MAF759/904:

Quantitative Methods for Finance

Dr. Ruipeng Liu
Unit Chair, Senior Lecturer
Office: LB4.121, Burwood campus
Tel: 03 9244 6359
Fax: 03 9244 6283
Email: ruipeng.liu@deakin.edu.au
Office hours: 9:30-11:30am Thursdays

Prescribed Textbook
Quantitative Investment Analysis,
2nd Edition, Wiley.
Richard A. Defusco, Dennis W. McLeavey,
Jerald E. Pinto and David E. Runkle
Workbook of Quantitative Investment Analysis

Lecture:
Mondays 17:00 - 19:50
Pls bring your textbook, workbook and calculator)

Assessments:
Online test: 5% +5%
Group assignment: 30%
Examination: 60% (Hurdle: 50%)
3

Topics covered
Week

1: Time value of money and

Discounted cash flow
Week 2 &3: Statistical concepts, and
Probability concepts.
1st online test: 24th March 2016
Week

4: Probability distribution
Week 5: Estimation and Hypothesis test.
4

Topics covered
Week

6: Correlation and regression

2nd online test: 22nd April 2016

Week

7 : Anzac Day Monday (no lecture).

Week 8&9: Regression analysis.
Assignment due 11th May 2016
Week

10: Time series analysis.

Week 11: Portfolio theory.
5

My expectations to you

Preview unit materials prior to lecture;

Lecture attendance (on-campus only);
Review after each topic;
Full-time student load: 10 hours per
unit per week.

Time value of Money

Suppose you as an investor lend $10,000 to Y for a

year. How much money do you want after a year?

You want your $10,000 back plus some

compensation in the year end.

What does this compensation consist of?

Time value of Money

1. You want some compensation for postponing your current consumption.
2. You want some compensation to account for the expected inflation in a
year.
3. You want some compensation to account for the fact that the borrower may
fail to return your money in an year. Essentially you will recover this
money from good debt than bad debt.
4. you want some compensation to account for the loss of liquidity, i.e, you
can not get your cash back whenever you want within that year.
5. You also want some compensation because you are lending the money for a
longer period.

Interest Rate

So what are these terms?

Real risk free rate
Inflation premium
Default risk premium
Liquidity premium
Maturity premium

Future value (FV) & Present value (PV)

What is Time value of Money and why is it important?

The value of money does not remain constant over time and i.e, money earns
interest over time. So it is important from the view point of capital budgeting
and investing and many other investment related decisions.

Suppose A wants to borrow $10,000 from B for a year. Let the market
rate of interest be 10%. How much should A pay B in a year?
FV = PV + interest at the rate of 10% p.a.
= PV + PV *10%
= PV(1 + 10%)
= PV(1 + r)
10

Future value of a Lump Sum

Suppose you invest $10,000 today at 8% p.a,

how much will this be worth in 2 years?
PV $10,000
r 8%
N 2
FVN PV (1 r ) N
$10,000(1 0.08) 2
$11,664
11

Frequency of Compounding
rs
FVN PV 1
m

mN

rs stated annual rate

m number of compounding periods in a year
e.g. 4 for quarterly, 12 for monthly
N number of years

12

Future Value with Quarterly Compounding

Find the FV of $10,000 after two years invested today at 8%

and if the interest is compounded quarterly.
PV $10,000
rs 8%
m4
N2
mN

r
FVN PV1 s
m
$10,000(1.02)8
$11,716.59
13

Frequency of Compounding

14

Continuous Compounding

Interest can be compounded in discrete intervals

such as daily, monthly or quarterly, or it can
compound continuously.
For continuous compounding we use,
FVN PVe rs N
e 2.7182818
15

Present Value (PV)

Present value is the amount of money today that yields a

certain amount in the future at a fixed rate of interest.
Suppose we loan someone an amount of PV today for n years
at a rate of r p.a. What is the total amount to be repaid after n
periods?
FV = PV(1 + r )n .
PV

FV
n

FV
(
1

r
)
(1 r ) n
16

Present Value of a Lump Sum

An insurance company promises to pay

$100,000 in six years with an 8% rate. What
amount must the insurer invest today at 8% to
make the promised payment?
PV

FV
N
FV
r

(
1

)
(1 r ) N

$100,000(1 0.08) 6
$63,016.96
17

Present Value of a Lump Sum

Find the present value of 5 million received 10 years

from today if the interest rate is 6% and monthly
compounding is used.
rs
PV FVN 1
m

mN

.06
5,000,0001

12
2,748,163.67

12 (10 )

18

Present Value with Continuous

Compounding

19

Present Value (PV) and Future Value (FV)

FV
r

PV

1/ N

ln( FV / PV )
N
ln(1 r )
20

Stated and Effective Rates

Stated rates do not account for the number of compounding

periods and so we need to compute the effective annual rate
(EAR)

EAR (1 Periodic interest rate) m 1

m

rs
EAR 1 1
m

The effective annual rate with continuous compounding is

EAR e rs 1
21

Stated and Effective Rates

Find the EAR if the stated interest rate is 8%

and semiannual compounding is used.
m

rs
EAR 1 1
m
2

.08
1
1
2

.0816
22

The Future Value of a Series of Cash Flows

Suppose we save $1000 each period

(beginning next year) at an interest rate of 5%
for 5 periods, how much money will we have
after the last deposit is made?

23

Geometric Progression/series
A sequence in which each element is obtained by multiplying
the preceding element by a constant.
n

x 0 x1 x 2 x 3 . . . x n

k 0

(1 x) x k
k 0

1 x n 1
A x A

,
k 0
1- x
n

x m x n 1
A x A

1
x
k m

24

The Future Value of Annuity

Annuity: finite set of level sequential cash flows:
ordinary annuity; annuity due; perpetuity.

FVN A[(1 r) N 1 (1 r) N 2 (1 r) N 3 . . . (1 r) 1]
which simplifies to
(1 r) N 1
FVN A

25

The Present Value of Annuity

Suppose you will receive $A each period for

N periods (beginning next year) with interest
rate of r, what is this stream of payments
worth today?
PV

which

PV

A
A

(1 r)
(1 r)
simplifies

A
(1 r)

...

A
(1 r)

N 1

A
(1 r)

to

(1 r)
A
r

26

Ordinary Annuity

How much you should pay to receive 1,000 per

year for 5 yrs, with the first payment one year
from now and if the required return is 12%?
1

(1 r) N
PV N A

(1 .12) 5
1,000
.12

3,604.78

27

Annuity due:
An immediate cash flow + ordinary annuity

Suppose you will receive $200,000/yr for 20 years, with the

first payment today. What is the PV if the interest rate is 7%?
1

(1 r) N -1
PVN A A

(1 .07)19
200,000 200,000

.07

200,000 2,067,119.05
2,267,119.05
28

Perpetuity

What is $A received every year (beginning next

year) forever, worth to us today?
1
PVN A
t
(1
r)

t 1

which simplifies to

A
PVN
r
29

Present Value of a Perpetuity

A British consol bond promises to pay 100

per year in perpetuity. If the required rate is
5%, what is the bond worth today?
PV

r
100

0 . 05
2 , 000
30

Solving for Interest Rates / Growth Rates

If we are interested in knowing the return or

growth rate, r, we can use the relationship
between PV and FV.

FVN
r

PV

1/ N

31

Solving for the Annuity

If we want to accumulate FV in N periods, what
amount, A, do we need to deposit each period to
reach this goal.

FV
A
(1 r ) N 1

32

Computing the Annuity that will Grow to FV

Suppose you would like to save for 30 years (beginning next

year). How much will you need to save each year so you will
have $1 million after the last deposit is made if the interest
rate is 6%?

FV
$1,000,000
A

$12,648.91
N
30
(1 r ) 1 (1.06) 1

r
.
06

33

Solving for the Annuity

If we borrow certain ammount, what is the

annuity, A, that will be needed to repay the loan.
PV
A
1

(1 r ) N

34

An example: Annuity payment

35

Discounted Cash Flow Applications

Discounted cash flow (DCF) has numerous

applications including:
determining

if an investment is desirable (capital

budgeting).
valuing securities (stock and bonds).

36

Calculate PV using Excel

COMPUTING THE PRESENT VALUE
Discount rate

10%

Year

Cash flow

Present
value

100

90.9091 <-- =B5/(1+$B$2)^A5

100

82.6446 <-- =B6/(1+$B$2)^A6

100

75.1315 <-- =B7/(1+$B$2)^A7

100

68.3013 <-- =B8/(1+$B$2)^A8

100

62.0921 <-- =B9/(1+$B$2)^A9

Net present value

Summing cells C5:C9

379.08 <-- =SUM(C5:C9)

Using Excel's NPV function

379.08 <-- =NPV(B2,B5:B9)

Using Excel's PV function

379.08 <-- =PV(B2,5,-100)

37

Calculate PV using Excel

COMPUTING THE PRESENT VALUE
In this example the cash flows are not equal
Either discount each cash flow separately or use Excel's NPV function
Excel's PV doesn't work for this case

Discount rate

10%

Year

Cash
flow

Present
value

Present value
of each cash flow

100

90.9091 <-- =B5/(1+$B$2)^A5

200

165.2893 <-- =B6/(1+$B$2)^A6

300

225.3944 <-- =B7/(1+$B$2)^A7

400

273.2054 <-- =B8/(1+$B$2)^A8

500

310.4607 <-- =B9/(1+$B$2)^A9

Net present value

Summing cells C5:C9

1065.26 <-- =SUM(C5:C9)

Using Excel's NPV function

1065.26 <-- =NPV(B2,B5:B9)

38

Net Present Value

Net present value (NPV) is one of the important

application of the DCF concept.
NPV compares the cash outflow to the present value
of the cash flows from the project.
If NPV 0 we accept the project. If NPV < 0, we
reject the project.
N

CFt
NPV
t
t 0 (1 r )
39

Example 2-1 Using NPV

RAD Corporation intends to invest $1 million in

R&D and expects incremental cash flows of $150,000
in perpetuity from this investment. If the opportunity
cost of capital is 10%, will RAD Corp. invest in the
project?
CF
NPV CF0
r
$1,000,000

$150,000
$500,000 0, accept
.10

40

Internal Rate of Return

Assumption: Cash flows are reinvested at IRR.

The internal rate of return on a project is the interest
rate that makes the NPV = 0.
If IRR discount rate (opportunity cost of the
project), we accept the project.

CFN
CF1
CF2

...
0
NPV CF0
1
2
N
(1 IRR )
(1 IRR ) (1 IRR )

41

Internal Rate of Return

INTERNAL RATE OF RETURN

Year

Cash flow
0

-800

200

250

300

350

400

USING EXCEL'S RATE FUNCTION TO

COMPUTE THE IRR
Initial investment
Periodic cash flow
Number of payments

IRR
Internal rate of return

1,000
100
30
<-- =RATE(B4,B3,9.307% B2)

22.16% <-- =IRR(B3:B8)

42

Multiple IRRs
Discount rate
NPV

Year
0
1
2
3
4
5

6%
-3.99<-- =NPV(B2,B7:B11)+B6

Cash flow
-145
100
100
100
100
-275

Two IRRs
5.00

Net present value

0.00
0%

10%

20%

30%

40%

-5.00
-10.00
Discount rate
-15.00
-20.00
-25.00

Identifying the two IRRs

First IRR
Second IRR

8.78%<-- =IRR(B6:B11,0)
26.65%<-- =IRR(B6:B11,0.3)

43

Further issues: NPV &IRR

If we are comparing different size projects,

the one with the highest IRR may not add
the greatest value to the firm.

If the timing of cash flows differ.

If the sign of the cash flows changes more

than once, we may get more than one IRR.

44

Money Market Measurements

Money market is the market for short-term debt instrument

(one year maturity or less).
Treasury bills (T-bills) are pure discount instruments (pays no
income until maturity, whereupon the investor receives the
face value of the instrument . These instruments are issued at
a price lower than face value).
T-bills are quoted on a bank discount basis:
rBD

F P 360

F
t

purchase price P, F is the face value, t = the actual number of days remaining to maturity
45

Money Market Measurements

Holding Period Yield

Effective Annual Yield

Money Market Yield

P1 P0 D1
HPY
P0

EAY (1 HPY)365 / t 1

rMM (HPY )(360 / t )

46