How To Calculate Present Values: Fixed Income Securities

How To Calculate Present
Values
Fixed Income Securities
Lecture 1
Present and Future Value

Future Value
Amount to which an
investment will grow
after earning interest
Present Value
Value today of a
future cash
flow.
Discount Factors and Rates

Discount Rate
Interest rate used
to compute
present values of
future cash flows.
Discount Factor
Present value of
a Rs.1 future
payment.
Future Values
Future Value of Rs.100 = FV
FV Rs.100 (1 r )
F
V
R
s.40,(1.05)R
s.420,
Future Values
FV Rs.100 (1 r )
Example - FV
What is the future value of Rs.400,000 if interest is

compounded annually at a rate of 5% for one year?
Present Value
Present Value = PV
PV = discount factor C1
Present Value
Discount Factor = DF = PV of Rs.1
DF
1
(1 r ) t
Discount Factors can be used to compute the present value of

any cash flow.
Valuing an Office Building

Step 1: Forecast cash flows
Cost of building = C0 = 400
Sale price in Year 1 = C1 = 420
Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 5%, then
Cost of capital = r = 5%
Valuing an Office Building

Step 3: Discount future cash flows
PV
C1
(1r )
420
(1.05 )
400
Step 4: Go ahead if PV of payoff exceeds investment
NPV 400 370 30
Net Present Value
NPV = PV - required investment

C1
NPV = C0
1 r
Risk and Present Value

Higher
risk projects require a higher rate of
return
Higher required rates of return cause lower
PVs
PV of C1 Rs.420 at 5%
420
PV
400
1 .05
Risk and Present Value

420
PV
375
1 .12
420
PV
400
1 .05
Risk and Net Present Value
NPV=PV-required investment
NPV=375,000-370,000
Rs.5,000
p
r
o
f
i
t
4
2
0
,
3
7
0
,
R
eturnivesm
.
1
3
5
o
r
1
3
.
5
%
n
Rate of Return Rule

Accept
investments that offer rates of return

in excess of their opportunity cost of capital
Example
In the project listed below, the foregone investment

opportunity is 12%. Should we do the project?
6
0
N
PV
=
-5+1.R
s.45
Net Present Value Rule

Accept
investments that have positive net

present value
Example
Suppose we can invest Rs.50 today and receive
Rs.60 in one year. Should we accept the project
given a 10% expected return?
Topics Covered
Valuing
Long-Lived Assets
PV Shortcuts Perpetuities and Annuities
Compound Interest & Present Values
Nominal and Real Rates of Interest (inflation)
D
F
1
t(
r)
Present Values
Discount Factor = DF = PV of Rs.1
Discount Factors can be used to compute

the present value of any cash flow.
Present Values
C1
PV DF C1
1 r1
1
D
F
(
r)t
Discount Factors can be used to compute

the present value of any cash flow.
Present Values
Ct
PV DF C t
t
(1 r )
Replacing 1 with t allows the formula
to be used for cash flows that exist at any
point in time
P
V
R
s.2,57.02
3(1.08)2
Present Values
Example
You just bought a new computer for Rs.3,000. The
payment terms are 2 years same as cash. If you can earn
8% on your money, how much money should you set aside
today in order to make the payment when due in two
years?
P
V
C
C
1
2
(1
r)(1
r)
Present Values
PVs can be added together to evaluate

multiple cash flows.
P
V
(1.07)1(1207)2265.8
Present Values
PVs can be added together to evaluate

multiple cash flows.
Present Values
Rs.200
Rs.100
Present Value
Year 0
100/1.07
= Rs.93.46
200/1.0772
= Rs.172.42
Total
= Rs.265.88
Year
D
F
.837
.12(
1
027)12
Present Values
Given two dollars, one received a year from now

and the other two years from now, the value of each
is commonly called the Discount Factor. Assume r1
= 20% and r2 = 7%.
Present Values
Example
Assume that the cash flows
from the construction and sale
of an office building is as
follows. Given a 5% required
rate of return, create a present
value worksheet and show the
net present value.
Year 0
Year 1
Year 2
170,000 100,000 320,000
Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office
building is as follows. Given a 5% required rate of return, create a
present value worksheet and show the net present value.
Period
Discount
Factor
Cash
Flow
Present
Value
0
1
1.0
1
1.05 .952
170, 000
100, 000
170, 000
95, 238
320, 000
290, 249
1
1.05 2
.907
NPV Total Rs.25, 011
Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office
building is as follows. Given a 5% required rate of return, create a
present value worksheet and show the net present value.
+Rs.320,00
0
-Rs.170,000
Rs.100,000
Present Value
Year
0
Year 0
-170,000
= -Rs.170,000
-100,000/1.05 =
Rs.95,238
320,000/1.052 = Rs.290,249
Total = NPV = Rs.25,011
Short Cuts
Sometimes
there are shortcuts that make it

very easy to calculate the present value of an
asset that pays off in different periods. These
tools allow us to cut through the calculations
quickly.
Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.
cash flow
Return
present value
C
r
PV
Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.
cash flow
PV of Cash Flow
discount rate
C1
PV0
r
Short Cuts
Annuity - An asset that pays a fixed sum each year
for a specified number of years.
Asset
Perpetuity (first
payment in year 1)
Perpetuity (first payment
in year t + 1)
Annuity from year
1 to year t
Year of Payment
1
2..t
Present Value
t+1
C
r
1
C
t
r (1 r )
1
C C

t
r r (1 r )
Short Cuts
Annuity - An asset that pays a fixed sum each
year for a specified number of years.
1
1
PV of annuity C
t
r r 1 r
Annuity Short Cut

Example
You agree to lease a car for 4 years at Rs.3000 per month.
You are not required to pay any money up front or at the
end of your agreement. If your opportunity cost of capital
is 0.5% per month, what is the cost of the lease?
Annuity Short Cut

Example - continued
You agree to lease a car for 4 years at Rs.3000
per month. You are not required to pay any money
up front or at the end of your agreement. If your
opportunity cost of capital is 0.5% per month,
what is the cost of the lease?
1
1
Lease Cost 3000
48
.005 .005 1 .005
Cost Rs.127, 741.0
Compound Interest
i
ii
Periods Interest
per
per
year
period
iii
APR
(i x ii)
iv
Value
after
one year
v
Annually
compounded
interest rate
6%
6%
1.06
6.000%
1.032
= 1.0609
6.090
1.5
1.0154 = 1.06136
6.136
12
.5
1.00512 = 1.06168
6.168
52
.1154
1.00115452 = 1.06180
6.180
365
.0164
1.000164365 = 1.06183
6.183
Compound Interest
Compound Interest
Compound Interest
Example
Suppose you are offered an automobile loan at an APR of
6% per year. What does that mean, and what is the true
rate of interest, given monthly payments?
Compound Interest
Example - continued
Suppose you are offered an
automobile loan at an APR of 6% per
year. What does that mean, and what
is the true rate of interest, given
monthly payments? Assume
Rs.10,000 loan amount.
Loan Pmt 10,000 (1.005)

10,616.78
APR 6.1678%
12
Inflation
Inflation - Rate at which prices as a whole are
increasing.
Nominal Interest Rate - Rate at which money
invested grows.
Real Interest Rate - Rate at which the
purchasing power of an investment
increases.
1
+
n
o
m
i
a
l
n
t
e
r
s
a
t
e
1realintresat=fo
Inflation
approximation formula
Real int. rate nominal int. rate - inflation rate
1
+
.
0
5
9
1
rA
lrep
ialoxim
+
e
a
tsato
n
erns=
ate9-.0
=
3
2
2
r3=
5
o
.0
5%
6or2.6%
Inflation
Example
If the interest rate on one year govt. bonds is 5.9%
and the inflation rate is 3.3%, what is the real
interest rate?
Savings
Bond
Inflation
Inflation Rates in India (1948 - 2006)
0.3
0.25
0.2
0.15
0.1
0.05
0
-0.05
-0.1
-0.15
-0.2
1952-
1957-
1962-
1967-
1972-
1977-
1982-
1987-
1992-
1997-
2002-
53
58
63
68
73
78
83
88
93
98
03
Investment vs. Consumption

Some
people prefer to consume now.

Some prefer to invest now and consume
later. Borrowing and lending allows us to
reconcile these opposing desires which
may exist within the firms shareholders.

income in period 1
100
A
80
Some investors will prefer A

and others B
60
40
20
40
60
income in period 0
80
100

The grasshopper (G) wants to
consume now. The ant (A) wants to
wait. But each is happy to invest.
Each invests Rs.185,000 and
returns Rs.210,000 at the end of the
year. G wants to consume now so G
borrows Rs.200,000 and repays
Rs.210,000 at the end of the year.
The existence of capital markets
allows G to consume now and still
invest with A in the project.
Rupees
Next Year
210
A invests Rs.185 now

and consumes Rs.210
next year
194
The grasshopper (G) wants to

consume now. The ant (A) wants
to wait. But each is happy to
invest. Each invests Rs.185,000
and returns Rs.210,000 at the end
of the year. G wants to consume
now so G borrows Rs.200,000 and
repays Rs.210,000 at the end of
the year. The existence of capital
markets allows G to consume now
and still invest with A in the project.
G invests Rs.185 now,

borrows Rs.200 and
consumes now.
185
200
Rupees
Now
Managers and Shareholder

Interests
Tools
to Ensure Management Pays Attention to

the Value of the Firm
Mangers actions are subject to the scrutiny of the
board of directors.
Shirkers are likely to find they are ousted by more
energetic managers.
Financial incentives such as stock options
Whose Company Is It?

** Survey of 378 managers from 5 countries
Dividends vs. Jobs

** Survey of 399 managers from 5 countries. Which is more important...jobs or
paying dividends?
Goals of The Corporation

Shareholders
desire wealth
maximization
Do managers maximize
shareholder wealth?
Mangers have many
constituencies stakeholders
Agency Problems represent the
conflict of interest between
management and owners
Goals of The Corporation

Agency Problem Solutions
1 - Compensation plans
2 - Board of Directors
3 - Takeovers
4 - Specialist Monitoring
5 - Auditors

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How To Calculate Present

Present and Future Value

Discount Factors and Rates

What is the future value of Rs.400,000 if interest is

Discount Factors can be used to compute the present value of

Valuing an Office Building

Valuing an Office Building

Step 4: Go ahead if PV of payoff exceeds investment

NPV 400 370 30

Net Present Value

NPV = PV - required investment

Risk and Present Value

risk projects require a higher rate of

Risk and Present Value

Risk and Net Present Value

Rate of Return Rule

investments that offer rates of return

In the project listed below, the foregone investment

Net Present Value Rule

investments that have positive net

Discount Factor = DF = PV of Rs.1

Discount Factors can be used to compute

Discount Factors can be used to compute

PVs can be added together to evaluate

PVs can be added together to evaluate

Given two dollars, one received a year from now

NPV Total Rs.25, 011

there are shortcuts that make it

Annuity Short Cut

Annuity Short Cut

Loan Pmt 10,000 (1.005)

Real int. rate nominal int. rate - inflation rate

Investment vs. Consumption

people prefer to consume now.

Investment vs. Consumption

Some investors will prefer A

Investment vs. Consumption

Investment vs. Consumption

A invests Rs.185 now

The grasshopper (G) wants to

G invests Rs.185 now,

Managers and Shareholder

to Ensure Management Pays Attention to

Whose Company Is It?

Dividends vs. Jobs

Goals of The Corporation

Goals of The Corporation

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