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1 Finance Theory I Haoxiang Zhu MIT Sloan School of Management Lecture 2: Present Value Lecture Notes

2 Key concept of Lecture 1 Opportunity cost of capital True or False? A company s 10-year debt is guaranteed by the US government. The US government can issue 10-year debt at 2% per year. Therefore, the company s cost of capital is 2%. No arbitrage Construct an arbitrage strategy. You can buy or sell a stock at \$10 per share now. You can also enter a contract, at no cost, that allows you to buy or sell the stock in 1 year for \$11 a share. You can borrow or lend money now at 4% per year. Lecture Notes 2

3 Key concepts Present value and future value Special cash flows (annuity, perpetuity, p etc) Compounding Nominal versus real cash flows and discount rates Extensions Readings: Brealey, Myers, and Allen, Chapter 2 Lecture Notes 3

4 Key concepts Key question: What is an asset? Business entity Property, plant, and equipment Patents, R&D Stocks, bonds, options Knowledge, reputation, opportunities, etc. From a business perspective, an asset is a sequence of cashflows Lecture Notes 4

5 Key concepts Lecture 2: Present value Valuing an asset requires valuing a sequence of cash flows Sequences of cash flows are the basic building blocks of finance Always draw a timeline to visualize the timing of cash flows An asset s s present value equals its expected cash flow discounted at the appropriate cost of capital (discount rate). Lecture Notes 5

6 Present value (PV) Example. Howmuchisasure cash flow of \$1,100 in one year worth now? Market: Traded d safe assets offer 5% annual return A potential buyer of the sure CF also expects 5% return (cost of capital). Let the price she is willing to pay be X. Then Thus, X(1+0.05) ( ) =1, 100 X = 1, =\$1, 048 which is the CF's present value, i.e., its current market value. Observation: Present value properly adjusts for time Lecture Notes 6

7 Present value (PV) Example. How much is a risky cash flow in one year with a forecasted value of \$1,100 worth now? Market: Traded d assets of similar il risk offer 20% annual return A potential buyer of the risky CF also expects 20% return. price be X. Then X( ) = 1, 100 Let the Thus, the present value of the risky CF is X = 1, 100 = \$ Observation: Present value properly adjusts for risk Lecture Notes 7

8 Present value (PV) Implicit assumptions for present value calculations Cash flows are known (magnitudes, signs, timing) Discount rates are known No frictions Do these assumptions hold in practice? Until Part C, We will take these assumptions as truth Focus now on the discount rates Where do they come from, how are they determined? Lecture Notes 8

9 Present value (PV) Expected rate of return on traded assets (1/1926 8/2010, nominal, monthly returns, annualized, in %) Asset Mean St. Dev. Premium Short term government debt Long term government debt Long term corporate debt Large stocks S&P Small stocks Risk-free interest rate --- time value of money Extra return of risky assets over the safe asset --- risk premium Lecture Notes 9

10 Present value (PV) PV(CF T )= CF T (1+r) T r is the discount rate, or opportunity cost of capital Example. (A) \$10M in 5 years or (B) \$15M in 15 years. Which is better if r = 5%? PV A = =7.84; PV 5 B = 15 = Lecture Notes 10

11 Present value (PV) \$1.0 \$0.8 PV of \$1 Received In Year t r = 0.04 r = 0.08 r = 0.12 \$0.6 \$0.4 \$0.2 \$ Year when \$1 is received Lecture Notes 11

12 Valuing cash flows Example. Drug company has developed a flu vaccine and needs to choose between two strategies: 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 The discount rate is 5%. How to value/compare the two strategies (i.e., their CFs)? Lecture Notes 12

13 Present value (PV) PV(CF 1,CF 2,...,CF T )= CF 1 (1+r) + CF 2 (1+r) CF T (1+r) T Solution to Example. Flu Vaccine. Strategy A: Time Cash Flow -1, Present Value -1, Total PV 98.2 Strategy B: Time Cash Flow Present Value Total PV Firm should choose strategy B, and its value would increase by \$140.8 M Lecture Notes 13

14 Future value (FV) How much will \$1 today be worth in one year? Current interest rate is, say, 4% \$1 investable at a rate of return r =4% FV in 1 year FV in T years FV = 1 + r =\$1.04 FV = \$1 (1 + r) ) (1 + r) ) = (1+r) 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 ( ) 2 =\$10, 816 Lecture Notes 14

15 Example Lecture 2: Present Value The Last Real Estate Bargain in New York City. The Dutch West India Company dispatched the first permanent settlers to Manhattan Island in They established Fort Amsterdam, which grew into the town of New Amsterdam as more settlers arrived. In 1626, the fledgling town's governor, Peter Minuit, bought Manhattan meaning "Island of Hills" from the Canarsie tribe for 24 dollars' worth of beads and trinkets. Locals sometimes cite this transaction as one of the last real estate t bargains in New York. How big of a bargain was it? At 6% interest rate? At 7%? In 2006, the total value of Manhattan property was about 802 billion. Lecture Notes 15

16 Special cash flows Annuity A constant cash flow for T periods (starting in period 1) A A A t =0 1 2 T time PV = A 1+r + A (1+r) A (1+r) T (1 + r) ) PV = A A A (1+r) (1+r) T 1 r PV = A A (1+r) T 1 PV (Annuity) = A 1 r 1 (1+r) T FV (Annuity) = (1+r) T PV (Annuity) Lecture Notes 16

17 An Example Which car can you afford: Lecture 2: Present Value or? You have no large amount of cash. You can afford up to \$632 per month. You can borrow at an interest rate of 1% per month. You want to have paid the loan in full in 48 month. PV = A * PV factor PV factor =(1-1/ )/0.01= PV=A * PV factor = 632 * = \$24,000 Lecture Notes 17

18 Special cash flows 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? PV = 10, = 124, µ =10, Lecture Notes 18

19 Special cash flows Annuity with constant growth rate g A A(1+g) A(1+g) T t =0 1 2 T time PV (Annuity with growth) = A = A ( ) T r + 1+g (1+r) + + (1+g)T 1 2 (1+r) T ³ T 1 r g 1 1+g 1+r if r 6= g T if r = g 1+r Lecture Notes 19

20 Special cash flows 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 thatt grows by 5% each year. How much should you start saving now, assuming that r = 8%? The answer is 6,473. How do you calculate it? Lecture Notes 20

21 Special cash flows Example. You just won the lottery and it pays \$100,000 a year for 20 years. Are you a millionaire? Suppose that r = 10%. PV = 100, µ =100, = 851, 356 What if the payments last for 50 years? PV = 100, µ = 991, 481 =100, How about forever - a perpetuity? PV = 100, =1, 000, 000 Lecture Notes 21

22 Special cash flows Perpetuity An annuity with infinite it maturity A A A t = time PV (Perpetuity) = A r Example. UK Consol bond, current coupon 2.5% Lecture Notes 22

23 Special cash flows Perpetuity with constant t grow g AA(1+g) A(1+g) t = time PV (Perpetuity with growth) = A r g, r > g 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 = = ( ) ( ) = Lecture Notes 23

24 Compounding 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? 10% Compounded Annually, Semi- Annually, Quarterly, and Monthly Typical quote convention: Annual Percentage Rate (APR) k periods of compounding Interest per period is APR/k Actual annual rate differs from APR Lecture Notes 24

25 Compounding 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( )( ) 000( )( ) = 10, In the second 6-month period, you earn interest on interest The actual annual rate, the Effective Annual Rate (EAR), is r EAR =( ) 2 1=5.0625% Lecture Notes 25

26 Compounding Let r APR be the APR and k be the number of compounding intervals per year. In one year, one dollar invested today yields: ³ 1+ r APR k k Effective annual rate, r EAR is given by or (1+r EAR ) = r EAR = Example. Suppose r APR =5%. Here, ³ r APR k 1+ r APR k ³ 1 r k APR ³1 + 1 k k Value of \$1 in a year r EAR % % % % 8, %... e % e 0.05 = % Lecture Notes 26

27 Mortgage example 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 year fixed rate mortgage at 8.5% APR compounded monthly The monthly payment M is determined by 360 X M 400, 000 = [1 + (0.085/12)] t t=1 n o M 1 = 1 (0.085/12) [1 + (0.085/12)] 360 = M (0.9212) (0.085/12) 085/12) M = Effective annual interest rate (EAR): [1+(0.085/12)] 12 1= =8.839% Lecture Notes 27

28 Mortgage example Monthly payments t (month) Principal Interest Sum Remaining P , , , , , , , , 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 Lecture Notes 28

29 Nominal vs. real CFs/rates Nominal vs. real CFs Example. Inflation is 4% per year. one year, what is this CF really worth next year? You expect to receive \$1.04 in The inflation adjusted or real value of \$1.04 in a year is Real CF = Nominal CF 1+inflation = =\$1.00 Nominal cash flows expressed in actual-dollar cash flows Real cash flows expressed in constant purchasing power At an annual inflation rate of i, we have (N i l CF) (Real CF) t = (Nominal CF) t (1 + i) t Lecture Notes 29

30 Nominal vs. real CFs/rates Nominal vs. real rates of return 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 = The real return is 1.9%. r real = 1+r nominal 1 + i 1 r nominal i Lecture Notes 30

31 Nominal vs. real CFs/rates 16% Annual Inflation rates in 2008, 2009, and 2010 (up to July) 14% 12% 10% 8% 6% % % 0% 2% ARGENTINA AUSTRALIA BRAZIL CANADA GERMANY GREECE HO ONG KONG INDIA NDONESIA JAPAN FINLAND MEXICO KINGDOM I UNITED UNIT TED STATES WORLD Lecture Notes 31

32 Nominal vs. real CFs and rates Example. Sales are \$1M this year and are 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) = PV = = Alternatively, next year s real sales forecast: (1)(1.02) = 1.02 r real = 1+r n 1+i 1= =0.9615% 1.02 PV = = For PV calculations, treat inflation consistently Discount nominal cash flows using nominal discount rates Discount real cash flows using real discount rates Lecture Notes 32

33 Extensions Taxes Currencies Term structure of interest rates Forecasting cash flows Choosing the right discount rate (risk adjustments) PV(CF 1,CF 2,...,CF T )= E[CF 1] (1+r 1 + E[CF 2] (1+r E[CF T ] ) ) (1+r T ) T Lecture Notes 33

34 Who s the boss? Lecture 2: Present Value Ben Bernanke Chairman of the Board of Governors of the United States Federal Reserve Chairman of the Federal Open Market Committee (FOMC), which sets the federal funds rate (the rate that commercial banks charge on overnight loans among themselves) Last change was Dec 16, 2008 when the target for the federal funds rate was lowered to % Stock market usually rallies after unexpected rate cut announcements. When Ben speaks, Wall Street listens. Lecture Notes 34

35 Summary Present value versus future value Special cash flows (annuity, perpetuity, etc) Compounding Nominal versus real cash flows and discount rates Extensions Next Class: Fixed income securities, Chapter 3 of textbook. Lecture Notes 35

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