Economics 122

FINANCIAL ECONOMI CS (LECTURE 3)

M. DE BUQUE - G ONZ ALES
AY2014 -201 5

S O U R C E : B R E A LY & M Y E R S , R O S S E T A L . , L O ( 2 0 0 8 )
Valuing an asset
Valuing an asset usually involves valuing a sequence of cash flows
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 ≡ 𝑉
Useful to always draw a timeline to have a clear picture of the timing of cash
flows

𝐶𝐹 𝐶𝐹 𝐶𝐹

t=0 t=1 t=2 t=T time

Valuing an asset
How is value determined? How do you compute for 𝑉 ?
If there is no uncertainty, we have a complete solution.
If there is uncertainty, can only get an approximation.
Present value and discounting
Point to ponder: Cash flows at different dates are in different currencies
Consider manipulating foreign currencies:
Php100 + USD100 = ???
Need to convert into a common currency!
Either currency can be used as a numeraire.
Same idea for cash flows at different dates.
Present value and discounting
Point to ponder: Cash flows at different dates are in different currencies
Cash flows at different dates cannot be combined
Value it in $’s today or $’s tomorrow
Need to pick a numeraire date, typically t=0 or today
Cash flows can then be converted to present value
𝐶𝐹
Have to have exchange raate
𝐶𝐹 𝐶𝐹
When you multiply it to the cash flow
WIll bring it to present value terms
t=0 t=1 t=2 t=T
Basic equation:
𝑉 𝐶𝐹 , 𝐶𝐹 , 𝐶𝐹 , … = 𝐶𝐹 + 𝐸𝑅 / × 𝐶𝐹 + 𝐸𝑅 / × 𝐶𝐹 + ⋯
Present value and discounting
Net  present  value:  “Net”  of  the  initial  cost  or  investment,  usually  captured  by  
cash flow at time, 𝐶𝐹
𝑉 𝐶𝐹 , 𝐶𝐹 , 𝐶𝐹 , … = 𝐶𝐹 + 𝐸𝑅 / × 𝐶𝐹 + 𝐸𝑅 / × 𝐶𝐹 + ⋯
If  there’s  an  initial  investment,  then  𝐶𝐹 < 0
Note that any 𝐶𝐹 can be negative (i.e., a future cost)
NPV Example 1
Suppose we have the following conversion rates:
𝐸𝑅 / = 0.90 and 𝐸𝑅 / = 0.80
What would be the NPV of a project requiring a current investment of Php100
million and cash flows of Php50 million in year 1 and Php75 million in year 2?
𝑁𝑃𝑉 = −100 + 0.90 × 50 + 0.8 × 75 = 5
Suppose someone wants to buy this project but pay for it 2years from now.
How much should you ask for it?
NPV Example 2
Suppose we have the following conversion rates:
𝐸𝑅 / = 0.90 and 𝐸𝑅 / = 0.80
What would be the NPV of a project requiring an investment of Php100 million
in year 2, with a cash flow of Php40 million immediately and Php50 million in
year 1?
𝑁𝑃𝑉 = 40 + 0.90 × 50 − 0.8 × 100 = 5
Suppose someone wants to buy this project but pay for it 2 years from now.
How much should you ask for it? NPV/ER

Again, 5/0.8
Time value of money
Implicit assumptions for NPV calculations
o Cash flows are known (magnitude, signs, timing)
o Conversion rates are known
o No frictions in conversion
For the moment take this as truth (will come back to this issue later)
We focus now on the conversion rates
o Where do they come from? How are they determined?
Time value of money
What  determines  the  growth  of,  let’s  say  $1,  over  T  years?
interest rate, inflation, etc
A dollar today should be worth more than a dollar in the future. Why?
o Supply and demand
o Opportunity cost of capital, 𝑟
$1 in year 0 = $1(1 + 𝑟) in year 1
$1 in year 0 = $1(1 + 𝑟) in year 2
⋮
$1 in year 0 = $1(1 + 𝑟) in year T
The value of a dollar today on the left-hand side of the equation
The future value of a dollar today on the right-hand side
Time value of money
What determines the value today of a $1 in year T?
A dollar in year T should be worth less than a dollar today. Why?
o Supply and demand
o Opportunity cost of capital, 𝑟
$
in year 0 = $1 in year 1
( )

$
in year 0 = $1 in year 2
( )
⋮
$
in year 0 = $1 in year T
( )

The left-hand side are our conversion rates or discount factors.

Time value of money
We now have an explicit expression for 𝑉 : Drawing
1 1
𝑉 = 𝐶𝐹 + × 𝐶𝐹 + × 𝐶𝐹 + ⋯
(1 + 𝑟) (1 + 𝑟)
𝐶𝐹 𝐶𝐹
𝑉 = 𝐶𝐹 + + +⋯
(1 + 𝑟) (1 + 𝑟)
With this expression, any cash flow can be valued!
Accept positive NPV projects, reject negative NPV projects
All capital budgeting and corporate finance problems reduces to this expression
However, this still requires many assumptions (perfect markets)
Special cash flows: Perpetuity
A perpetuity pays constant cash flow C forever
How much is this infinite cash flow worth?
𝐶 𝐶 𝐶
𝑃𝑉 = + + +⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝐶 𝐶 𝐶
1 + 𝑟 × 𝑃𝑉 = 𝐶 + + + +⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝑟 × 𝑃𝑉 = 𝐶
𝐶
𝑃𝑉 =
𝑟
 C, which grows at the rate 1+g
Special cash flows: Perpetuity
Growing perpetuity pays growing cash flow 𝐶(1 + 𝑔) forever
How much is this infinite cash flow worth?
𝐶 𝐶(1 + 𝑔) 𝐶(1 + 𝑔)
𝑃𝑉 = + + +⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
(1 + 𝑟) 𝐶 𝐶 𝐶(1 + 𝑔) 𝐶(1 + 𝑔)
× 𝑃𝑉 = + + + +⋯
(1 + 𝑔) (1 + 𝑔) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
-PV (1 + 𝑟) 𝐶
− 1 × 𝑃𝑉 =
(1 + 𝑔) (1 + 𝑔)
𝐶
𝑃𝑉 = , 𝑟 − 𝑔 > 0 r>g, otherwise,
𝑟−𝑔 you will not be able to value it
bec the equation will go on 4ever
Special cash flows: Annuity
Annuity pays constant cash flow C for T periods
How much is this cash flow worth?
𝐶 𝐶 𝐶
𝑃𝑉 = + +⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝐶 𝐶 𝐶
1 + 𝑟 × 𝑃𝑉 = 𝐶 + + + ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝐶
𝑟 × 𝑃𝑉 = 𝐶 −
(1 + 𝑟)
𝐶 𝐶 1
𝑃𝑉 = −
𝑟 𝑟 1+𝑟
Special cash flows: Annuity
Sometimes written as
𝐶 1
𝑃𝑉 = 1 −
𝑟 1+𝑟
1 1
=𝐶× 1−
𝑟 1+𝑟
1
= 𝐶 × 1 − 𝑃𝑉𝐹(𝑟, 𝑇)
𝑟
= 𝐶 × 𝐴𝐷𝐹(𝑟, 𝑇)
 Perpetuity - Day T Perpetuity

Special cash flows: Annuity

Annuity pays constant cash flow C for T periods
Related to perpetuity formula

Perpetuity
t=0 1 2 … T T+1 …
Minus
…
Date-T Perpetuity Starts at Date T
Equals
…
T-period Annuity
Examples
You just won the lottery and it pays $100,000 a year for 20 years. Are you a
millionaire? Suppose 𝑟 = 10%.
100,000 1
𝑃𝑉 = 1− = 851,356
0.10 1 + 0.10
What if the payments last 50 years?
100,000 1
𝑃𝑉 = 1− = 991,481
0.10 1 + 0.10
What if the payments last forever?
100,000
𝑃𝑉 = = 1,000,000
0.10
Examples
Suppose we were examining an asset that promised to pay $500 at the end of each of
the next three years. The cash flows from this asset are in the form of a three-year,
$500 ordinary annuity. If we wanted to earn 10% on our money, how much would we
offer for this annuity?
.
◦ 𝐴n𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = $500 ∗ = $500 ∗ 2.48685 = $1,243.43
.

After carefully going over your budget, you have determined you can afford to pay
$632 per month toward a new sports car. You call up your local bank and find out that
the going rate is 1% per month for 48 months. How much can you borrow?
.
◦ 𝐴n𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = $632 ∗ = $632 ∗ 37.974 = $24,000
.
Examples
Finding the payment: Suppose you wish to start up a new business that specializes in
the latest of health food trends, frozen yak milk. To produce and market your product,
the Yakee Doodle Dandy, you need to borrow $100,000. Because it strikes you as
unlikely that this particular fad will be long-lived, you propose to pay off the loan
quickly by making five equal annual payments. If the interest rate is 18%, what will the
payments be?
C = $? C = $? C = $? C = $? C = $?

$100,000
t=0 t=1 t=2 t=3 t=4 t=5

$ , $ , $ ,
◦ $100,000 = 𝐶 × 𝐴𝐷𝐹 => C= = = = = $31,978
.
. . .
◦ Answer: $31,978
Examples
Finding the number of payments: You ran a little short on your spring break vacation,
so you put $1,000 on your credit card. You can only afford to make the minimum
payment of $20 per month. The interest rate on the credit card is 1.5% per month.
How long will you need to pay off the $1,000?
$1000 = $20 × 1−
. .
$1,000 1
× 0.015 = 1 −
$20 1 + 0.015
1
= 1 − 0.75 = 0.25
1.015
1.015 = 4
𝑇 × ln 1.015 = ln 4
.
𝑇= = 93 months
.
◦ Answer: About 93 months (or 7.75 years)
Examples
Finding the rate: For example, an insurance company offers to pay you $1,000 per year
for 10 years if you pay $6,710 up front. What rate is implicit in this 10-year annuity?
$1,000 1
$6,710 = 1−
𝑟 1+𝑟
1 1 Get the implicit interest rate?
6.71 = 1 −
𝑟 1+𝑟

◦ How do you solve for r?

◦ Hard to compute this (use trial and error).
◦ Answer: 8%
Special cash flows: Annuity
Future value for annuity cash flows:
𝐹𝑉 = 𝐶 + 𝐶(1 + 𝑟) + 𝐶(1 + 𝑟) + ⋯ + 𝐶(1 + 𝑟)
1 + 𝑟 𝐹𝑉 = 𝐶 1 + 𝑟 + 𝐶(1 + 𝑟) + ⋯ + 𝐶(1 + 𝑟)
𝑟 × 𝐹𝑉 = 𝐶(1 + 𝑟) − 𝐶
𝐶
𝐹𝑉 = (1 + 𝑟) −1
𝑟
Special cash flows: Annuity
Sometimes written as
𝐶
𝐹𝑉 = (1 + 𝑟) −1
𝑟
1
= 𝐶 × (1 + 𝑟) −1
𝑟
= 𝐶 × 𝐹𝑉𝐹 𝑟, 𝑇 − 1
Example: Suppose you plan to contribute $2,000 every year into a
retirement account paying 8%. If you retire in 30 years, how much will
you have?
.
◦ 𝐹𝑉 = $2000 ∗ = $2000 ∗ 113.2832 = $226,566.4
.
Cash flow timing – some notes
Note: In cash flow timing (i.e., in working present and future value problems), cash flow
timing is critically important.
◦ In almost all such calculations, it is implicitly assumed that the cash flows occur at the
end of each period.
Note on Annuity Due
◦ An annuity for which the cash flows occur at the beginning of the period is called an
annuity due.
◦ The relationship between the value of an annuity due and an ordinary annuity with
the same number of payments is just:
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑑𝑢𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 ∗ (1 + 𝑟)
◦ This works for both present and future values, so calculating the value of an annuity
due involves two steps: (1) calculate the present or future value as though it were an
ordinary annuity and (2) multiply your answer by (1 + r).
Compounding
Interest may be charged more frequently than annually.
o Bank accounts – daily
o Mortgages, leases – monthly
o Bonds – semi-annually
Annual percentage rate: The interest rate charged per period multiplied by the
number of periods per year. The quoted or stated rate.
o By law, the APR is simply equal to the interest rate per period multiplied by the
number of periods in a year. quarters
o Ex. If interest rate is 1% per month, then APR is 12%.
Compounding
The effective annual rate (EAR) may differ from APR. How much your return is for one year
o Ex. If interest rate is 1% per month, APR is 12% but EAR is 12.68%.
Typical accounting conventions
o Let 𝑟 denote APR
o Let 𝑛 denote periods of compounding (e.g., 12 if monthly)
o 𝑟 /𝑛 is per-period rate for each period
EAR is where 1 + 𝑟 = 1+𝑟 /𝑛 , and therefore:

𝑟 = 1+𝑟 /𝑛 −1
APR = n[(1+EAR)^(1/n) - 1 ]
Examples
If a bank is charging 1.2% per month on car loans, then the APR that must be
reported is 1.2% × 12 = 14.4%. So, an APR is in fact a quoted, or stated, rate.
What is the EAR on such a loan?
.144
𝑟 = 1+ − 1 = 1.012 − 1 = 15.39%
12
A typical credit card agreement quotes an interest rate of 18 percent APR.
Monthly payments are required. What is the actual interest rate you pay on
such a credit card?
.
𝑟 = 1+ − 1 = 1.015 − 1 = 19.56%
Continuous compounding
Approaches infinity
Continuous compounding: As 𝑛 approaches zero, the relation of EAR to the
APR denoted by 𝑟 is given by the exponential function/s:
◦1+𝑟 = exp 𝑟 =𝑒
◦𝑟 =𝑒 −1
◦ 𝑟 = ln(1 + 𝑟 ), which is the continuously compounded rate.
Example: A bank offers you two alternative interest schedules for a savings
account of $100,000 locked in for 3 years: (a) a monthly rate of 1%; (b) an
annually, continuously compounded rate (𝑟 ) of 12%. Which alternative
should you choose?
◦ For monthly rate = 1%, 𝑟 = [1 + 0.01] = 12.68%
◦ For 𝑟 = 12%, 𝑟 = 𝑒 . − 1 = 12.75%
◦ You should therefore choose the continuously compounded rate for its
higher EAR.
5-29
Inflation
What is inflation?
o Change in real purchasing power over time
o Different from time value of money. (How?)
o Inflation can be problematic in some cases.
o How doe we quantify its effects?
If we take into account inflation, the real return would be:
1+𝑟 × $1 = (1 + 𝑟 )(1 + 𝜋) × $1
1+𝑟
1+𝑟 =
(1 + 𝜋)
1+𝑟
𝑟 = −1 ≈ 𝑟 −𝜋
(1 + 𝜋)
Think about it: Is the approximation overstated or understated?
if inflation > 0,
understated
otherwise