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Lecture 1: Time Value of Money

(Discounted Cash Flow Valuation)

Based on Chapter 4 from


S.A. Ross, R.W. Westerfield, and J. Jaffe (2010),
Corporate Finance, 9th ed., McGraw-Hill.
FIN3073: Financial Mathematics
---- Course Intended Learning Objectives (CILOs)

CILOs Upon completion of this course, students should be able to:

Understand basic financial calculations, statistical Methods in


finance and portfolio optimization, return forecasting models,
CILO 1
regression techniques in finance and CAPM, event studies and
capital market anomalies.

CILO 2 Develop financial modeling skills to solve financial problems.

Understand basic econometric methods to deal with large volume of


CILO 3
financial data.

CILO 4 Formulate discrete or continuous model to price derivatives.

Financial Mathematice 2
Course Outline
Lecture 1: Time Value of Money (basic interest theory)
Lecture 2: Derivatives (futures, options, swaps, etc.)
Lecture 3: Interest Rates (advanced interest theory)
Assignment 1 (due in one week)
Lecture 4: Capital Asset Pricing Model (CAPM)
Lecture 5: Binomial Trees (for pricing financial instruments)
Midterm Review/Exam (2 hours, close-book)
Lecture 6: Winner Process and Itos Lemma
Lecture 7: The Black-Scholes-Merton (BSM) Model
Assignment 2 (due in one week)

Financial Mathematice 3
Textbook & References
John C. Hull, Options, Futures & Other Derivatives, 9th/8th
ed., Prentice Hall, 2014/2012.

1. Stephen A. Ross, Randolph W. Westerfield, Jerrfey Jaffe, and Bradford


D. Jordan. Corporate Finance, 11th/9th ed., McGraw-Hill, 2015/2010.
2. Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan.
Fundamentals of Corporate Finance, 11th ed., McGraw-Hill, 2015.
3. Marek Capinski and Tomasz Zastawniak, Mathematics for Finance: An
Introduction to Financial Engineering, Springer, 2003.
4. Steven E. Shreve, Stochastic Calculus for Finance I, Springer, 2004.
5. Steven E. Shreve, Stochastic Calculus for Finance II, Springer, 2004.

Financial Mathematice 4
Useful Information
Lecturer: Dr. Ming-Lu Wu
Office: B-106 Email: MLWu@uic.edu.hk
Phone: 3620647 / 15819444601
Teaching Assistant: Ms. Sunny Ouyang
Office: C119A Email: OuyangSunny@uic.edu.hk
Phone: 3620295 / 15992638275
Course Assessments:
Class Attendance & Discussions 10%
Two (2) Assignments 20%
Midterm Test (Week 8 or 9) 20%
Final Exam 50%
Total 100%
Financial Mathematice 5
Time Value of Money
Time Value of Money
The relationship between present value and future value of money:
A dollar today is worth more than a dollar tomorrow.

Financial decisions often require combining cash flows or


comparing values. Three rules govern these processes:

Financial Mathematice 6
Basic Definitions
Present value todays money on a time line.
Future value money in later periods on a time line.
Interest rate exchange rate between earlier money and later
money.
Other names for interest rate
Discount rate
Cost of capital
Opportunity cost of capital
Required return
Financial Mathematice 7
Cash Flows over a Time Line
To help make things clear, drawing a time line could be a
useful step.
Cash flow at period 2
discounting compounding

C0 C1 C2

t=0 1 2 .
Convention:
Discounting and compounding
are done with interest rate (r). Positive cash inflow
Negative cash outflow
Financial Mathematice 8
Future Values: General Formula
FV
PV
(1 r ) n This is the relationship
where between PV and FV,
FV = future value

PV = present value

r = per period interest rate, expressed as a decimal

n = number of periods

Future value interest factor = (1 + r)n


1
Present value interest factor =
(1 r) n
Financial Mathematice 9
Annual Percentage Rate (APR)
This is the annual interest rate that is often stated in practice.
By definition APR = period rate times the number of periods per year.

Consequently, to get the period rate we rearrange the APR equation:

Period rate = APR / number of periods per year

Examples:
What is the APR if the monthly rate is 0.5%?

0.5% 12 = 6%

What is the APR if the semiannual rate is 0.5%?

0.5% 2 = 1%

What is the monthly rate if the APR is 12% with monthly


compounding?
12% / 12 = 1%.
Financial Mathematice 10
Effective Annual Rate (EAR)
This is the actual rate paid (or received) after accounting
for compounding that occurs during the year.

If you want to compare two alternative investments with


different compounding periods, you need to compute the
EAR and use that for comparison.

You should NEVER divide the effective rate by the


number (m) of periods per year it will NOT give you
the period rate.
Financial Mathematice 11
Effective Annual Rates and Compounding Periods
Effective annual rate (EAR) formula:
m
APR
EAR 1 1
m
where m = compounding frequency (number of periods) per year.
Examples
$1,000 invested for one year at 12% p.a. (per annum):
1,000 (1 + 0.12) = 1,120 EAR = 12%
$1,000 invested for one year at 12% p.a. compounded monthly:
1,000 (1 + 0.12/12)12 = 1,126.83 EAR = 12.683%
$1,000 invested for one year at 12% p.a. compounded daily:
1,000 (1 + 0.12/365)365 = 1,127.47 EAR = 12.747%
Financial Mathematice 12
PV Example
You are considering an investment that will pay you C1 = $1,000
in one year, C2 = $2,000 in two years, and C3 = $3,000 in three
years. If you want to earn r = 10% annually on your money, how
much (P0) would you like to make investment today?
PV1 = C1 / (1 + r)1 = 1,000 / (1.1)1 = 909.09.
PV2 = C2 / (1 + r)2 = 2,000 / (1.1)2 = 1,652.89.
PV3 = C3 / (1 + r)3 = 3,000 / (1.1)3 = 2,253.94.
P0 = 909.09 + 1,652.89 + 2,253.94 = $4,815.92.
With initial investment P0 = $4,815.92 and an annual interest rate r = 10%,
you can get the mentioned three future payments ---- no more, no less.
With another initial investment (at another rate), you will get more or less
than the mentioned three future payments.
The difference is called net present value (NPV) of the investment.

Financial Mathematice 13
NPV of an Investment
Suppose an investment (or a project) can be acquired now
(time 0) at price or cost P0 > 0, which can produce non-
negative cash flows C1, ..., Cn at future times 1, , n.
The appropriate discount (or return, interest) rate is r (per period).
Then the net present value (NPV) of the investment is the
present value of its future cash flows C1, ..., Cn minus its
initial price or cost: NPV = k=1~n Ck/(1+r)k P0.
If NPV is positive, you should make the investment (with an initial cash
amount P0 to receive the future cash flows of C1, ..., Cn).
In the previous Example, if you can acquire the investment at a
lower price, say $4,500, you should do it since it has a
positive NPV of 4,815.92 4,500 = $815.92.
Financial Mathematice 14
Simplifications
Applying the PV equation all the time could be
troublesome. We want to find some simplifications.
When the cash flows follow certain patterns, we
may be able to use formulas to calculate the
present values.
Perpetuity
Cash Flow
1. Constant cash flow. Growing Perpetuity
2. Cash flow growing at a constant rate g.
Time Frame Annuity
1. Goes to infinity.
Growing Annuity
2. Stop after T periods.
Financial Mathematice 15
Simplifications
After understanding the concept of Present Value, we could have
some simplifications if some assumptions are met.
Perpetuity
A constant stream of cash flows that lasts forever.
Growing perpetuity
A stream of cash flows that grows at a constant rate forever.
(Ordinary) Annuity
A stream of constant cash flows that lasts for a fixed number
of periods.
Growing annuity
A stream of cash flows that grows at a constant rate for a
fixed number of periods.
Financial Mathematice 16
Perpetuity
A constant stream of cash flows that lasts forever.
Cash flows are the same in every period.

C C C

0 1 2 3

C C C C
PV 0
(1 r ) (1 r ) 2
(1 r ) 3
r

Financial Mathematice 17
Proof of Perpetuity Formula
Sum of geometric series (of n terms):
Sumn = a + aq + aq2 + + aqn-1 = a(1 qn)/(1 q).
If | q | < 1, then qn 0 when n .
So sum of infinite geometric series: Sum = a/(1 q).
For our perpetuity,
a = C/(1 + r) and q = 1/(1 + r) < 1.
So: PV0 = C/(1 + r) + C/(1 + r)2 + C/(1 + r)3 +
= a + aq + aq2 +
= a/(1 q) = [C/(1 + r)][1 1/(1 + r)] = C/r.
Financial Mathematice 18
Perpetuity: Example

What is the value of a British bond that promises


to pay 15 every year for ever?
The interest rate is 10% annually.
15 15 15

0 1 2 3

15
PV 0 150
0 .10
Financial Mathematice 19
Growing Perpetuity
A stream of cash flows that grows at a constant rate and lasts forever.

C C(1+g) C(1+g)2

0 1 2 3
C C (1 g ) C (1 g ) C 2
PV 0
(1 r ) (1 r ) 2
(1 r ) 3
rg
Need to assume: g < r !
Financial Mathematice 20
Growing Perpetuity: Example
The expected dividend next year is $1.30, and dividends are
expected to grow at 5% forever.
If the discount rate is 10% annually, what is the value of this
promised dividend stream?

$1.30 $1.30(1.05) $1.30(1.05)2


0 1 2 3
$ 1 .30
PV 0 $ 26 .00
0 .10 0 .05
Financial Mathematice 21
(Ordinary) Annuity

An annuity is a stream of constant cash flows (C) that lasts


for a fixed number of periods.
Simplification: PV0 = C[1 1/(1 + r)n]/r = CAr,n,
FVn = C[(1 + r)n 1]/r = C(1 + r)nAr,n,
where Ar,n = [1 1/(1 + r)n]/r is the (unit) annuity factor.
Example: $100 $100 $100 (r = 10%)

0 1 2 3
PV0 = 100[1 1/(1 + 10%)3] / 10% = 249,
FV3 = 100[(1 + 10%)3 1] / 10% = 331 [= 249(1.1)3].
Financial Mathematice 22
Annuity Present Value Formula
Annuity cash flow line:
C C C C

0 1 2 3 n
C C C C
PV 0
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) n
{ denoting: a = C/(1 + r) and q = 1/(1 + r) }
= a + aq + aq2 + + aqn-1 = a(1 qn)/(1 q).
= [C/(1 + r)] [1 1/(1 + r)n] / [1 1/(1 + r)]
C 1
= C[1 1/(1 + r)n]/r = CAr,n 1
n
r 1 r
Financial Mathematice 23
Annuity PV Example: assume monthly compounding
If you can afford a $400 monthly car payment-by-
installments (), how much is the car you can
afford if stated annual interest rate, called annual
percentage rate (APR), is 7% on a 36-month loan?

$400 $400 $400 $400

0 1 2 3 36
$ 400 1
PV 0 1 36
$ 12 ,954 .59
0 .07 / 12 (1 0 .07 12 )
Financial Mathematice 24
Ordinary Annuity Another Example
Your mother bought an annuity from Rock Solid Insurance
Company for $200,000 when she retired. In exchange for the
$200,000, Rock Solid will pay her $25,000 per year until she
dies. The interest rate is 5%. How long must she live after she
retired to get more in value than what she paid in?
200,000 < PV of annuity = 25,000[1 1/(1 + 5%)n] / 5%.
8 < (1 1/1.05n) / 0.05 0.4 < 1 1/1.05n.
1/1.05n < 0.6 1/0.6 < 1.05n.
ln(1/0.6) < n ln(1.05) n > ln(1/0.6) / ln(1.05) = 10.47.
Financial Mathematice 25
Annuity: Future Value Formula
FV n PV 0 (1 r )
n C
r

1 r 1
n

Example: To provide for college education, you are
going to deposit $2,000 at the end of each year for
the next five years in a bank account where you will
earn 10% annual interest. Then how much will you
have at the end of five years?
FV5 = C[(1 + r)n 1]/r
= 2,000[(1 + 0.1)5 1] / 0.1
= 2,000(6.1051) = $12,210.2.
Financial Mathematice 26
Annuity Due
An annuity due is a stream of constant cash flows, paid at the
beginning of each period, that lasts for a fixed number of periods.
(for ordinary annuity, cash flows come at the end of periods.)
$100 $100 $100 $100 $100 $100
|---------|---------|--------|---------| (r = 10%) |---------|--------|---------|
-1 0 1 2 3 0 1 2 3
annuity due ordinary annuity
Method 1: Annuity due value = ordinary annuity value (1+r)
PV-1

PV0 = C 1 (1 + r) CAr,n (1 + r),
1
r 1 r n
PV0 = 100A10%,3 (1.1) = 100(1/1.1 + 1/1.12 + 1/1.12) 1.1 = 273.55.
Method 2: PV0 = C + CAr,n-1.
PV0 = 100 + 100A10%,2 = 100 + 100(1/1.1 + 1/1.12) = 273.55.
Financial Mathematice 27
Annuity Due Example
You want to buy a new sports car from Muscle Motors for
$65,000. The contract is in the form of a 48-month annuity due
at a 6.45% APR. What will your monthly payment be?
PV-1 = CAr,n = C[1 1/(1 + r)n]/r.
PV0 = PV-1 (1 + r) = CAr,n (1 + r) = 65,000.
C = 65,000 / [Ar,n (1 + r)].
r = 6.45% / 12 = 0.005375, n = 48,
Ar,n = (1 1/1.00537548)/0.005375 = 42.2085204.
C = 65,000/(42.20852041.005375)
= $1,531.74.
Financial Mathematice 28
Growing Annuity
A stream of cash flows that grows at a constant rate (g)
over a fixed number of periods.
C C(1+g) C(1+g)2 C(1+g)n-1

0 1 2 3 n
C C (1 g ) C (1 g ) 2 C (1 g ) n 1
PV 0
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) n
The formula for the present value of a growing annuity:

C 1 g n
PV 0 1
rg 1 r
Financial Mathematice 29
Growing Annuity: Example
A defined-benefit retirement plan offers to pay you annually for
40 years. The first payment is $20,000 at the end of your first
retirement year. Later payments will increase by 3% each year.
What is the present value at retirement of these payments, if the
appropriate discount rate is 10%?

$20,000 $20,000(1.03) $20,000(1.03)39

0 1 2 40

$ 20 ,000 1 .03
40

PV 0 1 $ 265 ,121 .57


0 .10 0 .03 1 .10
Financial Mathematice 30
Formula Review
Cn
Single Payment: P V0 F Vn C 0 1 r
n
(1 r ) n
Multi-Payments:
C
Perpetuity PV0
r
C 1
Annuity PV 0 1
r 1 r n r

FV n 1 r 1
C n

C
Growing Perpetuity PV 0
rg
C 1 g
n
Growing Annuity PV 0 1
rg 1 r

Financial Mathematice 31
Exercise Question 1
Mark has been working on an advanced technology in laser
eyes surgery. His technology will be available in the near term.
He anticipates his first annual cash flow from the technology
to be $215,000, received two years from today. Subsequent
annual cash flows will grow at 4% in perpetuity.
What is the present value of the technology if the discount rate
is 10%?
Solution:
PV1 = C/(r g) = 215,000/(10% 4%) = 3,583,333.33.
PV0 = PV1 /(1 + r) = 3,583,333.33/(1 + 10%) = 3,257,575.76.
Financial Mathematice 32
Exercise Question 2
Your job pays you only once a year for all the work you did
over the previous 12 months.
Today, December 31, you just received your salary of $60,000,
for the past year, and you plan to spend all of it.
However, you want to start saving for retirement beginning
next year.
You have decided that one year from today you will begin
depositing 5% of your annual salary in a retirement account
that will earn 9% per year.
Your salary will increase at 4% per year throughout your
career.
How much money will you have on the date of your retirement
40 years from today?
Financial Mathematice 33
Exercise Question 2: Solution
Since your salary grows at 4% per year, your salary next year
will be: $60,000 (1 + 0.04) = $62,400.
This means your first deposit into the account next year will be:
$62,400(0.05) = $3,120.
Since your salary grows at 4% annually, you deposit will also
grow at 4% annually. We can use the present value formula of a
growing annuity to find the value of your deposits today:
C 1 g
n
3,120 1 0 .04
40

PV 0 1 1 = 52,861.98
rg 1 r 0 .09 0 .04 1 0 . 09
Now, we can find the future value of this lump sum in 40 years:
FV40 = PV0 (1 + r)40 = $52,861.98(1.09)40 = $1,660,364.12.
Financial Mathematice 34
Exercise Question 3: Buying a House
You are ready to buy a house and you have $20,000 for a
down (first) payment and closing (administrative) costs.
Closing costs are estimated to be 4% of the loan value.
You have an annual salary of $36,000 and the bank is willing to
allow your monthly mortgage payment to be equal to 28% of your
monthly income.
The interest rate on the loan is 6% per year with monthly
compounding (0.5% per month) for a 30-year fixed rate loan.
How much money will the bank loan you per month?
How much can you offer for the house?

Financial Mathematice 35
Exercise Question 3: Solution
Bank loan
Monthly income = 36,000 / 12 = $3,000
Maximum monthly mortgage payment = 0.28(3,000) = $840
Loan value = present value of all (360) mortgage payments:
PV0 = 840[1 1/1.005360] / 0.005 = $140,105
Total Price
1. Closing costs = 0.04(140,105) = $5,604
2. Down payment = 20,000 5,604 = $14,396
3. Total (House) Price = 140,105 + 14,396 = $154,501

Financial Mathematice 36