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Basic Definitions

Basic Definitions

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Basic Definitions

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  1. Basic Definitions • Present Value – earlier money on a time line • Future Value – later money on a time line • Interest rate – “exchange rate” between earlier money and later money • Discount rate • Cost of capital • Opportunity cost of capital • Required return

  2. Future Values • Suppose you invest $1000 for one year at 5% per year. What is the future value in one year? • Suppose you leave the money in for another year. How much will you have two years from now?

  3. Future Values: General Formula • FV = PV(1 + r)t • FV = future value • PV = present value • r = period interest rate, expressed as a decimal • T = number of periods • Future value interest factor = (1 + r)t

  4. Effects of Compounding • Simple interest • Compound interest • Consider the previous example • FV with simple interest = 1000 + 50 + 50 = 1100 • FV with compound interest = 1102.50 • The extra 2.50 comes from the interest of .05(50) = 2.50 earned on the first interest payment

  5. Future Values – Example 2 • Suppose you invest the $1000 from the previous example for 5 years. How much would you have? • The effect of compounding is small for a small number of periods, but increases as the number of periods increases. (Simple interest would have a future value of $1250, for a difference of $26.28.)

  6. Future Values – Example 3 • Suppose you had a relative deposit $10 at 5.5% interest 200 years ago. How much would the investment be worth today? • What is the effect of compounding? • Simple interest = 10 + 200(10)(.055) = 210.55 • Compounding added $446,979.29 to the value of the investment

  7. Future Value as a General Growth Formula • Suppose your company expects to increase unit sales of widgets by 15% per year for the next 5 years. If you currently sell 3 million widgets in one year, how many widgets do you expect to sell in 5 years?

  8. Quick Quiz – Part I • What is the difference between simple interest and compound interest? • Suppose you have $500 to invest and you believe that you can earn 8% per year over the next 15 years. • How much would you have at the end of 15 years using compound interest? • How much would you have using simple interest?

  9. Present Values • How much do I have to invest today to have some amount in the future? • FV = PV(1 + r)t • Rearrange to solve for PV = FV / (1 + r)t • When we talk about discounting, we mean finding the present value of some future amount. • When we talk about the “value” of something, we are talking about the present value unless we specifically indicate that we want the future value.

  10. Present Value – One Period Example • Suppose you need $10,000 in one year for the down payment on a new car. If you can earn 7% annually, how much do you need to invest today?

  11. Present Values – Example 2 • You want to begin saving for you daughter’s college education and you estimate that she will need $150,000 in 17 years. If you feel confident that you can earn 8% per year, how much do you need to invest today?

  12. Present Values – Example 3 • Your parents set up a trust fund for you 10 years ago that is now worth $19,671.51. If the fund earned 7% per year, how much did your parents invest?

  13. Present Value – Important Relationship I • For a given interest rate – the longer the time period, the lower the present value • What is the present value of $500 to be received in 5 years? 10 years? The discount rate is 10%

  14. Present Value – Important Relationship II • For a given time period – the higher the interest rate, the smaller the present value • What is the present value of $500 received in 5 years if the interest rate is 10%? 15%?

  15. Quick Quiz – Part II • What is the relationship between present value and future value? • Suppose you need $15,000 in 3 years. If you can earn 6% annually, how much do you need to invest today? • If you could invest the money at 8%, would you have to invest more or less than at 6%? How much?

  16. The Basic PV Equation - Refresher • PV = FV / (1 + r)t • There are four parts to this equation • PV, FV, r and t • If we know any three, we can solve for the fourth • If you are using a financial calculator, be sure and remember the sign convention or you will receive an error when solving for r or t

  17. Multiple Cash Flows – FV Example 2 • Suppose you invest $500 in a mutual fund today and $600 in one year. If the fund pays 9% annually, how much will you have in two years?

  18. Multiple Cash Flows – Example 2 Continued • How much will you have in 5 years if you make no further deposits? • First way: • Second way – use value at year 2:

  19. Multiple Cash Flows – FV Example 3 • Suppose you plan to deposit $100 into an account in one year and $300 into the account in three years. How much will be in the account in five years if the interest rate is 8%?

  20. Multiple Cash Flows – Present Value Example 6.3 • Find the PV of each cash flows and add them • Year 1 CF: 200 • Year 2 CF: 400 • Year 3 CF: 600 • Year 4 CF: 800 • 12% Interest

  21. 0 1 2 3 4 200 400 600 800 178.57 318.88 427.07 508.41 1432.93 Example 6.3 Timeline

  22. Multiple Cash Flows – PV Another Example • You are considering an investment that will pay you $1000 in one year, $2000 in two years and $3000 in three years. If you want to earn 10% on your money, how much would you be willing to pay?

  23. Annuities and Perpetuities Defined • Annuity – finite series of equal payments that occur at regular intervals • If the first payment occurs at the end of the period, it is called an ordinary annuity • If the first payment occurs at the beginning of the period, it is called an annuity due • Perpetuity – infinite series of equal payments

  24. Annuity – Sweepstakes Example • Suppose you win the Publishers Clearinghouse $10 million sweepstakes. The money is paid in equal annual installments of $333,333.33 over 30 years. If the appropriate discount rate is 5%, how much is the sweepstakes actually worth today?

  25. 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?

  26. Future Values for Annuities • Suppose you begin saving for your retirement by depositing $2000 per year in an IRA. If the interest rate is 7.5%, how much will you have in 40 years?

  27. Bond Definitions • Bond • Par value (face value) • Coupon rate • Coupon payment • Maturity date • Yield or Yield to maturity

  28. Present Value of Cash Flows as Rates Change • Bond Value = PV of coupons + PV of par • Bond Value = PV annuity + PV of lump sum • Remember, as interest rates increase the PV’s decrease • So, as interest rates increase, bond prices decrease and vice versa

  29. Valuing a Discount Bond with Annual Coupons • Consider a bond with a coupon rate of 10% and coupons paid annually. The par value is $1000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? • Using the formula: • B = PV of annuity + PV of lump sum

  30. Valuing a Premium Bond with Annual Coupons • Suppose you are looking at a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond? • Using the formula: • B = PV of annuity + PV of lump sum

  31. Graphical Relationship Between Price andYield-to-maturity

  32. Bond Prices: Relationship Between Couponand Yield • If YTM = coupon rate, then par value = bond price • If YTM > coupon rate, then par value > bond price • Why? • Selling at a discount, called a discount bond • If YTM < coupon rate, then par value < bond price • Why? • Selling at a premium, called a premium bond

  33. The Bond-Pricing Equation

  34. Computing Yield-to-maturity • Yield-to-maturity is the rate implied by the current bond price • Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity • If you have a financial calculator, enter N, PV, PMT and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign)

  35. YTM with Annual Coupons • Consider a bond with a 10% annual coupon rate, 15 years to maturity and a par value of $1000. The current price is $928.09. • Will the yield be more or less than 10%?

  36. YTM with Semiannual Coupons • Suppose a bond with a 10% coupon rate and semiannual coupons, has a face value of $1000, 20 years to maturity and is selling for $1197.93. • Is the YTM more or less than 10%? • What is the semiannual coupon payment? • How many periods are there?

  37. Bond Pricing Theorems • Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate • If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond • This is a useful concept that can be transferred to valuing assets other than bonds

  38. Debt Not an ownership interest Creditors do not have voting rights Interest is considered a cost of doing business and is tax deductible Creditors have legal recourse if interest or principal payments are missed Excess debt can lead to financial distress and bankruptcy Equity Ownership interest Common stockholders vote for the board of directors and other issues Dividends are not considered a cost of doing business and are not tax deductible Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid An all equity firm can not go bankrupt Differences Between Debt and Equity

  39. The Bond Indenture • Contract between the company and the bondholders and includes • The basic terms of the bonds • The total amount of bonds issued • A description of property used as security, if applicable • Sinking fund provisions • Call provisions • Details of protective covenants

  40. Bond Ratings – Investment Quality • High Grade • Moody’s Aaa and S&P AAA – capacity to pay is extremely strong • Moody’s Aa and S&P AA – capacity to pay is very strong • Medium Grade • Moody’s A and S&P A – capacity to pay is strong, but more susceptible to changes in circumstances • Moody’s Baa and S&P BBB – capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay

  41. Bond Ratings - Speculative • Low Grade • Moody’s Ba, B, Caa and Ca • S&P BB, B, CCC, CC • Considered speculative with respect to capacity to pay. The “B” ratings are the lowest degree of speculation. • Very Low Grade • Moody’s C and S&P C – income bonds with no interest being paid • Moody’s D and S&P D – in default with principal and interest in arrears

  42. Government Bonds • Treasury Securities • Federal government debt • T-bills – pure discount bonds with original maturity of one year or less • T-notes – coupon debt with original maturity between one and ten years • T-bonds coupon debt with original maturity greater than ten years • Municipal Securities • Debt of state and local governments • Varying degrees of default risk, rated similar to corporate debt • Interest received is tax-exempt at the federal level

  43. Example 7.3 • A taxable bond has a yield of 8% and a municipal bond has a yield of 6% • If you are in a 40% tax bracket, which bond do you prefer? • At what tax rate would you be indifferent between the two bonds?

  44. Bond Markets • Primarily over-the-counter transactions with dealers connected electronically • Extremely large number of bond issues, but generally low daily volume in single issues • Makes getting up-to-date prices difficult, particularly on small company or municipal issues • Treasury securities are an exception

  45. Bond Quotations • Highlighted quote in Figure 7.3 • ATT 6s09 6.4 177 93 7/8 + ¼ • What company are we looking at? • What is the coupon rate? If the bond has a $1000 face value, what is the coupon payment each year? • When does the bond mature? • What is the current yield? How is it computed? • How many bonds trade that day? • What is the quoted price? • How much did the price change from the previous day?

  46. Treasury Quotations • Highlighted quote in Figure 7.4 • 8 Nov 21 125:05 125:11 -46 5.86 • What is the coupon rate on the bond? • When does the bond mature? • What is the bid price? What does this mean? • What is the ask price? What does this mean? • How much did the price change from the previous day? • What is the yield based on the ask price?

  47. Cash Flows for Stockholders • If you buy a share of stock, you can receive cash in two ways • The company pays dividends • You sell your shares, either to another investor in the market or back to the company • As with bonds, the price of the stock is the present value of these expected cash flows

  48. Developing The Model • You could continue to push back when you would sell the stock • You would find that the price of the stock is really just the present value of all expected future dividends • So, how can we estimate all future dividend payments?

  49. Estimating Dividends: Special Cases • Constant dividend • The firm will pay a constant dividend forever • This is like preferred stock • The price is computed using the perpetuity formula • Constant dividend growth • The firm will increase the dividend by a constant percent every period • Supernormal growth • Dividend growth is not consistent initially, but settles down to constant growth eventually

  50. Zero Growth • If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity • P0 = D / R • Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price? • P0 = .50 / (.1 / 4) = $20