 is received further in the future, one would require a smaller
amount of money now to invest and generate $1000 in that future year.
– Future money is discounted more heavily because the denominator of the
Present Value formula (1+r)n is larger when n is larger.
• For any given year that the money is received, the Present Value
declines when the interest rate is higher. What is the intuition?
– When the interest rate is higher, there are better investment opportunities.
– As a result, money NOW is more valuable than money in the future.
– Thus, the Present Value of money in the future must be lower.
– Future money is discounted more heavily because the denominator of the
Present Value formula (1+r)n is larger when r is larger.

I.E.13
Infinite and Finite Sums
• Expression for an Infinite Sum starting with x (for x < 1)
– SUM(1,∞) = x + x2 + x3 + x4 + … and so on for infinity (∞)
• Factor x from all but the first term (Note that x1 = x)
– SUM(1,∞) = x + x · [x + x2 + x3 + x4 + …]
• Rewrite SUM(1,∞) in terms of itself
– SUM(1,∞) = x + x ∙ SUM(1,∞)
• Solve for SUM(1,∞) in terms of x
– SUM(1,∞) = x / (1 – x) {Note that x must be less than one, x < 1}
• Expression for an Infinite Sum starting with xn+1
– SUM(n+1,∞) = xn+1 + xn+2 + xn+3 + xn+4 + xn+5 + … and so on for infinity (∞)
– SUM(n+1,∞) = xn · [ x + x2 + x3 + x4 + x5 + … ] = xn · SUM(0,∞)
– SUM(n+1,∞) = xn · [ x / (1 – x) ]
• Expression for a Finite Sum, starting with x, ending with xn
– SUM(1,n) = x + x2 + x3 + … + xn
– SUM(1,n) = SUM(1,∞) – SUM(n+1,∞)
– SUM(1,n) = ( 1 – xn ) · [ x / (1 – x) ]
I.E.14
Present Value of an Infinite Constant Flow
• What is the Present Value of $1000 received every year into the
future (forever), STARTING NEXT YEAR in YEAR ONE (Y1)?
– PV($1000,r; (1,∞)) = ($1000)/(1+r) + ($1000)/(1+r)2 + … and so on
• Factor $1000 from every term
– PV($1000,r; (1,∞)) = $1000 · [1/(1+r) + 1/(1+r)2 + … + 1/(1+r)n +… ]
• Infinite sum with x = 1/(1+r): (1–x) = 1 – [1/(1+r)] = [(1+r) – 1]/(1+r) = r/(1+r)
– PV($1000,r; (1,∞)) = $1000·[x/(1–x)] = $1000·[1/(1+r)]·[(1+r)/r] = $1000/r
• PV($1000,r; (1,∞)) = $1000 / r
– Stock $1000 NOW is equivalent to Flow [r·($1000)] starting NEXT YEAR
– If you invest $1000 NOW forever, you will receive [r · ($1000)] every year,
starting NEXT YEAR.
• What is the Present Value of $1000 received forever, but not
starting until (n+1) years from now?
– Present Value of a Stock in year n that equals PV($1000,r; (n+1,∞))
• PV($1000, r ; (n+1,∞)) = [1/(1+r)n] · [ $1000 / r ]
• PV($1000, r ; (n+1,∞)) = [1 / (1+r)n] · [ $1000 / r ]
I.E.15
Present Value of a Finite Constant Flow
• What is the Present Value of $1000 received for a finite number of
years, STARTING NEXT YEAR in YEAR ONE (Y1)?
– PV($1000, r ; (1,3)) = ($1000)/(1+r) + ($1000)/(1+r)2 + ($1000)/(1+r)3
• The Present Value of a $1000 flow for three years starting next year equals the
Present Value of a $1000 flow forever MINUS the Present Value of a $1000 flow
forever that does not start until the fourth year from NOW.
• The Present Value of a $1000 flow forever that starts in the fourth year from
NOW is the Present Value DISCOUNTED BY THREE YEARS of a STOCK
OF MONEY equal to the Present Value of a $1000 flow forever.
– PV($1000, r ; (1,3)) = PV($1000, r ; (1,∞)) – [1/(1+r)3] · PV($1000, r ;
(1,∞))
– PV($1000, r ; (1,3)) = {1 – [1/(1+r)3]} · PV($1000, r ; (1,∞))
– PV($1000, r ; (1,3)) = {1 – [1/(1+r)3]} ∙ [ $1000 / r ]
• PV($1000, r ; (1,n)) = {1 – [1/(1+r)n]} · [ $1000 / r ]
• What is the Present Value of $1000 received for n years, but not
starting until m years from now?
– Present Value of a Stock in year m equal to the PV($1000, r ; (1,n))
– PV($1000, r ; (m,m+n)) = [1/(1+r)m] · {1 – [1/(1+r)n] · [ Copyright
$1000©/2009
r ]}by Martin K. Perry
I.E.16
Present Value of a Flow for Three Years
• Consider a flow of $1000 for three years (suppress the zeros)
• Years Y1 Y2 Y3 Y4 Y5 ...
• Flow($1, (1,∞)) $1 $1 $1 $1 $1 ...
• Flow($1 , (4,∞) 0 0 0 $1 $1 ...
• Flow($1, (1,3)) $1 $1 $1 0 0 ...
• Flow for 3 years (third row) is equal to an infinite flow starting next year (first
row) minus an infinite flow starting in year 4 (second row).
– PV($1000, r ; (1,3)) = PV($1000, r ; (1,∞)) – PV( PV($1000, r ; (4,∞))
– PV($1000 , r ; (1,3)) = [ $1000 / r ] – [1/(1+r)3] · [ $1000 / r ]
• PV($1000, r ; (1,3)) = { 1 – [1/(1+r)3] } · [ $1000 / r ]
• Once you understand the derivations, there is no reason to memorize these

formulas. Instead, we can construct tables for the values of the coefficients in
terms of the interest rate, the start date for the flow, and the end date for the
flow.
I.E.17
FLOW TABLE
Present Value of $1000 Received EVERY YEAR
Starting Next Year for Given Number of Years (n)
• FLOW: Number of Years that $1000 is Received
• Present Value of this FLOW at Different Interest Rates
• PV($1000, r ; (1,n)) = {1 – [1/(1+r)n]} · [ $1000 / r ]
• for n years PV(5%) PV(10%) PV(15%) PV(20%)

• for 5 yrs 4330 3790 3353 2990
• for 10 yrs 7722 6145 5019 4192
• for 15 yrs 10380 7606 5847 4675
• for 20 yrs 12462 8514 6259 4870
• forever 20000 10000 6667 5000
• For each interest rate, the Present Value for a 5-year flow of $1000 is equal to
the summation of the five lines (years 1 – 5) in the Present Value table for
$1000 received once in each of those five years, Slide I.E.11.
I.E.18
Present Value of a Financial Asset
• Present Value (PV) allows you to place a VALUE on an “IOU” (I own you)
issued by some person or corporation (Marty) who is promising to make some
stream of cash payments to the “bearer of the IOU” (owner) into the future,
where the payments can be in any amounts and on any dates.
• IF YOU DO NOT OWN THE IOU, the Present Value (at your interest rate) is
your “Willingness to Pay” for the IOU.
– The PV is the MOST that you would pay for the IOU NOW.
– You would pay less than the PV for the IOU, but NOT more than the PV.
– If the Price of the IOU in a market is lower than your PV, YOU BUY THE IOU.
• IF YOU DO OWN THE IOU, the Present Value (at your interest rate) is your
“Willingness to Sell” the IOU.
– The PV is the LEAST that you would sell the IOU for NOW.
– You would sell the IOU for more than the PV, but NOT for less than the PV.
– If the Price of the IOU in a market is higher than your PV, YOU SELL THE IOU.
• Thus, the Present Value of a Financial Asset is BOTH the highest price that
you would pay to buy that asset, and the lowest price at which you would sell
that asset. The PV is the highest Bidding Price and the lowest Asking Price.
I.E.19
Present Value of Two Flows

• Consider two flows of profits:
– (1) $1000 received every year, starting now, lasting for 20 years
– (2) $2000 received every year, starting now, lasting for 5 years
• Using the Tables, what are the Present Values of these two flows,
at the four different interest rates [5%, 10%, 15%, and 20%].
• Which flow do you prefer to receive at each of the interest rates?
– Which has the higher Present Value?
– If the market price of flow (1) was $10,000, when would you BUY flow (1)?
– If the market price of flow (2) was $6,000, when would you BUY flow (2)?
– Suppose you can only BUY one flow, which flow would you BUY at those
same price?
• Explain why the interest rate determines which of these two flows
you would prefer to receive.
I.E.20
Present Value of Two Flows: Answer
First, calculate the Present Value of each flow for the different interest rates.
Flow(1) is simply row four in the FLOW table.
Flow(2) is simply row one in the FLOW table MULTIPLIED BY TWO.
Interest Rate 5% 10% 15% 20%

Flow (1) $12,462 $8,514 $6,259 $4,870
Flow (2) $ 8,660 $7,580 $6,706 $5,980
With Flow(1), you receive $20,000, but further out in the future. With Flow(2),
you receive only $10,000, but much sooner. When the interest rate is low (5% and
10%), you prefer Flow(1) because the future dollars have a higher Present Value
(discounted less). In other words, you prefer more dollars, even though they are
received further in the future. But when the interest rate is high (15% and 20%),
you prefer Flow(2) because the future dollars have a lower Present Value
(discounted more). This makes the higher payments of $2000 received during the
first five years relative more valuable in the present. In other words, you prefer
less dollars because they are received sooner.

I.E.21
Investment and Future Flow of Profits
• PV($1000, r ; (1,∞)) = $1000/r
• Suppose a corporation is considering making a one-time R&D
investment of $50 million this year NOW in order to develop a
new product that can be sold every year into the future and earn
annual profits forever STARTING NEXT YEAR.
• If the interest rate is 10% (r = .10), what would the annual profits
have to be in order for the present value of this future flow of
these profits to exceed the $50 million investment in R&D?
• Answer: PV(Profits, r ; (1,∞)) = Profits/.1 > $50 m .
– Thus, Profits > $5 million
• What would be the answer if the interest rate is 20%?
• Answer: PV(Profits, r ; (1,∞)) = Profits/.2 > $50 m .
– Thus, Profits > $10 million
I.E.22
What is an Annuity?
• An Annuity is a constant flow of dollars into the future.
– The future flow can be for a fixed time period, or forever.
– An Annuity is purchased by paying cash now.
– Often purchased by retired people, maybe using the equity in their home.
• Suppose you purchased an ten-year Annuity for $100,000.
• What are the minimum annual payments that you would expect
to receive at the interest rate of 10%?
– From Flow Table, the dollar value of $6145 is equivalent to the Present
Value of a ten-year flow of $1000.
– At r = 10% , $100,000 can purchase what ten-year flow with the same PV?
– Solve for x: $100,000 / $6145 = x / $1000 {ratio of stocks = ratio of
flows}
– Annuity payment x = $16,273 per year for ten years
• If you purchase a fifteen-year Annuity for $200,000, what annual
payments would you expect to receive at the interest
Copyrightrate ofMartin
© 2008 by 5%? K. Perry
I.F.1
What is a Bond?
• Bonds are promises to pay (IOUs) issued by governments and
corporations in order to borrow money.
– A Bond is a standardized contract to pay money in the future.
– Bonds are issued and sold to individuals, banks, and investment funds.
– The price of the bond is the loan and the contract is the repayment.
• Each Bond Issue has a standardized obligation of repayments.
– Bonds have a Coupon Payment each year (often set as % of the Face
Value)
– Bonds have a Term of years over which the payments are made.
– Bonds have a Face Value payment at the end of the Term (at Maturity).
– Define the Coupon Rate (CR) = Annual Coupon Payments / Face Value
• Thus, a Bond has both flow and stock payments over time.
– Bond has a FLOW of Coupon Payments over the Term of years.
– Bond has a STOCK of the Face Value payment at Maturity.
– The Present Value is the willingness to pay (or sell) a Bond.
• How do governments and corporations repay the Face Value?
– Governments issue new bonds to repay the face value of old bonds.
– Corporations save money in a “sinking fund” over the term of the bond.
I.F.2
Present Value of a Bond
• Present Value of a Bond is the “Willingness to Pay” for a Bond,
and the “Willingness to Sell” the Bond.
– Recall that the Present Value converts the Coupon Payments and Face
Value into the equivalent dollars NOW.
• The “Willingness to Pay” is the maximum amount that an
investor would pay NOW for the Bond in order to receive the
Coupon and Face Value payments into the future from the Bond.
– The investor would NOT be willing to pay MORE than the Present Value.
– The investor would be willing to pay LESS than the Present Value.
– Thus, the Present Value is the maximum amount that the investor would
pay NOW for the Bond.
• The “Willingness to Sell” is the minimum amount that an investor
would sell the Bond for cash NOW.
– The investor would NOT be willing to sell for LESS than the Present Value.
– The investor would be willing to sell for MORE than the Present Value.
– Thus, the Present Value is the minimum amount that the investor would
accept to sell the Bond NOW.
I.F.3
Types of Bonds
• Zero-Coupon Bond, also called Discount Bonds
– Face Value paid at maturity (end of the Term)
– But NO coupon Payments paid during the Term
• Consol Bond
– No Term and thus NO Face Value
– Coupon Payments paid every year FOREVER
• Standard Bond
– Face Value paid at maturity
– Coupon Payments paid every year, starting in next year, until maturity
• Junk Bond
– Any Bond with a low “Bond Rating” because the corporation who issued
the Bond may stop making the payments (default) and declare bankruptcy.
• Mortgage Bond
– A Bond which specifies “Collateral” in the contract.
– Collateral is assets of the corporation that can be taken by the Bond
Holders if the corporation stops making the payments (default).
I.F.4
Payments under a Standard Bond
$/year
Face Value
$1000
First Coupon Payment Y1

Last Coupon Payment Y20
Yearly
Coupon
Payment
$100 time (years)
0 1 5 10 15 20 yrs
• Bond with a 20 year Term, and a Face Value of $1000 at the end of the Term.
• Yearly coupon payment of $100 (Coupon Rate of 10% on Face Value of $1000)
• We will assume that the first Coupon Payment under an Standard Bond will
be made in the next year after purchase of the Bond from the Corporation.
• Of course, Bonds are purchased at any point of time in the secondary market.
I.F.5
Present Value of Zero-Coupon Bonds
• A Zero-Coupon Bond has NO annual Coupon Payments but pays
only a Face Value at the end of the Term.
– Zero-Coupon Bonds are also called Discount Bonds.
• Present Value of a Zero-Coupon Bond is the Present Value of the
Face Value at the year in which the Term ends (Maturity).
– The Face Value is a STOCK that will be received at Maturity.
– The name Discount Bond refers to the fact that the Present Value is
obtained by merely discounting the Face Value back to the present.
• If the interest rate is 10% (r =.10), what is the Present Value of a
Zero-Coupon Bond with a Face Value of $100,000 and a Term of
10 years?
– Answer: $38,600
– Scale up the entry in Stock Table by 100 since the FV = $100,000
• Suppose the term is 20 years?
– Answer: $14,900
I.F.6
Problems on Valuation of Zero-Coupon Bonds
• Consider a Zero-Coupon Bond which pays only a Face Value and
has NO annual Coupon Payments.
Zero-Coupon Bond with a Face Value of $100,000 and a Term of
10 years?
– Answer: $24,700
• What is the Present Value if the term is 20 years?
– Answer: $6,100
• What is the Present Value if the interest rate is 20% (r = .20)?
– Answer: $16,200 for 10 year Bond
– Answer: $2,600 for 20 year Bond
Zero-Coupon Bond with a Face Value of $50,000 and a Term of 5
years?
– Answer: $39,200
I.F.7
Present Value of Consol Bonds
• A Consol Bond has NO Face Value and NO Term, but pays yearly
Coupon Payments FOREVER, starting next year.
– Preferred Stock is similar to a Consol Bond in that Preferred Stock has a
specified dividend each year.
– The dividend on Preferred Stock continues forever unless the shares are
redeemed by the corporation or converted into Common Stock.
• The Present Value of a Consol Bond is the Present Value of the
yearly Coupon Payments received forever, starting next year.
– The Coupon Payments are a FLOW that will be received forever.
• Consol Bonds can be replicated by a series of Standard Bonds each
having a Term of n years.
– Series of Standard Bonds with CP = $1000 and Terms of n years.
– Each new Bond is purchased with the FV of the previous Bond.
– PV = {1 – [1/(1+r)n]} · [$1000/r] + [1/(1+r)n]·{1 – [1/(1+r)n]} · [$1000/r] + ···
– PV = $1000/r – [1/(1+r)∞ ] · [$1000/r] (the second term is effectively zero)
I.F.8
Problems on Valuation of Consol Bonds
• If the interest rate is 10%, what is the Present Value of a Consol
Bond with a yearly Coupon Payment of $2000 per year starting
next year and continuing forever?
– Answer: $20,000
• What is the Present Value if the interest rate is 20%?
– Answer: $10,000
• If the interest rate is 15%, what is the Present Value of a Consol
Bond with a yearly Coupon Payment of $3000 per year starting
now and continuing forever?
– Answer: $20,000 (3 x $6667)
• What is the Present Value if the coupon payment is $5000 per
year?
– Answer: $33,335 (5 x $6667)
• What is the Present Value if the interest rate is 20% (r = .20)?
– Answer: $25,000 (5 x $5000)
I.F.9
Problems on Valuation of Standard Bonds
• We will assume that the first coupon payment will occur in the
next year after the Bond is issued and purchased.
• Consider a bond with a Face Value of $100,000, a Term of 20
years, and a yearly Coupon Payment of $2000 per year.
• In order to calculate the Present Value of a standard bond, you
can separately calculate the Present Value of the yearly Coupon
Payments and Present Value of the Face Value at Maturity.
• If the interest rate is 10% (r =.10), what is the Present Value of
this bond?
• Suppose the Term of the bond is now only 10 years. What is the
Present Value?
• Suppose the Term is 20 years, but the interest rate is 20%. What
is the Present Value?

I.F.10
Answers on Valuation of Standard Bonds

• If the interest rate is 10% (r = .10), what is the present value of
this bond?
– Face Value (stock): PV($100,000, .10 ; 20) = $14,900 (See Stock Table)
– Yearly Coupon (flow): PV($2000, .10 ; (1,20)) = $17,028 (See Flow Table)
– Answer: $14,900 + $17,028 = $31,928
• Suppose the term of the bond is now only 10 years (r = .10).
– Answer: $38,600 + $12,290 = $50,890
• Suppose the term is 20 years, but the interest rate is 20%.
– Answer: $2,600 + $9,740 = $12,340
I.F.11
What is a Share of Common Stock?
• Common Stock is issued by corporations to borrow money.
– Common Stock is a standardized ownership contract.
– The issue price of the common stock is the loan to the corporation.
• Each Share of Common Stock is paid dividends and can be resold.
– Each share receives an equal dividend from the profits of the corporation.
– BUT the amount of the dividend is NOT specified in the stock certificate.
– The amount of the dividend is decided each year by the Board of Directors.
– The corporation can repurchase its shares, but has no obligation to do so.
– Shareholders can sell their shares to other individuals, banks, or funds.
• Each Share of Stock has both flow and stock payments over time.
– A share of stock has an uncertain FLOW of dividends each year.
– A share of stock has an uncertain STOCK in that the shareholder can sell
the share in a stock market at any point of time.
– The price that buyers are willing to pay for a Share depends on the Present
Value of these payments.
I.F.12
Expected Present Value of Common Stock
• Difference between Shares of Common Stock and Bonds
– Unlike Bonds, Common Stock has no fixed term, no face value, and no
fixed dividend payments.
– A share of Common Stock is a perpetual investment with no redemption
price, and dividends are decided by the Board of Directors each year.
– However, a share of Common Stock can be resold in the stock market.
– The stock price will be high if the corporation’s profits are increasing, and
low is the corporation’s profits are decreasing.
• The “Expected” Present Value of a Common Stock can be
calculated from the expected dividends and the expected future
market price.
– Choose a future date for the expected market price.
– Calculate the Present Value of the expected market price.
– Calculate the Present Value of the expected dividends to that point.
– Calculate the combined Present Value of dividends and market price.
– Buy shares if the PV > current market price
– Sell shares if the PV < current market price
I.F.13
Problem on Valuation of Common Stock

• If the interest rate is 15% (r =.15), what is the Present Value of
this stock with the following expected dividends and future
market price?
– Expected Dividends = $10 per year
– Expected market price 10 years from now = $100 per share
• Present Value of the dividends = $50.19
• Present Value of the share price 10 years from now = $24.70
• Answer: Present Value = $84.89
• If the market price is $75 per share, would you buy this stock?
– Answer: Yes, because the Present Value of the expected dividends and
future price ($84.89) is greater than the current price ($75).
• If the market price was $90 per share, would you sell this stock?
– Answer: Yes, because the Present Value of the expected dividends and
future price ($84.89) is less than the current price ($90).
I.F.14
Sample Questions on Common Stock
• Suppose you own 100 shares of common stock in a corporation that does NOT
pay any dividends. The stock is currently trading for $9.00 per share on the
New York stock market. All the analysts on Wall Street predict that the price
per share will increase to $10.00 one year from now. Suppose you are going
to sell these shares either now or one year from now. Using Present Value
analysis, which of the following statements is correct? (Use Stock Table)
• If the interest rate is 5%, sell now or next year? PV = $9.52 Sell Next Year
• If the interest rate is 10%, sell now or next year? PV = $9.09 Sell Next Year
• If the interest rate is 15%, sell now or next year? PV = $8.70 Sell Now
• If the interest rate is 20%, sell now or next year? PV = $8.33 Sell Now
• Consider a common stock in a corporation that you plan to buy and hold
forever. The corporation is paying no dividends now, and will not pay any
dividends for the next five years. But after that, the corporation will pay
$1000 per year forever in dividends for each share of the common stock.
What is the Present Value of one share of this stock if your interest rate is
10% (r = .10)? PV = $6210 (Use Flow and Stock Tables)
I.F.15
What is a Junk Bond?
• Junk Bond is a bond with a high probability of default
– Rating Agencies are suppose to assess the risk of default
• What is Default?
– Corporation fails to make any further Coupon Payments
– Trustee for the bondholders would then file a lawsuit for the Face Value.
– If the corporation defaulted on a Bond issue, it would probably declare
bankruptcy and the bondholders would receive little or nothing.
• The Probability of Default reduces the Present Value of the Bond
– Present Value formula assumed that Coupon Payments would be paid
– But if Default occurs, no further Coupon Payments would be made
• Lets calculate the “Expected” Present Value of a Junk Bond
– For simplicity, assume that Junk Bond is a Consol Bond
• Coupon Payments are suppose to be received forever (No Term or Face Value)
– Coupon Payments are received in the first year
– After the first year, there is a Probability of Default each year
– If Default occurs, no further Coupon Payments are received
I.F.16
Expected Present Value of a Consol Junk Bond
Y0 Y1 Y2 Y3 Y4
0 0 λ 0 λ 0
λ λ
BUY CP CP CP CP
1-λ 1-λ 1-λ 1-λ
• Let λ be the probability of default

– Coupon Payments in any year are received only if the Coupon Payments
have been received in ALL previous years
• Probability of receiving CP in Y1 is (1 – λ)
• Probability of receiving CP in Y2 is (1 – λ)2
• Probability of receiving CP in Yn is (1 – λ)n
• Expected Present Value
– EPV = CP · { [(1-λ)/(1+r)] + [(1-λ)/(1+r)]2 + [(1-λ)/(1+r)]3 + … }
• Note that x = [(1-λ)/(1+r)] , so that SUM{-} = x/(1-x) = (1-λ)/(r+λ)
– EPV( CP, r ; (1, ∞) , λ ) = [(1-λ) / (r+λ)] · CP < (1/r) · CP
• Default Risk (λ > 0) LOWERS the Present Value of a Bond
– EPV( CP, r ; (1, ∞) , λ ) < PV( CP, r ; (1, ∞))
I.F.17
Tradeoff between Risk and Return
• With the same Coupon Payments, the Junk Bond with a positive
probability of default has a lower Expected Present Value.
• Consider how much higher the Coupon Payments on a Junk Bond
must be in order for the Expected Present Value to be the same as
the Present Value on a Bond with no probability of default.
– Let CP(0) be the Coupon Payments on a Bond with λ = 0.
– Let CP(λ) be the Coupon Payments necessary to equate the Present Values.
– EPV( CP(λ) , r ; (1, ∞) , λ ) = PV(CP(0) , r ; (1,∞))
– [(1-λ) / (r+λ)] · CP(λ) = (1/r) · CP(0)
– CP(λ) = { (r+λ) / [r·(1-λ)] } · CP(0)
• CP(λ) must increase when the probability of default λ increases.
– Higher risk (λ) must have a higher return (CP).
– CP(λ) also increases at an increasing rate with λ (calculus needed)
• Coupon Rate is CR(λ) = CP(λ) / FV (FV = $1000 typically)
• Risk Premium = CR(λ) – CR(0) = { (r+λ)/[r·(1-λ)] – 1 } · CR(0) .
– Risk Premium increases at an increasing rate.
I.F.18
Risk Premium
Rate (fraction)
CR(λ)
Risk Premium
for λ = 1/3
Risk Premium
for λ = 1/2
CR(0)
λ
0 λ=1/3 λ=1/2 1
• CR(λ) = [ (r+λ) / [r·(1-λ) ] · CR(0)
• Risk Premium = CR(λ) – CR(0) is increasing at increasing rate
• Calculus: Derivative of CR(λ) = [ (1+r) / r·(1-λ)2 ] · CR(0) > 0
• Risk Premium is also decreasing with an increase in the interest rate r

Stocks Versus Flows: Held by A Firm or Consumer at A Given Point in Time

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Stocks Versus Flows: Held by A Firm or Consumer at A Given Point in Time

Uploaded by

Copyright:

Available Formats

I.E.

• Gift of $5000 by Henry Rutgers in December 1825

Copyright © 2008 by Martin K. Perry

Copyright © 2006 by Martin K. Perry

• year PV(5%) PV(10%) PV(15%) PV(20%)

Copyright © 2008 by Martin K. Perry

• Once you understand the derivations, there is no reason to memorize these

• for n years PV(5%) PV(10%) PV(15%) PV(20%)

Present Value of Two Flows

Interest Rate 5% 10% 15% 20%

Copyright © 2002 by Martin K. Perry

First Coupon Payment Y1

Copyright © 2002 by Martin K. Perry

Answers on Valuation of Standard Bonds

Problem on Valuation of Common Stock

• Let λ be the probability of default

You might also like