FIn 351: Lecture 2

Financial markets and time value of money

Some important concepts

Learning objective

Understand financial markets and their functions Understand the concept of the cost of capital and

the time value of money Learn how to draw cash flows of projects Learn how to calculate the present value of annuities Learn how to calculate the present value of

perpetuities Inflation, real interest rates and nominal interest

rates, and their relationship

Financial

Manager

Firm's

operations

Investors

(1) Investors buy shares with cash

(1)

(2)Cash is invested

(2)

(3) Operations generates cash

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

Financial markets and investors

Real assets

(timberland)

(stockholders save and invest in closely held firm.)

Financial markets

A financial market • Securities are issued and traded

The classification of the financial market• By seasoning of claim

• Primary market

• Secondary market

• By nature of market• Debt market

• Equity market

Financial markets (continue)

• By maturity of claim• Money market

• Capital market

The functions of financial markets

1. Conducting exchange

2. Providing liquidity

3. Pooling money to fund large corporations

4. Transferring money across time and distance

5. Risk management (hedge, diversify)

6. Providing information

7. Providing efficient allocation of money

Conducting exchange

What does it mean ? Examples

Providing liquidity

What does this mean? Examples

Pooling money to fund large corporation investments

What does this mean? Examples

Transferring money across time and distance

What does this mean? Examples

Risk management

What does this mean? Examples

Providing information

What does this mean? Examples

Providing efficient allocation of money

What does this mean? Examples

The cost of capital

The cost of capital is a very important concept in capital budgeting.

It links investment opportunities in financial markets and investment opportunities in real assets markets.

What is the cost of capital?

Cash

Investment opportunity (real

asset)Firm Shareholder

Investment opportunities

(financial assets)

Invest Alternative: pay dividend to shareholders

Shareholders invest for themselves

Financial choices

Which would you rather receive today?

• TRL 1,000,000,000 ( one billion Turkish lira )

• USD 652.72 ( U.S. dollars ) Both payments are absolutely

guaranteed. What do we do?

Financial choices

We need to compare “apples to apples” - this means we need to get the TRL:USD exchange rate

From www.bloomberg.com we can see:

• USD 1 = TRL 1,186,899 Therefore TRL 1bn = USD 843

Financial choices with time

Which would you rather receive?• $1000 today

• $1200 in one year

Both payments have no risk, that is, • there is 100% probability that you will be paid

• there is 0% probability that you won’t be paid

Financial choices with time (2)

Why is it hard to compare ?• $1000 today

• $1200 in one year This is not an “apples to apples” comparison.

They have different units $100 today is different from $100 in one year Why?

• A cash flow is time-dated money• It has a money unit such as USD or TRL

• It has a date indicating when to receive money

Present value In order to have an “apple to apple”

comparison, we convert future payments to the present values• this is like converting money in TRL to money in USD

• Certainly, we can also convert the present value to the future value to compare payments we get today with payments we get in the future.

• Although these two ways are theoretically the same, but the present value way is more important and has more applications, as to be shown in stock and bond valuations.

Present value (2)

The formula for converting future cash flows or payments:

= present value at time zero = cash flow in the future (in year t)

= discount rate for the cash flow in year t

tt

t

r

CPV

)1(0

0PV

trtC

itC

Example 1

What is the present value of $100 received in one year (next year) if the discount rate is 7%?• Step 1: draw the cash flow diagram

• Step 2: think !

PV<?> $100

• Step 3: PV=100/(1.07)1 =

Year one

$100

PV=?

Example 2

What is the present value of $100 received in year 5 if the discount rate is 7%?• Step 1: draw the cash flow diagram

• Step 2: think !

PV<?> $

• Step 3: PV=100/(1.07)5 = Year 5

$100

PV=?

Example 3

What is the present value of $100 received in year 20 if the discount rate is 7%?• Step 1: draw the cash flow diagram

• Step 2: think !

PV<?> $

• Step 3: PV=100/(1.07)20 =

Year 20

$100

PV=?

Present value of multiple cash flows For a cash flow received in year one and a

cash flow received in year two, different discount rates must be used.

The present value of these two cash flows is the sum of the present value of each cash flow, since two present value have the same unit: time zero USD.

2

221

11

2010210

)1()1(

)()(),(

rCrC

CPVCPVCCPV ttt

Example 4 John is given the following set of cash flows and

discount rates. What is the PV?

• Step 1: draw the cash flow diagram• Step 2: think ! PV<?> $200• Step 3: PV=100/(1.1)1 + 100/(1.09)2 =

%101 r

Year one

$100

PV=?

1001 C

%92 r1002 C

$100

Year two

Example 5 John is given the following set of cash flows and

discount rates. What is the PV?

• Step 1: draw the cash flow diagram• Step 2: think ! PV<?> $350• Step 3: PV=100/(1.1)1 + 200/(1.09)2 + 50/(1.07)3 =

503 C

1.01 r

Yr 1

$100

PV=?

1001 C

09.02 r2002 C

$50

Yr 3

07.03 r

Yr 2

$200

Projects

A “project” is a term that is used to describe the following activity:• spend some money today

• receive cash flows in the future A stylized way to draw project cash flows is

as follows:

Initial investment(negative cash flows)

Expected cash flows in year one (probably positive)

Expected cash flows in year two (probably positive)

Examples of projects An entrepreneur starts a company:

• initial investment is negative cash outflow.

• future net revenue is cash inflow . An investor buys a share of IBM stock

• cost is cash outflow; dividends are future cash inflows. A lottery ticket:

• investment cost: cash outflow of $1

• jackpot: cash inflow of $20,000,000 (with some very small probability…)

Thus projects can range from real investments, to financial investments, to gambles (the lottery ticket).

Firms or companies

A firm or company can be regarded as a set of projects.• capital budgeting is about choosing the best

projects in real asset investments.

How do we know one project is worth taking?

Net present value

A net present value (NPV) is the sum of the initial investment (usually made at time zero) and the PV of expected future cash flows.

T

tt

t

t

T

r

CC

CCPVCNPV

10

10

)1(

)(

NPV rule

If NPV > 0, the manager should go ahead to take the project; otherwise, the manager should not.

Example 6

Given the data for project A, what is the NPV?

• Step1: draw the cash flow graph

• Step 2: think! NPV<?>10

• Step 3: NPV=-50+50/(1.075)+10/(1.08)2 =

%0.810

%5.750

50

22

11

0

rC

rC

C

Yr 0

Yr 1 Yr 2

$10$50-$50

Example 1 John got his MBA from SFSU. When he was interviewed by a

big firm, the interviewer asked him the following question: A project costs 10 m and produces future cash flows, as shown

in the next slide, where cash flows depend on the state of the economy.

In a “boom economy” payoffs will be high• over the next three years, there is a 20% chance of a boom

• In a “normal economy” payoffs will be medium• over the next three years, there is a 50% chance of normal

In a “recession” payoffs will be low• over the next 3 years, there is a 30% chance of a recession

In all three states, the discount rate is 8% over all time horizons.

Tell me whether to take the project or not

Cash flows diagram in each state

Boom economy

Normal economy

Recession

-$10 m$8 m $3 m $3 m

-$10 m

-$10 m

$2 m$7 m

$0.9 m$1 m$6 m

$1.5 m

Example 1 (continues)

The interviewer then asked John:• Before you tell me the final decision, how do

you calculate the NPV?• Should you calculate the NPV at each economy or

take the average first and then calculate NPV

• Can your conclusion be generalized to any situations?

Calculate the NPV at each economy

In the boom economy, the NPV is• -10+ 8/1.08 + 3/1.082 + 3/1.083=$2.36

In the average economy, the NPV is• -10+ 7/1.08 + 2/1.082 + 1.5/1.083=-$0.613

In the bust economy, the NPV is • -10+ 6/1.08 + 1/1.082 + 0.9/1.083 =-$2.87The expected NPV is 0.2*2.36+0.5*(-.613)+0.3*(-2.87)=-$0.696

Calculate the expected cash flows at each time

At period 1, the expected cash flow is• C1=0.2*8+0.5*7+0.3*6=$6.9

At period 2, the expected cash flow is• C2=0.2*3+0.5*2+0.3*1=$1.9

At period 3, the expected cash flows is• C3=0.2*3+0.5*1.5+0.3*0.9=$1.62

The NPV is• NPV=-10+6.9/1.08+1.9/1.082+1.62/1.083

• =-$0.696

Perpetuities We are going to look at the PV of a perpetuity starting one year from

now. Definition: if a project makes a level, periodic payment into perpetuity,

it is called a perpetuity. Let’s suppose your friend promises to pay you $1 every year, starting

in one year. His future family will continue to pay you and your future family forever. The discount rate is assumed to be constant at 8.5%. How much is this promise worth?

PV???

C CC C C C

Yr1 Yr2 Yr3 Yr4 Yr5 Time=infinity

Perpetuities (continue)

Calculating the PV of the perpetuity could be hard

1

21

)1(

1

)1()1()1(

iir

C

r

C

r

C

r

CPV

Perpetuities (continue)

To calculate the PV of perpetuities, we can have some math exercise as follows:

rrr

S

SS

S

S

r

1)1/(11

)1/(11

1)1(

1

32

2

1

Perpetuities (continue)

Calculating the PV of the perpetuity could also be easy if you ask George

rC

SCCr

C

r

C

r

C

r

CPV

i

i

ii

..)1(

1

)1()1()1(

11

21

Calculate the PV of the perpetuity

Consider the perpetuity of one dollar every period your friend promises to pay you. The interest rate or discount rate is 8.5%.

Then PV =1/0.085=$11.765, not a big gift.

Perpetuity (continue)

What is the PV of a perpetuity of paying $C every year, starting from year t +1, with a constant discount rate of r ?

C CC C C C

t+1 t+2 t+3 t+4 T+5 Time=t+infYr0

Perpetuity (continue)

What is the PV of a perpetuity of paying $C every year, starting from year t +1, with a constant discount rate of r ?

rr

Crr

C

rr

C

rrrr

C

r

C

r

C

r

CPV

tti

it

t

tt

)1(

1.

)1()1(

1

)1(

)1(

1

)1(

1

)1(

1

)1(

)1()1()1(

1

21

21

Perpetuity (alternative method)

What is the PV of a perpetuity that pays $C every year, starting in year t+1, at constant discount rate “r”?• Alternative method: we can think of PV of a perpetuity

starting year t+1. The normal formula gives us the value AS OF year “t”. We then need to discount this value to account for periods “1 to t”

That is

rr

C

r

VPV

V

ttt

rC

t

)1()1(

Annuities

Well, a project might not pay you forever. Instead, consider a project that promises to pay you $C every year, for the next “T” years. This is called an annuity.

Can you think of examples of annuities in the real world?

PV???

C CC C C C

Yr1 Yr2 Yr3 Yr4 Yr5 Time=T

Value the annuity

Think of it as the difference between two perpetuities• add the value of a perpetuity starting in yr 1

• subtract the value of perpetuity starting in yr T+1

rrrC

rr

C

r

CPV

TT )1(

11

)1(

Example for annuities

you win the million dollar lottery! but wait, you will actually get paid $50,000 per year for the next 20 years if the discount rate is a constant 7% and the first payment will be in one year, how much have you actually won (in PV-terms) ?

My solution

Using the formula for the annuity

71.700,529$07.0*07.1

1

07.0

1*000,50

20

PV

FIn 351: Lecture 3

Example

You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

Solution

10.774,12$

005.1005.

1

005.

1300Cost Lease 48

Cost

Lottery example

Paper reports: Today’s JACKPOT = $20mm !!• paid in 20 annual equal installments.

• payment are tax-free.

• odds of winning the lottery is 13mm:1

Should you invest $1 for a ticket?• assume the risk-adjusted discount rate is 8%

My solution

Should you invest ? Step1: calculate the PV

Step 2: get the expectation of the PV

Pass up this this wonderful opportunity

mm

mmmmmmPV

818.9$

)08.1(

0.1

)08.1(

0.1)08.1(

0.1202

1$76.0$

0*)13

11(818.9*

13

1][

mm

mmmm

PVE

Mortgage-style loans

Suppose you take a $20,000 3-yr car loan with “mortgage style payments”• annual payments

• interest rate is 7.5% “Mortgage style” loans have two main

features:• They require the borrower to make the same payment

every period (in this case, every year)

• The are fully amortizing (the loan is completely paid off by the end of the last period)

Mortgage-style loans

The best way to deal with mortgage-style loans is to make a “loan amortization schedule”

The schedule tells both the borrower and lender exactly:• what the loan balance is each period (in this case -

year)

• how much interest is due each year ? ( 7.5% )

• what the total payment is each period (year) Can you use what you have learned to figure

out this schedule?

My solution

year Beginningbalance

Interest payment

Principlepayment

Total payment

Ending balance

0

1

2

3

$20,000

13,809

7,154

$1,500 $6,191 $7,691 $13,809

1,036 6,655

537 7,154 7,691 0

7,691 7,154

Future value

The formula for converting the present value to future value:

= present value at time zero = future value in year t

= discount rate during the t years

ttt rPVFV )1(0

0PV

trtFV

itC

Manhattan Island Sale

Peter Minuit bought Manhattan Island for $24 in 1629. Was this a good deal? Suppose the interest rate is 8%.

Manhattan Island Sale

Peter Minuit bought Manhattan Island for $24 in 1629. Was this a good deal?

trillion

FV

979.75$

)08.1(24$ 374

To answer, determine $24 is worth in the year 2003, compounded at 8%.

FYI - The value of Manhattan Island land is FYI - The value of Manhattan Island land is well below this figure.well below this figure.

Inflation

What is inflation? What is the real interest rate? What is the nominal interest rate?

Be consistent in how you handle inflation!! Use nominal interest rates to discount

nominal cash flows. Use real interest rates to discount real cash

flows. You will get the same results, whether you

use nominal or real figures

Inflation rule

Example

You own a lease that will cost you $8,000 next year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?

1 real interest rate = 1+nominal interest rate1+inflation rate

Inflation

Example - nominal figures

99.429,26$

78.59708741.82=8000x1.034

56.63768487.20=8000x1.033

92.68098240=8000x1.032

73.727280001

10% @ PVFlowCash Year

4

3

2

10.182.87413

10.120.84872

10.18240

1.108000

Inflation

Example - real figures

Year Cash Flow PV@6.7961%

1 = 7766.99

2 = 7766.99

= 7766.99

= 7766.99

80001.03

7766.991.068

82401.03

8487.201.03

8741.821.03

2

3

4

7272 73

6809 92

3 6376 56

4 5970 78

26 429 99

7766 991 068

7766 991 068

7766 991 068

2

3

4

.

.

.

.

..

..

..

= $ , .