Key Concepts and Skills

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1 Chapters 5 and 6 Calculators Time Value of Money and Discounted Cash Flow Valuation McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Key Concepts and Skills Be able to compute the future value of multiple cash flows Be able to compute the present value of multiple cash flows Be able to compute loan payments Be able to find the interest rate on a loan Understand how interest rates are quoted Understand how loans are amortized or paid off 6C-2 1. Draw a Time Line End i% CF 0 CF 1 CF 2 CF 3 There are only three types of problems: 1. Even Cash Flows, like Present Value, Future Value, and Annuities 2. Perpetuities, where the cash flows last forever 3. Uneven Cash Flow problems, like Net Present Value and Internal Rate of Return LOTS OF HELP AVAILABLE 1

2 Hints on Solving Time Value of Money Problems Draw a Time Line Begin with the End in Mind Watch the Signs of the Cash Flows The Number of Periods (N) usually equals the greater of the number of Cash Flows or the Number of Years Always use either the Effective Annual or the Periodic Interest Rate Recognize hidden Perpetuities, Annuities, and Annuities Due. Set up the Calculator correctly and always Clear the Calculator before starting a problem. Use the course webpage Practice Chapter Outline Future and Present Values of Multiple Cash Flows Valuing Level Cash Flows: Annuities and Perpetuities Comparing Rates: The Effect of Compounding Loan Types and Loan Amortization 6C-5 Contact Charles Hodges D2L or chodges@westga.edu Chat Sessions Skype (bufordshighway), LinkedIn and Facebook (Charles Hodges). Office Phone (678) and Cell Phone (770) , target is under 24 hours 2

3 Amortized Loan with Fixed Payment - Example Each payment covers the interest expense plus reduces principal Consider a 4 year loan with annual payments. The interest rate is 8%, and the principal amount is $5,000. What is the annual payment? 4 N 8 I/Y 5,000 PV CPT PMT = -1, Click on the Excel icon to see the amortization table 6C-7 Year Beginning Total Interest Principal Ending Balance Payment Paid Paid Balance 1 5, , , , , , , , , , , , , , , Totals 6, , , Note: The ending balance of.01 is due to rounding. The last payment would actually be 1, Amortization Relationships Payment = Principal + Interest Beginning Balance = Previous Ending Balance Interest = Beginning Balance * Interest Rate Beginning Balance Principal = Ending Balance Ending Balance Beginning Balance = Principal 3

4 Solving with Calculators Find the Payment Without clearing calculator, change N and compute FV May need to do this twice, with some questions Use Amortization Relationships to answer question Work the Web Example There are web sites available that can easily prepare amortization tables Click on the web surfer to check out the Bankrate.com website and work the following example You have a loan of $25,000 and will repay the loan over 5 years at 8% interest. What is your loan payment? What does the amortization schedule look like? 6C-11 Amortized Loan with Fixed Principal Payment - Example Consider a $50,000, 10 year loan at 8% interest. The loan agreement requires the firm to pay $5,000 in principal each year plus interest for that year. Click on the Excel icon to see the amortization table 6C-12 4

5 Beginning Interest Principal Total Ending Year Balance Payment Payment Payment Balance 1 50,000 4,000 5,000 9,000 45, ,000 3,600 5,000 8,600 40, ,000 3,200 5,000 8,200 35, ,000 2,800 5,000 7,800 30, ,000 2,400 5,000 7,400 25, ,000 2,000 5,000 7,000 20, ,000 1,600 5,000 6,600 15, ,000 1,200 5,000 6,200 10, , ,000 5,800 5, , ,000 5,400 0 Ethics Issues Suppose you are in a hurry to get your income tax refund. If you mail your tax return, you will receive your refund in 3 weeks. If you file the return electronically through a tax service, you can get the estimated refund tomorrow. The service subtracts a $50 fee and pays you the remaining expected refund. 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? (50/(978-50))=Periodic rate = %. APR = %*52/3=93.39% What is the EAR? EFF(93.39%,52/3)=148.33% 6C-14 Contact Charles Hodges D2L or chodges@westga.edu Chat Sessions Skype (bufordshighway), LinkedIn and Facebook (Charles Hodges). Office Phone (678) and Cell Phone (770) , target is under 24 hours 5

6 Hints on Solving Time Value of Money Problems Charles Hodges Professor of Finance University of West Georgia Hints on Solving Time Value of Money Problems Draw a Time Line Begin with the End in Mind Watch the Signs of the Cash Flows The Number of Periods (N) usually equals the greater of the number of Cash Flows or the Number of Years Always use either the Effective Annual or the Periodic Interest Rate Recognize hidden Perpetuities, Annuities, and Annuities Due. Set up the Calculator correctly and always Clear the Calculator before starting a problem. Use the course webpage Practice 1. Draw a Time Line End i% CF 0 CF 1 CF 2 CF 3 There are only three types of problems: 1. Even Cash Flows, like Present Value, Future Value, and Annuities 2. Perpetuities, where the cash flows last forever 3. Uneven Cash Flow problems, like Net Present Value and Internal Rate of Return 6

7 2. Begin with the End In Mind N I% PV PMT PMT PMT FV There are only five variables: 1. PV= Present Value (occurs in Period 0, single cash flow) 2. FV=Future Value (occurs in Period N/last Period, single cash flow) 3. PMT=Payment (series of N constant payments) 4. I=Interest Rate (either Periodic or Effective Rate) 5. N=Number (greater of # of PMTs or # of years) 3. Frequency of Cash Flows usually determines the interest rate used. Always use either the Effective Annual or the Periodic Interest Rate. Annual (or less often) cash flows use effective rate, more than one time per year use periodic rate. nominal, or stated, or quoted, YTM, APR, rate per year. (NEVER USE THIS RATE) i Per = periodic rate= (Nominal / Periods per Year) EAR = EFF% = ((1+periodic rate) to the compounding periods per year power) - 1 Payments more than one time per year, use periodic rate Payment annually or less often, use effective rate 4. The Number of Periods (N) usually equals the greater of the number of Cash Flows or the Number of Years Examples: 1. What is the future value of $4 compounded at 8% for 5 years? N =5 (Effective Rate=8%) 2. What is the monthly payment for a 30-year mortgage at 6% on a $150,000 home? N=30*12=360 (Periodic Rate, 6/12=.5%) 3. What is the future value of $4 compounded at 8% (with quarterly compounding) for 5 years? Can be either, 5 years (Effective rate=8.243%) or 20 (5*4, Periodic rate=8/4=2%). 7

8 5. Recognize hidden Perpetuities, Annuities, and Annuities Due. Look for Buzzwords Forever and From Now On imply Perpetuity Anything suggesting level payments, such as rent, mortgage payments, salary, dividends, coupon payments implies annuity Starting today and Beginning Now indicate Annuity Due (Payments made at beginning of Period) 6. Watch the Signs of the Cash Flows i% Sources= Inflows= + 2. Uses = Outflows = - 3. Only Cash counts 7. Set up the Calculator correctly and always Clear the Calculator before starting a problem % -1,000 PMT PMT PMT INPUTS OUTPUT N I/YR PV PMT FV

9 8. Use the course webpage Lots of videos, audios, written instructions Currently, Learning Management System D2L Webct Blackboard Practice, Practice, Practice Practice, Practice, Practice, Practice Contact Information Professor: Charles Hodges Webpage: D2L Phone:(678) Office: Room 205B - Adamson Hall Office Hrs: Not Applicable (I am in my office most days. Feel free to drop-in. ) 9

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