CLASS 2

NPV ANALYSIS
Bridge Program 2005
Finance module
Finance, Bridge Program 2005 1
Contents
1 The PV formula 4
2 Assignment 2: bond pricing 11
3 Assignment 2: mortgage application 15
4 Loose ends 19
4.1 Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.2 Ination . . . . . . . . . . . . . . . . . . . . . . . . 20
Finance, Bridge Program 2005 2
Recap
Main concepts from last class:
1. Eect of compounding.
2. Calculating the term structure of interest rates.
Next two classes will be applications of the idea of
discounting to dierent business situations.
Finance, Bridge Program 2005 3
1 The PV formula
The value today of a cash ow C
t
occuring at date t is
PV(C
t
) =
C
t
(1 + r
t
)
t
;
The value of a stream of cash ows C
0
, C
1
, . . . is
PV(C
0
, C
1
, . . . , C
T
) = C
0
+
C
1
1 + r
1
+
C
2
(1 + r
2
)
2
+ . . .
=
T

t=0
C
t
(1 + r
t
)
t
.
Finance, Bridge Program 2005 4
Discounting
First, the PV rule is obvious: we cant just add up cash ows
(money) of a project, since a dollar today may have a dierent
value than a dollar tomorrow. So we nd the value of future
cash ows by discounting them at some rates.
The discount rates will be taken as given in the next two classes.
Easiest way to think about the projects/problems we will
look into: risk-free cash ows, so the r
t
s are just the spot
rates from bond prices (term structure).
Loosely (will make this precise in class 6) interpretation:
the cash ows have some risk and they are therefore
discounted at a higher rate to adjust for this risk.
Finance, Bridge Program 2005 5
Perpetuities and annuities (shortcuts)
Assume at term structure (all spot rates equal to r).
A perpetuity is a stream of cash ows that are the same each
period forever.
PV
t
=
CF
t+1
r
.
Example 1. Security that pays $100 annually in perpetuity
starting next year. Discount rate 10% (annual terms). What is
its value?
V =
100
0.10
= 100(10) = $1000.
Example 2. Security that pays $100 annually in perpetuity
starting 5 years from today. Discount rate 10% (annual terms).
What is its value?
V =
1
1.1
4
_
100
0.10
_
=
1000
1.1
4
= 683.01
Finance, Bridge Program 2005 6
An annuity is a stream of (equal) cash ows for a given number
of periods. Unlike a perpetuity, payments stop after T periods.
PV
t
=
CF
t+1
r
_
1
1
(1 + r)
T
_
Remembering the annuity formula:
CF
t+1
r
. .
Perpetuity value
_
1
1
(1 + r)
T
_
. .
Annuity adjustment
Note: the annuity and perpetuity formulas are simple shortcuts
to summations, i.e.
PV(C
1
, . . . , C
T
) =
T

t=1
C
(1 + r)
t
= C
T

t=1
1
(1 + r)
t
.
Finance, Bridge Program 2005 7
Example 3. Security that pays $100 annually for the next 4
years. Discount rate 10% (annual terms). What is its value?
V =
100
0.1
_
1
1
1.1
4
_
= 316.98
Note: value in example 3 is equal to value in example 1 minus
value in example 2 (not by chance).
Example 4. Security that pays $100 each month in perpetuity.
First compute monthly discount rate:
(1 + r
m
)
12
= 1.10; r
m
0.7974%
Therefore perpetuity value is
V =
100
0.007974
= 100(125.40) = $12540.54.
Finance, Bridge Program 2005 8
Example 5. Now suppose you plan to work for the
next three years. How much of your after-tax income
would you need to save to go to Business School?
Assume you need to pay $50,000 three years from now,
and $55,000 four years from now.
For simplicity assume you get paid at the end of years
t = 1, . . . , 3. Let r = 10% (annual rate).
Good practice problem: nd the amount you would have
to save on a monthly basis. Answer (following similar
logic as in next slide): $2409 a month.
Finance, Bridge Program 2005 9
First, lay out the cash ows.
Time 0 1 2 3 4
Cash ow MBA - - - 50 55
Cash ow from income - x x x -
From which we see that x must satisfy:
x
0.10
_
1
1
(1.1)
3
_
. .
Value of savings
= 75.13
. .
Value of MBA
so that x $30, 211.
Note that
75.13 =
50
1.1
3
+
55
1.1
4
.
Finance, Bridge Program 2005 10
2 Assignment 2: bond pricing
Find the value of a 6%-coupon bond with a face value of
$100,000, which matures in May 2048. Assume coupons
are paid annually.
This bond pays $6K in May 45, May 46, and May 47,
and $106K (principal plus coupon) on May 48.
To nd the value we discount these cash ows:
V =
6
1.0299
+
6
1.0681
+
6
1.1248
+
106
1.1883
= $105.983
Finance, Bridge Program 2005 11
Assignment 2: bond pricing
Find the value of a 8%-coupon bond with a face value of
$500,000, which matures in February 2049. Assume the
coupons are paid semi-annually.
The bond has 9 coupon payments of $20K each, plus a
payment of principal and the last coupon, amounting to
$520K at maturity.
V =
20
1.009
0.25
+
20
1.02
0.75
+
20
1.025
1.25
+ +
520
1.04
4.75
= $583.838
Finance, Bridge Program 2005 12
An aside on discounting
Note in previous two slides I discounted (1) using total holding
returns, (2) using annualized returns (and accounting for when
cash ows occured). They are equivalent.
Yet one more way: use discount factors, the price of $1 at time t
p
t
=
1
(1 + r
t
)
t
PV formula can be written as
PV =
T

t=1
p
t
C
t
For example, for 6% coupon bond
V = 6(0.9709) + 6(0.9362) + 6(0.8891) + 106(0.8416) = 105.983
Finance, Bridge Program 2005 13
Assignment 2: bond pricing
Imagine you want to issue a coupon bond with face value of
$300,000, which matures in May 2047, and which pays an
annual coupon of x%. For what coupon x would the bond sell at
par (i.e. its price would equal its face value)?
This bond has cash ows of 300x in May 45 and May 46, and of
300(1 + x) in May 47.
V =
300x
1.0299
+
300x
1.0681
+
300(1 + x)
1.1248
.
The above is the value of the bond, given x. Setting V = 300
(its face value), we can solve for x = 3.967%.
Finance, Bridge Program 2005 14
3 Assignment 2: mortgage application
$300000 mortgage loan, with 6% annual interest rate. Payable
in equal monthly installments.
What is the monthly payment the bank will ask for?
First we convert the annual rate into a monthly rate:
r
m
= 0.06/12 = 0.5%.
Using the annuity formula we can nd the payment as before by
solving
300000
. .
House cost (nanced)
=
C
0.005
_
1
1
(1 + 0.005)
240
_
. .
Value of cash ows to the bank
so that
300000 = 139.58C; C = 2149.29
Finance, Bridge Program 2005 15
Payments of interest and principal
Each year calculate what portion of the $2149 payment is
interest, and what portion is principal repayment.
Month Balance Interest Principal Balance
(before payment) (after payment)
1 300,000.00 1,500.00 649.29 299,350.71
2 299,350.71 1,496.75 652.54 298,698.17
3 298,698.17 1,493.49 655.80 298,042.36
4 298,042.36 1,490.21 659.08 297,383.28
Interest is simply (0.5%)(Outstanding balance).
The outstanding balance at the end of the month equals the
beginning balance minus the principal payment.
You pay more interest than principal early on, and pay more
principal than interest when the loan approaches its maturity
date.
Finance, Bridge Program 2005 16
Amortization schedule
Months
I
n
t
e
r
e
s
t

a
n
d

p
r
i
n
c
i
p
a
l

p
a
y
m
e
n
t
s
0 50 100 150 200
0
5
0
0
1
0
0
0
1
5
0
0
2
0
0
0
2
5
0
0
Finance, Bridge Program 2005 17
Tax eects
Mortgate payments are deductible from federal taxes (at
least). Therefore, for an investor who buys a house, the
actual yearly cash ow due to the loan is actually lower
than $2149.
The actual after-tax amount will depend on their marginal
tax rate, and can be easily obtained from the calculations
outlined above once this tax rate is known
A simple approximation subtracts
(tax rate) (Interest expense) to the actual mortgage
payment.
In month 1 for example, the after-tax payment on the
mortgage with a marginal tax rate of 30% would be
2149 (0.3)1500 = 2149 450 = 1699.
In month 20 (see spreadsheet) we have an after-tax
payment of 2149 (0.3)1435 = 1718.
Finance, Bridge Program 2005 18
4 Loose ends
4.1 Taxes
We care about what we consume: after-tax dollars.
Important concepts:
Marginal tax rates. Most decisions are incremental: will get
taxed at marginal tax rate.
Capital gains taxes versus ordinary income taxes. Capital
gains taxes are only paid when an asset is sold (at 15%). In
contrast, interest income is taxed on the year you receive it
(at ordinary income tax rate, say 34%).
Taxes ll up hundreds of volumes of books.
You should know the basics discussed in chapter 6.
Finance, Bridge Program 2005 19
4.2 Ination
Nominal interest rate (r
n
): the return you receive in dollars.
Real interest rate (r
r
): the return you receive in consumption
units.
Ination rate (): the increase in the dollar price of a particular
basket of goods.
Their relationship
(1 + r
n
) = (1 + r
r
)(1 + ).
Think about the above formula as compounding eect of
ination.
Rule of thumb: discount real CFs at real rate, nominal CFs at
nominal rate.
Finance, Bridge Program 2005 20
Main topics for class 2
The NPV rule.
Annuities and perpetuities.
Mortgage calculations and after-tax eects.
Taxes and ination.
Main topics for class 3
More applications of the NPV rule.
Assignment 3: evaluating projects (accounting plus
discounting).
Finance, Bridge Program 2005 21