Discounted Cash Flow Analysis (Time Value of Money)

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Discounted Cash Flow Analysis (Time Value of Money). Future value Present value Rates of return. Time lines show timing of cash flows. 0. 1. 2. 3. i%. CF 0. CF 1. CF 2. CF 3.

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Discounted Cash Flow Analysis(Time Value of Money)
• Future value
• Present value
• Rates of return
Time lines show timing of cash flows.

0

1

2

3

i%

CF0

CF1

CF2

CF3

Tick marks at ends of periods, so Time 0 is today; Time 1 is the end of Period 1, or the beginning of Period 2; and so on.

Time line for uneven CFs -\$50 at t = 0 and \$100, \$75, and \$50 at the end of Years 1 through 3.

0

1

2

3

i%

-50

100

75

50

What’s the FV of an initial\$100 after 3 years if i = 10%?

0

1

2

3

10%

100

FV = ?

Finding FVs is compounding.

After 1 year

FV1 = PV + INT1 = PV + PV(i)

= PV(1 + i)

= \$100(1.10)

= \$110.00.

After 2 years

FV2 = FV1(1 + i)

= PV(1 + i)2

= \$100(1.10)2

= \$121.00.

After 3 years

FV3 = PV(1 + i)3

= 100(1.10)3

= \$133.10.

In general,

FVn = PV(1 + i)n.

PVIFi,n and FVIFi,n

• FVIFi,n = (1+i)n

EX. i=10%, n=7

= (1+.1)7

=1.94871

• PVIFi,n = 1/(1+i)n
What’s the PV of \$100 due in 3 years if i = 10%?

Finding PVs is discounting, and it’s the reverse of compounding.

0

1

2

3

10%

PV = ?

100

Solve FVn = PV(1 + i )n for PV:

PV = = FVn( ).

n

FVn

(1 + i)n

1

1 + i

PV = \$100( ) = \$100(PVIFi, n)

= \$100(0.7513) = \$75.13.

1

1.10

3

If sales grow at 20% per year, how long before sales double?

Solve for n:

FVn = 1(1 + i)n

2 = 1(1.20)n

(1.20)n = 2

n ln(1.20) = ln 2

n(0.1823) = 0.6931

n = 0.6931/0.1823 = 3.8 years.

Graphical Illustration:

FV

2

3.8

1

Years

0

1

2

3

4

ordinary annuity and annuity due
• An ordinary or deferred annuity consists of a series of equal payments made at the end of each period.
• An annuity due is an annuity for which the cash flows occur at the beginning of each period.
• Annuity due value=ordinary due value x (1+r)

Ordinary Annuity

0

1

2

3

i%

PMT

PMT

PMT

Annuity Due

0

1

2

3

i%

PMT

PMT

PMT

What’s the PV of this ordinary annuity?

0

1

2

3

10%

100

100

100

90.91

82.64

75.13

248.69 = PV

PVIFAi,n and FVIFAi,n
• PVIFAi,n = [1 - (1+i)-n ] / i
• Ex. i=10%, n=3
• = [1 - (1+0.1)-3 ] / 0.1
• = 2.48685
• FVIFAi,n = [(1+i)n – 1] / i
Ordinary Annuity and Annuity Due

Ordinary Annuity

PVAn (OA)= PMT(PVIFAi,n)

FVAn (OA)= PMT(FVIFAi,n)

Annuity Due

What is the PV of this uneven cashflow stream?

0

1

2

3

4

10%

100

300

300

-50

90.91

247.93

225.39

-34.15

530.08 = PV

\$100 (1 + i )3 = \$125.97.

(1+i)3 = 1.2597

(1+i) = 1.07999

i = 8% approx.

Will the FV of a lump sum be larger or smaller if we compound more often, holding the stated i% constant? Why?

LARGER! If compounding is more frequent than once a year--for

example, semiannually, quarterly,

or daily--interest is earned on interest more often.

0

1

2

3

10%

100

133.10

Annually: FV3 = 100(1.10)3 = 133.10.

0

1

2

3

4

5

6

0

1

2

3

5%

100

134.01

Semiannually: FV6 = 100(1.05)6 = 134.01.

We will deal with 3

different rates:

iNom = nominal, or stated, or

quoted, rate per year.

iPer = periodic rate.

EAR = EFF% = effective

annual rate.

• Examples:

8%, Quarterly interest

8%, Daily interest

Periodic rate = iPer = iNom/m, where m is number of compounding periods per year. m = 4 for quarterly, 12 for monthly, and 360 or 365 for daily compounding.
• Examples:

8% quarterly: iPer = 8/4 = 2%.

8% daily (365): iPer = 8/365 = 0.021918%.

Effective Annual Rate (EAR = EFF%):

The annual rate which causes PV to grow to the same FV as under multiperiod compounding.

Example: EFF% for 10%, semiannual:

FV= (1.05)2 = 1.1025.

EFF% = 10.25% because

(1.1025)1 = 1.1025.

Any PV would grow to same FV at 10.25% annually or 10% semiannually.

An investment with monthly compounding is different from one with quarterly compounding. Must put on EFF% basis to compare rates of return.
• Banks say “interest paid daily.” Same as compounded daily.
An Example: Effective Annual Rates
• Suppose you’ve shopped around and come up with the following three rates:
• Bank A: 15% compounded daily
• Bank B: 15.5% compounded quarterly
• Bank C: 16% compounded annually
• Which of these is the best if you are thinking of opening a savings account?
Bank A is compounding every day. = 0.15/365

= 0.000411

At this rate, an investment of \$1 for 365 periods would grow to (\$1x1.000411365)= \$1.1618

So, EAR = 16.18%

Bank B is paying 0.155/4 = 0.03875 or 3.875% per quarter.

At this rate, an investment of \$1 of 4 quarters would grow to: (\$1x1.038754)= 1.1642

So, EAR = 16.42%

Bank C is paying only 16% annually.

In summary, Bank B gives the best offer to savers of 16.42%.

The facts are (1) the highest quoted rate is not necessarily the best and (2) the compounding during the year can lead to a significant difference between the quoted rate and the effective rate.

How do we find EFF% for a

nominal rate of 10%, compounded

semiannually?

EAR = EFF% of 10%

EARAnnual = 10%.

EARQ = (1 + 0.10/4)4 - 1 = 10.38%.

EARM = (1 + 0.10/12)12 - 1 = 10.47%.

EARD(360) = (1 + 0.10/360)360 - 1= 10.52%.

Can the effective rate ever beequal to the nominal rate?
• Yes, but only if annual compounding is used, i.e., if m = 1.
• If m > 1, EFF% will always be greater than the nominal rate.
When is each rate used?

iNom:

Written into contracts, quoted by banks and brokers. Not used in calculations or shown on time lines unless compounding is annual.

Used in calculations,

shown on time lines.

iPer:

If iNom has annual compounding,

then iPer = iNom/1 = iNom.

EAR = EFF%:

Used to compare returns on investments with different compounding patterns.

Also used for calculations if dealing with annuities where payments

don’t match interest compounding periods.

mn

i

Nom

FV

=

PV

1 .

+

n

m

2x3

0.10

FV

=

\$100

1

+

3S

2

= \$100(1.05)6 = \$134.01.

FV3Q = \$100(1.025)12 = \$134.49.

What’s the value at the end of Year 3 of the following CF stream if the quoted interest rate is 10%, compounded semi-annually?

4

5

0

1

2

3

6 6-mos.

periods

5%

100

100

100

• So we can’t use normal annuity valuation techniques.
Compound Each CF

0

1

2

3

4

5

6

5%

100

100.00

100

110.25

121.55

331.80

FVA3 = 100(1.05)4 + 100(1.05)2 + 100

= 331.80.

b. The cash flow stream is an annual

annuity whose EFF% = 10.25%.

What’s the PV of this stream?

0

1

2

3

5%

100

100

100

90.70

82.27

74.62

247.59

Amortization

Construct an amortization schedule

for a \$1,000, 10% annual rate loan

with 3 equal payments.

Step 1: Find the required payments.

0

1

2

3

10%

-1000

PMT

PMT

PMT

3 10 -1000 0

INPUTS

N

I/YR

PV

FV

PMT

OUTPUT

402.11

Step 1: Find the required payments.

PVAn (OA)= PMT(PVIFAi,n)

PMT=PVA3 /(PVIFA10%,3)

=1000/2.4869

= 402.107

Step 2: Find interest charge for Year 1.

INTt = Beg balt (i)

INT1 = 1,000(0.10) = \$100.

Step 3: Find repayment of principal in

Year 1.

Repmt = PMT - INT

= 402.11 - 100

= \$302.11.

Step 4: Find ending balance after Year 1.

End bal = Beg bal - Repmt

= 1,000 - 302.11 = \$697.89.

Repeat these steps for Years 2 and 3

to complete the amortization table.

BEG PRIN END

YR BAL PMT INT PMT BAL

1 \$1,000 \$402 \$100 \$302 \$698

2 698 402 70 332 366

3 366 402 37 366 0

TOT 1,206.34 206.34 1,000

Interest declines. Tax implications.

\$

402.11

Interest

302.11

Principal Payments

0

1

2

3

Level payments. Interest declines because outstanding balance declines. Lender earns

10% on loan outstanding, which is falling.

Amortization tables are widely used--for home mortgages, auto loans, business loans, retirement plans, etc. They are very important!
• Financial calculators (and spreadsheets) are great for setting up amortization tables.

On January 1 you deposit \$100 in an account that pays a nominal interest rate of 10%, with daily compounding (365 days).

How much will you have on October 1, or after 9 months (273 days)? (Days given.)

iPer = 10.0% / 365

= 0.027397% per day.

0

1

2

273

0.027397%

FV=?

-100

273

(

)

FV

=

\$100

1.00027397

273

(

)

=

\$100

1.07765

=

\$107.77.

Note: % in calculator, decimal in equation.

You are offered a note which pays \$1,000 in 15 months (or 456 days) for \$850. You have \$850 in a bank which pays a 7.0% nominal rate, with 365 daily compounding, which is a daily rate of 0.019178% and an EAR of 7.25%. You plan to leave the money in the bank if you don’t buy the note. The note is riskless.

Should you buy it?

iPer = 0.019178% per day.

0

365

456 days

-850

1,000

2 Ways to Solve:

1. Greatest future wealth: FV

2. Greatest wealth today: PV

1. Greatest Future Wealth

Find FV of \$850 left in bank for

15 months and compare with

note’s FV = \$1000.

FVBank = \$850(1.00019178)456

= \$927.67 in bank.

Buy the note: \$1000 > \$927.67.

2. Greatest Present Wealth

Find PV of note, and compare

with its \$850 cost:

PV = \$1000(1.00019178)456

= \$916.27.