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15.401 Finance Theory I

Alex Stomper
MIT Sloan School of Management Institute for Advanced Studies, Vienna

Lecture 2: Present Value

Agenda

15.401

Lecture 2: Present value

_ Present value _ Future value _ Special cash flows _ Compounding _ Nominal versus real cash flows and discount rates _ Extensions

Readings: _ Brealey, Myers, and Allen, Chapters 2 3

Review of last class

15.401

Lecture 2: Present value

_ Objective of a financial manager: maximize firm s market value _ The value of a firm/an asset/a project/a portfolio depends on features of the cash flow (CF) that the firm/asset/project/portfolio generates. _ Two important characteristics of CFs: timing and riskiness. _ Financial market prices can be used to value CFs. _ Cost of capital: expected return on equivalent investments in financial markets.

Valuing cash flows Visualizing cash flows (assets):

Invest CF0

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Lecture 2: Present value

CF3

Earn CF1 CF2

CF4 ...

Example. Drug company has developed a flu vaccine:

_ Strategy A: To bring to market in 1 year, invest $1B (billion) now and returns $500M (million), $400M and $300M in years 1, 2 and 3, respectively _ Strategy B: To bring to market in 2 years, invest $200M in years 0 and 1, and returns $300M in years 2 and 3

How to value/compare CFs?

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Present value (PV)

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Lecture 2: Present value

Example. How much is a sure cash flow of $1,100 in one year worth now? Market: Traded safe assets offer 5% annual return A potential buyer of the sure CF also expects 5% return. Let the price she is willing to pay be X. Then X (1+5%)=$1,100.

Thus, X=$1,100/1.05=$1,048 which is the CF's present value, i.e., its current market value.

Observation: Present value properly adjusts for time

Present value (PV)

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Lecture 2: Present value

Example. How much is a risky cash flow in one year with a forecasted value of $1,100 worth now? Market: Traded assets of similar risk offer 20% annual return A potential buyer of the risky CF also expects 20% return. Let the price be X. Then

X (1+20%)=$1,100
Thus, the present value of the risky CF is X=$1,100/1.20=$917 Observation: Present value properly adjusts for risk An asset s present value equals its expected cash flow discounted at the appropriate cost of capital (discount rate).
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Expected returns

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Lecture 2: Present value

Average annual returns on different assets (1926-2005, nominal) Asset Mean Standard deviation 9.2 8.5 20.2 32.9

Short-term gov bond 3.8 Long-term gov bond Long-term corp debt Large stocks Small stocks 5.8 6.2 12.3 17.4

Present value (PV)

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Lecture 2: Present value

CFT PV = (1 + r )T
Example. (1) $10M in 5 years or (2) $15M in 15 years. Which is better if r = 5%?

PVA = 10 PVB = 15

1.05

= 7.84 = 7.22

1.0515

Present value (PV)

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Lecture 2: Present value

PV of $1 Received In Year t
$1.0

r = 0.04
$0.8 $0.6 $0.4 $0.2 $0.0 0 2 4 6 8

r = 0.08

r = 0.12

10 12 14 16 18 20 22 Year when $1 is received

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Present value (PV)

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Lecture 2: Present value

T CF1 CF2 CFT CFt PV = + + ... + = 2 T t 1 + r (1 + r ) (1 + r ) t = 0 (1 + r )

Solution to Example. Flu Vaccine. Assume that r = 5%. Strategy A: Time CF PV Total 0 1 2 400 362.8 3 300 259.2 98.2

-1,000 500 -1,000 476.2

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Present value (PV)

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Lecture 2: Present value

T CF1 CF2 CFT CFt PV = + + ... + = 2 T t 1 + r (1 + r ) (1 + r ) t = 0 (1 + r )

Solution to Example. Flu Vaccine. Assume that r = 5%. Strategy B: Time CF PV Total 0 -200 -200 1 -200 2 300 3 300 259.2 140.8

-190.5 272.1

Firm should choose strategy B. Firm value would increase by $140.8 M

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Future value (FV)

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Lecture 2: Present value

How much will $1 today be worth in one year? Current interest rate is, say, 4% _ $1 investable at a rate of return _ FV in 1 year: $(1+4%)

_ FV in T years: $(1+4%) (1+4%)

(1+4%)=$(1+4%)T

Example. Bank pays an annual interest of 4% on 2-year CDs and you deposit $10,000. What is your balance two years later?

FV = $10, 000(1 + 0.04)2 = $10, 816

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Special cash flows

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Lecture 2: Present value

Annuity: A constant cash flow for T periods (starting in period 1)

Today is t=0 and cash flows start at t=1.

A A A 1 1 PV = + + ... + = A 1 2 T T 1 + r (1 + r ) (1 + r ) r (1 + r ) FV = PV (1 + r )T
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Special cash flows

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Lecture 2: Present value

Example. An insurance company sells an annuity of $10,000 per year for 20 years. Suppose r = 5%. What should the company sell it for?

1 1 PV = $10, 000 1 = $124, 622.1 20 0.05 1.05

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Special cash flows

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Lecture 2: Present value

Annuity with constant growth rate g

1 1+ gT 1 if r g T 1 1 1+ g (1 + g ) r g 1+ r PV = A + + ... + = A 2 T (1 + r ) 1 + r (1 + r ) T if r = g 1 + r

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Special cash flows

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Lecture 2: Present value

Example. Saving for retirement - Suppose that you are now 30 and need $2 million at age 65 for your retirement. You can save each year an amount that grows by 5% each year. How much should you start saving now, assuming that r = 8%?
35 1 1.05 PV = A 1 1.08 0.08 0.05 20.898

FV = PV 1.08 35 = A 308.978 A = 2, 000, 000 / 308.978

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Special cash flows

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Lecture 2: Present value

Example. You just won the lottery and it pays $100,000 a year for 20 years. Are you a millionaire? Suppose that r = 10%.

1 1 PV = $100, 000 1 20 = $851, 356 0.1 1.1

_ What if the payments last for 50 years?

1 1 PV = $100, 000 1 50 = $991.481 0.1 1.1

_ How about forever - a perpetuity?

1 1 $100, 000 PV = $100, 000 1 = = $1, 000, 000 0.1 1.1 0.1

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Special cash flows Perpetuity with constant grow g

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Lecture 2: Present value

PV =

A , for r > g rg

Example. Super Growth Inc. will pay an annual dividend next year of $3. The dividend is expected to grow 5% per year forever. For companies of this risk class, the expected return is 10%. What should be Super Growth's price per share?

PV =

$3 = $60 0.10 0.05

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Compounding

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Lecture 2: Present value

Interest may be credited/charged more often than annually

Bank accounts: daily Loans and leases: monthly Bonds: semi-annually

For the same quoted interest rate, the effective annual rate may differ Why? Typical quote convention: Annual Percentage Rate (APR) k periods of compounding Interest per period is APR/k Actual annual rate differs from APR
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10% Compounded Annually, SemiAnnually, Quarterly, and Monthly

Compounding

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Lecture 2: Present value

Example. Bank of America's one-year CD offers 5% APR, with semiannual compounding. If you invest $10,000, how much money do you have at the end of one year? What is the actual annual rate of interest you earn? Quoted APR of 5% is not the actual annual rate It is only used to compute the 6-month interest rate: (5%)(1/2) = 2.5% Investing $10,000, at the end of one year you have: 10,000(1+0.025)(1+0.025) = 10,506.25 In the second 6-month period, you earn interest on interest The actual annual rate, the Effective Annual Rate (EAR), is

rEAR = 1.025 1 = 5.0625%

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Compounding

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Lecture 2: Present value

Let rAPR be the APR and k be the number of compounding intervals per year. In one year, one dollar invested today yields:

Effective annual rate, rEAR is given by: or

rAPR 1+ k

r rEAR = 1 + APR 1 k

Example. Suppose rAPR = 5%. Here, e 2.71828

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Nominal vs. real CFs/rates Nominal vs. real CFs

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Lecture 2: Present value

Example. Inflation is 4% per year. You expect to receive $1.04 in one year, what is this CF really worth next year? The inflation adjusted or real value of $1.04 in a year is

RCF =

NCF $1.04 = = $1 1 + i 1 + 0.04

expressed in constant purchasing power

_ Nominal cash flows expressed in actual-dollar cash flows _ Real cash flows

At an annual inflation rate of i , we have

NCFt RCFt = (1 + i )t
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Nominal vs. real CFs/rates

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Lecture 2: Present value

Inflation in Europe (2008)

EMU = Euro-zone (MUICP), EU = EICP, AT = Austria, BE = Belgium, BG = Bulgaria, CY = Cyprus, CZ = Czech Republic,DE = Germany, DK = Denmark, EE = Estonia, EL = Greece, ES = Spain, FI = Finland, FR = France, HU = Hungary, IE = Ireland, IT = Italy, LT = Lithuania, LU = Luxembourg, LV = Latvia, MT = Malta, NL = Netherlands, PL = Poland, PT = Portugal,RO = Romania, SE = Sweden, SI = Slovenia, SK = Slovakia,UK = United Kingdom. EU = EICP includes 15 member countries up to April 2004, 25 member countries from May 2004 and 27 member countries from Jan 2007. EMU = MUICP includes 13 member countries.

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Nominal vs. real CFs/rates Nominal vs. Real Rates

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Lecture 2: Present value

_ Nominal rates of return prevailing market rates _ Real rates of return inflation adjusted rates

Example. $1.00 invested at a 6% interest rate grows to $1.06 next year. If inflation is 4% per year, then the real value is $1.06/1.04 = 1.019 The real return is 1.9%.

rreal

1 + rnom = 1 rnom i 1+ i

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Nominal vs. real CFs and rates

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Lecture 2: Present value

Example. Sales is $1M this year and is expected to have a real growth of 2% next year. Inflation is expected to be 4%. The appropriate nominal discount rate is 5%. What is the present value of next year's sales revenue? _ Next year s nominal sales forecast: (1)(1.02)(1.04) = 1.0608 _ Next year s real sales forecast: (1)(1.02) = 1.02

1.0608 PV = = 1.0103 1.05

For PV calculations, treat inflation constantly

1.05 rreal = 1 = 0.9615% 1.04 1.02 PV = = 1.0103 1.009615

_ Discount nominal cash flows using nominal discount rates _ Discount real cash flows using real discount rates
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Mortgage example
_ _ _

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Lecture 2: Present value

Example. Fixed rate mortgage calculation in the U.S.

20% down payment, and borrow the rest from bank using property as collateral Pay a fixed monthly payment for the life of the mortgage Have the option to prepay

Suppose that you bought a house for $500,000 with $100,000 down payment and financed the rest with a thirty-year fixed rate mortgage at 8.5% APR compounded monthly _ The monthly payment M is determined by

$400, 000 =
t =1

360

M M 1 1 t = 0.085 1 + 0.085 12 1 + 0.085 12 12

360

M = $3075.65
_ Effective annual interest rate (EAR):

(1 + 0.085 12)

12

1 = 8.839%
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Mortgage example
Monthly payments

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Lecture 2: Present value

_ Total monthly payment is the same for each month _ The percentage of principal payment increases over time _ The percentage of interest payment decreases over time
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Extensions _ Taxes _ Currencies

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Lecture 2: Present value

_ Term structure of interest rates _ Forecasting cash flows _ Choosing the right discount rate (risk adjustments)

E[CF1 ] E[CF2 ] PV = + + ... 2 1 + r1 (1 + r2 )

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Summary _ Present value _ Future value _ Special cash flows _ Compounding

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Lecture 2: Present value

_ Nominal versus real cash flows and discount rates _ Extensions

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