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McGraw-Hill/Irwin
Chapter Outline
Today 1 2 3 4 5
PV Compounding
FV
Today 1 2 3 4 5
PV Discounting
FV
6-3
MULTIPLE CASH
FLOWS
What if we have
more than one cash
flow?
The concept (and
formula) are
identical if we
simply look at
the problem as a
series of single 6-4
payments.
MULTIPLE CASH FLOWS
FUTURE VALUE 1
SUPPOSE YOU HAVE $1,000 NOW IN A SAVINGS
ACCOUNT THAT IS EARNING 6%. YOU WANT TO
ADD $500 ONE YEAR FROM NOW AND $700 TWO
YEARS FROM NOW.
Today 1 Year 2 Years
adjusted to be in “year 3”
TI BA II
Plus
2 years =N
1123.60
6% = I/Y
-$1,000 = PV
1st CPT
? = FV
2nd
6-7
2 years = N HP 12-C
6% = i
-$1,000 = PV
? = FV
1123.60
6-8
MULTIPLE CASH FLOWS
FUTURE VALUE 1
Let’s add one more twist to the
problem:
What would be the value at year 5
if we made no further deposits into
our
Today 1 account?
savings 2 3 4 5
$1,338
?
$1,000 500 700
$ 631
$ 8336-11
$2,803
MULTIPLE CASH FLOWS
PRESENT VALUE
be worth today?
MULTIPLE CASH FLOWS
PRESENT VALUE _1
Visually, the time line
would look like this:
Today 1 2 3 4
6-14
MULTIPLE CASH FLOWS
PRESENT VALUE _1
To compute the present value of
this future stream of cash, we just
take each year to the present, one
Today at 1 2
a time: 3 4
?
178.57
318.88
427.07
200 400 600 800
508.41 6-15
1,432.93
MULTIPLE CASH FLOWS
PRESENT VALUE _1
USING A CALCULATOR, FIND THE PV OF
EACH CASH FLOW AND JUST ADD THEM
UP!
6-17
MULTIPLE CASH FLOWS
PRESENT VALUE _2
YOU ARE CONSIDERING AN INVESTMENT THAT WILL PAY
YOU $1,000 IN ONE YEAR, $2,000 IN TWO YEARS AND
$3,000 IN THREE YEARS. IF YOU WANT TO EARN 10%
ON YOUR MONEY, HOW MUCH WOULD YOU BE WILLING
TO PAY?
6-19
DECISIONS,
DECISIONS
YOUR BROKER CALLS YOU AND TELLS YOU THAT
HE HAS THIS GREAT INVESTMENT OPPORTUNITY.
IF YOU INVEST $100 TODAY, YOU WILL RECEIVE
$40 IN ONE YEAR AND $75 IN TWO YEARS. IF YOU
REQUIRE A 15% RETURN ON INVESTMENTS OF
THIS RISK, SHOULD YOU TAKE THE INVESTMENT?
USE THE CF KEYS TO COMPUTE THE PRESENT VALUE OF THE
PROPOSED INVESTMENT’S CASH FLOWS
6-21
MULTIPLE UNEVEN CASH FLOWS
USING THE HP 12C CALCULATOR
ANOTHER WAY TO USE THE FINANCIAL
CALCULATOR FOR UNEVEN CASH FLOWS
IS TO USE THE CASH FLOW KEYS
91.49
6-24
QUICK QUIZ I
6-25
Chapter Outline
6-26
ANNUITIES AND
PERPETUITIES DEFINITIONS
1
1
(1 r ) t
PV C
r
(1 r ) t 1
FV C
r
6-28
ANNUITIES ON THE
SPREADSHEET - EXAMPLE
THE PRESENT VALUE AND
FUTURE VALUE FORMULAS
IN A SPREADSHEET
INCLUDE A PLACE FOR
ANNUITY PAYMENTS
6-30
ANNUITIES AND
THE CALCULATOR
6-33
ANNUITY:
SWEEPSTAKES WINNER
SUPPOSE YOU WIN THE PUBLISHERS CLEARINGHOUSE
$10 MILLION SWEEPSTAKES. THE MONEY IS PAID IN
EQUAL ANNUAL END-OF-YEAR INSTALLMENTS OF
$333,333.33 OVER 30 YEARS.
IF THE APPROPRIATE
DISCOUNT RATE IS 5%, HOW
MUCH IS THE SWEEPSTAKES
ACTUALLY WORTH TODAY?
6-34
SAVING FOR
RETIREMENT
YOU ARE OFFERED THE OPPORTUNITY
TO PUT SOME MONEY AWAY FOR
RETIREMENT. YOU WILL RECEIVE FIVE
ANNUAL PAYMENTS OF $25,000 EACH,
BEGINNING IN 40 YEARS.
How much
would you be
willing to invest
today if you
desire an 6-35
interest rate of
SAVING FOR
RETIREMENT TIMELINE
0 1 2 … 39 40 41 42 43 44
6-36
ANNUITY: BUYING A
HOUSE
YOU ARE READY TO BUY A HOUSE, AND YOU HAVE
$20,000 FOR A DOWN PAYMENT AND CLOSING
COSTS. CLOSING COSTS ARE ESTIMATED TO BE 4%
OF THE LOAN VALUE. YOU HAVE AN ANNUAL SALARY
OF $36,000, AND THE BANK IS WILLING TO ALLOW
YOUR MONTHLY MORTGAGE PAYMENT TO BE EQUAL
TO 28% OF YOUR MONTHLY INCOME.
6-37
ANNUITY: BUYING A
HOUSE (CONTINUED)
THE INTEREST RATE ON THE LOAN IS 6% PER YEAR
WITH MONTHLY COMPOUNDING (.5% PER MONTH)
FOR A 30-YEAR FIXED RATE LOAN.
1. HOW MUCH MONEY WILL THE BANK LOAN YOU?
2. HOW MUCH CAN YOU OFFER FOR THE HOUSE?
6-38
ANNUITY: BUYING A
HOUSE (CONTINUED)
• BANK LOAN
• MONTHLY INCOME = 36,000 / 12 = 3,000
• MAXIMUM PAYMENT = .28(3,000) = 840
• 30*12 = 360 N
• .5 I/Y
• -840 PMT
• CPT PV = $140,105
• TOTAL PRICE
• CLOSING COSTS = .04(140,105) = 5,604
• DOWN PAYMENT = 20,000 – 5,604 = 14,396
• TOTAL PRICE = 140,105 + 14,396 = $154,501
6-39
QUICK QUIZ II
6-40
FINDING THE
PAYMENT
SUPPOSE YOU WANT TO BORROW $20,000 FOR A NEW
CAR. YOU CAN BORROW AT 8% PER YEAR,
COMPOUNDED MONTHLY
(8/12 = .66667% PER MONTH).
IF YOU TAKE A 4-YEAR LOAN, WHAT IS YOUR MONTHLY
PAYMENT?
6-43
FINDING
THE NUMBER OF PAYMENTS I
CPT N = 3 YEARS
Chapter Outline
• Comparing Rates:
6-46
FINDING THE RATE
SUPPOSE YOU BORROW $25,000 FROM YOUR
PARENTS TO BUY A CAR. YOU AGREE TO PAY $207.58
PER MONTH FOR 60 MONTHS.
60 N
25,000 PV
-207.58 PMT
CPT I/Y = 2.05%
6-47
ANNUITY – FINDING THE
RATE WITHOUT A FINANCIAL
CALCULATOR
TRIAL AND ERROR PROCESS (UGH!)
1. CHOOSE AN INTEREST RATE AND COMPUTE THE PV OF
THE PAYMENTS BASED ON THIS RATE
2. COMPARE THE COMPUTED PV WITH THE ACTUAL LOAN
AMOUNT
3. IF THE COMPUTED PV > LOAN AMOUNT, THEN THE
INTEREST RATE IS TOO LOW
4. IF THE COMPUTED PV < LOAN AMOUNT, THEN THE
INTEREST RATE IS TOO HIGH
5. ADJUST THE RATE AND REPEAT THE PROCESS UNTIL
THE COMPUTED PV AND THE LOAN AMOUNT ARE
EQUAL
6-48
QUICK QUIZ III
40 N
7.5 I/Y
-2,000 PMT
CPT FV = $454,513.04 6-50
ANNUITY DUE
YOU ARE SAVING FOR A NEW HOUSE AND YOU NEED
20% DOWN TO GET A LOAN. YOU PUT $10,000 PER
YEAR IN AN ACCOUNT PAYING 8%. THE FIRST
PAYMENT IS MADE TODAY.
32,464
35,016.12
6-52
PERPETUITY
EXAMPLE
Suppose the Fellini Company
wants to sell preferred stock at
$100 per share. A similar issue of
preferred stock already
outstanding has a price of $40
per share and offers a dividend of
$1 every quarter.
going to sell?
PERPETUITY
PERPETUITY FORMULA: PV = C / R
CURRENT REQUIRED RETURN:
40 = 1 / R
R = .025 OR 2.5% PER QUARTER
DIVIDEND FOR NEW PREFERRED:
100 = C / .025
C = 2.50 PER QUARTER
6-54
QUICK QUIZ IV
1.YOU WANT TO HAVE $1 MILLION TO USE
FOR RETIREMENT IN 35 YEARS. IF YOU
CAN EARN 1% PER MONTH, HOW MUCH
DO YOU NEED TO DEPOSIT ON A
MONTHLY BASIS IF THE FIRST PAYMENT
IS MADE IN ONE MONTH?
2.WHAT IF THE FIRST PAYMENT IS MADE
TODAY?
3.YOU ARE CONSIDERING PREFERRED
STOCK THAT PAYS A QUARTERLY
DIVIDEND OF $1.50. IF YOUR DESIRED
RETURN IS 3% PER QUARTER, HOW MUCH 6-55
6-57
GROWING ANNUITY
A GROWING STREAM OF CASH FLOWS WITH A
FIXED MATURITY
C C (1 g ) C (1 g )t 1
PV
(1 r ) (1 r ) 2
(1 r ) t
C (1 g )
t
PV 1
r g (1 r )
6-58
GROWING ANNUITY: EXAMPLE
A DEFINED-BENEFIT RETIREMENT PLAN OFFERS TO PAY
$20,000 PER YEAR FOR 40 YEARS AND INCREASE THE
ANNUAL PAYMENT BY THREE-PERCENT EACH YEAR.
$20,000 1.03
40
PV 1 $265,121.57
.10 .03 1.10
6-59
GROWING
PERPETUITY
A GROWING STREAM OF CASH FLOWS THAT
LASTS FOREVER
C C (1 g ) C (1 g ) 2
PV
(1 r ) (1 r ) 2
(1 r ) 3
C
PV
rg
6-60
GROWING PERPETUITY
EXAMPLE
THE EXPECTED DIVIDEND NEXT YEAR IS $1.30,
AND DIVIDENDS ARE EXPECTED TO GROW AT 5%
FOREVER.
IF THE DISCOUNT RATE IS 10%, WHAT IS THE
VALUE OF THIS PROMISED DIVIDEND STREAM?
$1.30
PV $26.00
.10 .05
6-61
EFFECTIVE ANNUAL
RATE (EAR)
• THIS IS THE ACTUAL RATE PAID (OR
RECEIVED) AFTER ACCOUNTING FOR
COMPOUNDING THAT OCCURS
DURING THE YEAR
• BY DEFINITION: APR
= PERIOD RATE
TIMES THE NUMBER
OF PERIODS PER
YEAR 6-63
ANNUAL PERCENTAGE RATE
(APR)
.5(12) = 6%
2. WHAT IS THE APR IF THE SEMIANNUAL RATE IS
.5%?
.5(2) = 1%
3. WHAT IS THE MONTHLY RATE IF THE APR IS
12% WITH MONTHLY COMPOUNDING?
12 / 12 = 1%
6-65
THINGS TO
REMEMBER
YOU ALWAYS NEED TO
MAKE SURE THAT THE
INTEREST RATE AND
THE TIME PERIOD
MATCH.
• IF YOU ARE LOOKING
AT ANNUAL PERIODS,
YOU NEED AN 6-66
ANNUAL RATE.
THINGS TO
REMEMBER
IF YOU HAVE AN APR
BASED ON MONTHLY
COMPOUNDING, YOU
HAVE TO USE MONTHLY
PERIODS FOR LUMP
SUMS, OR ADJUST THE
INTEREST RATE
APPROPRIATELY IF YOU
HAVE PAYMENTS OTHER 6-67
THAN MONTHLY
COMPUTING EARS
EXAMPLE
SUPPOSE YOU CAN EARN 1% PER MONTH
ON $1 INVESTED TODAY.
= .1255 = 12.55%
EAR - FORMULA
m
APR
EAR 1 1
m
Remember that the APR is the
quoted rate, and
“m” is the number of 6-70
FIRST ACCOUNT:
EAR = (1 + .0525/365)365 – 1 = 5.39%
SECOND ACCOUNT:
EAR = (1 + .053/2)2 – 1 = 5.37%
WHICH ACCOUNT SHOULD YOU CHOOSE AND WHY?
6-71
DECISIONS, DECISIONS
II CONTINUED
LET’S VERIFY THE CHOICE.
SUPPOSE YOU INVEST $100 IN
EACH ACCOUNT. HOW MUCH WILL
YOU HAVE IN EACH ACCOUNT IN
ONE YEAR?
FIRST ACCOUNT:
365 N; 5.25 / 365 = .014383562 I/Y; 100 PV;
CPT FV = $105.39
SECOND ACCOUNT:
2 N; 5.3 / 2 = 2.65 I/Y; 100 PV; CPT FV = $105.37
AND YOU GET:
m
APR m (1 EAR) - 1
1
6-73
APR - EXAMPLE
SUPPOSE YOU WANT TO EARN AN
EFFECTIVE RATE OF 12% AND YOU ARE
LOOKING AT AN ACCOUNT THAT
COMPOUNDS ON A MONTHLY BASIS.
WHAT APR MUST THEY PAY?
APR 12 (1 .12) 1 .1138655152
1/12
or 11.39%
6-74
COMPUTING PAYMENTS
WITH APRS
SUPPOSE YOU WANT TO BUY A NEW
COMPUTER SYSTEM AND THE STORE IS
WILLING TO ALLOW YOU TO MAKE
MONTHLY PAYMENTS. THE ENTIRE
COMPUTER SYSTEM COSTS $3,500. THE
LOAN PERIOD IS FOR 2 YEARS, AND THE
INTEREST RATE IS 16.9% WITH MONTHLY
COMPOUNDING.
WHAT IS YOUR MONTHLY PAYMENT?
2(12) = 24 N; 16.9 / 12 = 1.408333333 I/Y; 3,500 PV; CPT PMT
6-75
= -$172.88
FUTURE VALUES WITH
MONTHLY COMPOUNDING
SUPPOSE YOU DEPOSIT $50 A MONTH
INTO AN ACCOUNT THAT HAS AN APR
OF 9%, BASED ON MONTHLY
COMPOUNDING. HOW MUCH WILL
YOU HAVE IN THE ACCOUNT IN 35
YEARS?
35(12) = 420 N
9 / 12 = .75 I/Y
50 PMT 6-76
CPT FV = $147,089.22
PRESENT VALUE WITH
DAILY COMPOUNDING
YOU NEED $15,000 IN 3 YEARS
FOR A NEW CAR. IF YOU CAN
DEPOSIT MONEY INTO AN
ACCOUNT THAT PAYS AN APR OF
5.5% BASED ON DAILY
COMPOUNDING, HOW MUCH
WOULD YOU NEED TO DEPOSIT?
3(365) = 1,095 N
5.5 / 365 = .015068493 I/Y
15,000 FV 6-77
CPT PV = -$12,718.56
CONTINUOUS
COMPOUNDING
SOMETIMES INVESTMENTS OR LOANS ARE
FIGURED BASED ON CONTINUOUS COMPOUNDIN
EAR = EQ – 1
THE E IS A SPECIAL FUNCTION ON THE CALCULA
NORMALLY
DENOTED BY EX
EXAMPLE: WHAT IS THE EFFECTIVE ANNUAL RAT
COMPOUNDED CONTINUOUSLY?
EAR = E.07 – 1 = .0725 OR 7.25%
6-78
QUICK QUIZ V
6-80
Types of Loans
6-82
PURE DISCOUNT
LOANSTO REPAY
IF A T-BILL PROMISES
$10,000 IN 12 MONTHS AND THE
MARKET INTEREST RATE IS 7
PERCENT, HOW MUCH WILL THE
BILL SELL FOR IN THE MARKET?
1 N; 10,000 FV; 7 I/Y; CPT PV = -
$9,345.79
6-83
INTEREST-ONLY LOAN
EXAMPLE
CONSIDER A 5-YEAR, INTEREST-ONLY LOAN
WITH A 7% INTEREST RATE. THE PRINCIPAL
AMOUNT IS $10,000. INTEREST IS PAID
ANNUALLY.
WHAT WOULD THE STREAM OF CASH FLOWS
BE?
YEARS 1 – 4: INTEREST PAYMENTS OF .
07(10,000) = 700
YEAR 5: INTEREST + PRINCIPAL = 10,700
6-84
6-89
ETHICS ISSUES
(CONTINUED)
THE ACTUAL REFUND IS THEN MAILED TO THE
PREPARATION SERVICE. ASSUME YOU EXPECT TO GET
A REFUND OF $978. WHAT IS THE APR WITH WEEKLY
COMPOUNDING? WHAT IS THE EAR? HOW LARGE DOES
THE REFUND HAVE TO BE FOR THE APR TO BE 15%?
WHAT IS YOUR OPINION OF THIS PRACTICE?
6-90
COMPREHENSIVE PROBLEM
PART 1
• AN INVESTMENT WILL
PROVIDE YOU WITH $100 AT
THE END OF EACH YEAR FOR
THE NEXT 10 YEARS. WHAT IS
THE PRESENT VALUE OF THAT
ANNUITY IF THE DISCOUNT
RATE IS 8% ANNUALLY?
• WHAT IS THE PRESENT VALUE
OF THE ABOVE IF THE
6-91
• Continuous Compounding
Terminology
(continued)
• Pure Discount Loan
• Interest-only Loan
• Amortized Loan with Fixed
Principle
• Amortized Loan with Fixed
Payment
6-94
Formulas
Perpetuity: PV =
C/r
1
1 (1 r ) t
PV C
r
Annuity:
(1 r ) t 1
FV C
r
6-95
Formulas
(continued)
C (1 g )
t
PV 1
r g (1 r )
C
PV
rg
6-96
Formulas
(continued)
m
APR
EAR 1 1
m
APR m (1 EAR)
1
m
-1
6-97
Key Concepts and
• Compute the Skills
future value
of multiple cash flows
• Distinguish between an
ordinary annuity and an
annuity due 6-98
Key Concepts and
•
Skills
Compute loan payments