Professional Documents
Culture Documents
Objectives
What do we mean by Time value of
money
Present Value, Discounted Value,
Annuity
Discount Rate
Rate at which present and future cash
flows are traded off.
It incorporates
The preference for current consumption
(greater preference ____ Higher discount rate).
Expected inflation (higher inflation ____ higher
discount rate).
The uncertainty in the future cash flows (higher
risk ____ higher discount rate).
A higher discount rate will lead to a lower
present value for future cash flows
Rate of Interest
Nominal or market rate of
interest rate = Real rate of
interest + Expected rate of
Inflation + Risk of premiums to
compensate uncertainty
Compounding concepts
FVn P * (1 i )
Compounding
Compounding Formula
FVn P * (1 i ) n
What if compounding is done on monthly
n*t
basis?
i
FVn P * 1
t
Charting of Cashflow
Interest Received
Sold Bond
Total
31.12.08
Timeline
30.06.08
Invested in Bonds
(1,000)
+ 100
+2,050
+2,150
30.06.08
Interest Received
New Bond Purchased
Net
+ 50
(1,020)
( 970)
Discount Rate
Rate at which present and future
cash flows are traded off
Higher discount rate lower the
present value for future cash flows
Discounting
Present Value
You have an option to receive Rs. 1,000/- either today or
after one year. Which option you will select? Why?
Decision will depend upon the present value of money;
which can be calculated by a process called
Discounting (opposite of Compounding)
Interest Rate and Time of Receipt of money decide
Present Value
What is the present value of Rs. 1,000/- today and a year
later?
Let us find out Present Value?
Discounting
contd
1 i n
1000
1 10% 1
b.
Discounting of a Series
Periodic Discounting
What if the receipts are over six
months interval ? Find Present Value of
the money receipts
Receive Rs. 1,000/- at the end of every 6 months for 1-1/2 years OR
Receive Rs. 2,600/- today
Assume Rate of interest @10%
i
1
t
Periodic Discounting
Formula
Expressed mathematically, the equation will look like:
2723 .25
1000
10 %
1
1000
10 %
1
1000
10 %
1
Genericallyexpressed,
expressed,
Generically
theformula
formulais:
is:
the
PV
N
xn
Assuming Discounting Done Semi-Annually
Principal
P
1,000
1,000 1,000
i
n 1
1
Interest Rate
i
10%
10%
10%
t
HY
n
1
2
3 Here,
Here,NN==33
Times Discounting in a Year
t
2
2
2
Discount Factor
DF
0.9524 0.9070 0.8638
Present Value
PV=P*DF 952.38 907.03 863.84
2,723.25
Sum of Present Value
Annuities
Constant cash flow
occurring at
regular intervals of
time
An annuity can
1
the beginning of
each period.
example
Outright Buy V/s Deferred Payment
Choice of Rs. 4,00,000 upfront or pay
90000 for five years
PV for 90,000 using earlier formula
3,24,430
Therefore choice.
When the present values of your
instalment payments exceed the cash
down price it is better to pay cash down
and acquire the asset.
(1 r ) t 1
AFV C
1
1 (1 r ) t
PVIFA( r , t )
r
Number
of
periods
5%
10%
15%
20%
0.9524
0.9091
0.8696
0.8333
1.8594
1.7355
1.6257
1.5278
2.7232
2.4869
2.2832
2.1065
3.5460
3.1699
2.8550
2.5887
4.3295
3.7908
3.3522
2.9906
Another problem
Finding C
Example: Finding C
Finding t
Q. Suppose you owe 2000 on a
Visa card, and the interest rate
is 2% per month. If you make the
minimum monthly payments
of 50, how long will it take you to
pay off the debt? (Assume you
quit
charging immediately!)
A.
A long time:
2000 = 50 {1 - 1/(1.02)t}/.02
.80
= 1 - 1/1.02t
1.02t
= 5.0
t ln(1.02)
= 5.0
t
=
ln(5.0)/ln(1.02)
t
= 81.3 months, or about
6.78 years
(1 r )t 1
FVIFA(r , t )
Interest rate
5%
10%
15%
20%
1.0000
1.0000
1.0000
1.0000
2.0500
2.1000
2.1500
2.2000
3.1525
3.3100
3.4725
3.6400
4.3101
4.6410
4.9934
5.3680
5.5256
6.1051
6.7424
7.4416
FVIFA(r , t )
Example contd
Q. Suppose you deposit 2000 each year for the next three
years into an account that pays 8%. How much will you
have in 3 years? Important: You make the first deposit in
exactly one year.
(1 r ) t 1
FVIFA(r , t )
Q. Suppose you deposit 2000 each year for the next three
years into an account that pays 8%. How much will you
have in 3 years? Important: You make the first deposit in
exactly one year.
(
1
r
)
1
FV = 2000 * {(1 + 0.08) - 1} / 0.08
FVIFA( r , t )
r
= 2000 * 3.2464
= 6492,80
3
Perpetuity
A perpetuity is a constant cash flow paid
(or received) at regular time intervals
forever.
Thus a lifetime pension can be considered
as a perpetuity or rentals received from
exploitation of land which is passed on
from generation to generation.
The present value of a perpetuity can be
written as C/r
Console Bond
A is a bond that has no maturity and pays
a fixed coupon (rate of interest).
Assume that you have a 6 per cent coupon
console bond. The original face value = Rs
1000. The current value of this bond if the
interest rate is 9 per cent is as follows.
Growing Annuity
A growing Annuity is a cash flow that is
expected to grow at a constant rate
forever
PV = C [1/(r-g) - (1/(r-g))*((1+g)/(1+r))t ],
Although a growing annuity and a growing
perpetuity share several features, the fact
that a growing perpetuity lasts forever
puts constraints on the growth rate. It has
to be less than the discount rate for the
formula to work.
C = 10,000
r = 0.12
g = 0.05
t = 16
PV = 10,000 [(1/0.07) (1/0.07)*(1.05/1.12)16] = $91,989.41
< $100,000, therefore, you would
prefer to be paid out right now.
Growing Perpetuity
A growing perpetuity is the same as
a regular perpetuity (C/r),but the
cash flow is growing (or declining)
each year.
A perpetuity has no limit to the
number of cash flows, it will go
indefinitely. The growing perpetuity
is in that way just the same as a
growing annuity with an extremely
large t.
PV = C / (r-g),
What would you be willing to pay
(given that you could live forever,
and hence could receive cash flows
for a share in the ABC Co., that
promises you to pay a cash dividend
to you at the end of the year of 25,
which will increase every year by 1%,
forever. The interest rate is fixed at
4.75%.
Capital Budgeting
Every business has four basic decisions to
make:
Which projects to take? (Investment
decisions)
How to finance these projects? (Financing
decisions)
How much to return to investors?
(Dividend decisions)
How to manage working capital and its
components? (Liquidity decisions)
NPV
contd
Description
Invested in 10% Bonds
Interest received
Interest received
New Bond Purchased from
Open Market
Interest received
Sold Bond in Open Market
How these values are arrived at?
Date
Amount In / Out
01-Jan-08
(1,000) Outflow
30-Jun-08
50
Inflow
31-Dec-08
50
Inflow
31-Dec-08
30-Jun-08
30-Jun-08
(1,020) Outflow
100
2,050
PV Outflow PV Inflow
(1,000.00)
47.62
45.35
(925.17)
Inflow
Inflow
Sum
(1,925.17)
Net Present Value
86.38
1,770.87
1,950.22
25.05
What is IRR?
NPV
If...
It means...
Then...
NPV > 0
NPV < 0
We should be indifferent in
the decision whether to
accept or reject the
project. This project adds
no monetary value.
Decision should be based
on other criteria, e.g.IRR
etc.
NPV = 0
IRR
Contd
1000
11 .38 %
1
50
11 .38 %
1
970
11 .38 %
1
2150
11 .38 %
1
IRR contd
As an investment decision tool, the
calculated IRR should not be used to
rate mutually exclusive projects, but
only to decide whether a single
project is worth investing in.
Since IRR does not consider cost of
capital, it should not be used to
compare projects of different
duration
BOND VALUATION
Objectives
Distinguish bonds coupon rate,
current yield, yield to maturity
Find the market price of a bond given
its yield to maturity, find a bonds
yield given its price, and
demonstrate why prices and yields
may vary inversely
Why bonds Interest rate risk
Bond ratings and investors demand
for appropriate interest rates
Bond characteristics
Bond - evidence of debt issued by a body
corporate or Govt. In India, Govt
predominantly
A bond represents a loan made by investors to
the issuer. In return for his/her money, the
investor receives a legaI claim on future cash
flows of the borrower.
The issuer promises to:
Make regular coupon payments every period until the
bond matures, and
Pay the face/par/maturity value of the bond when it
matures
Elements of Bond
Bonds require coupon or interest payments
determined as part of the contract
Coupon payments represent interest on the
bond
Final interest payment and principal are paid
at specific date of maturity
Bond Concepts
Time
0 1 2 3 4 5
Coupons
Rs.80 Rs.80 Rs.80 Rs.80 Rs.80
Face Value1000
Market Price Rs.____
How much is this bond worth? It depends on the level of
current market interest rates. If the going rate on bonds like
this one is 10%, then this bond has a market value of
Rs.924.18. Why?
Coupon payments
PV ( price ) of bond
80
80
80
80
80
1000
Annuity component
2
1 r (1 r )
(1 r ) n
Lump sum
component
Bond terminology
Yield to Maturity
Discount rate that makes present value
of bonds payments equal to its price
Current Yield
Annual coupon divided by the
current market price of the bond
Current yield = 80 / 924.18 =
8.66%
Rate of return
Rate of return
= Coupon income + price change
---------------------------------------Investment
e.g. you buy 6 % bond at 1010.77 and sell
next year at 1020
Rate of return = 60+9.33/1010.77 =
6.86%
Risks in Bonds
Interest rate risk
Short term v/s long term
Default risk
Default premium
Variations in Corporate
Bonds
Bond pricing
The following statements about bond pricing are always
true.
Bond prices and market interest rates move in
opposite directions.
When a bonds coupon rate is (>=<) the markets
required return, the bonds market value will be
(>=<) its par value.
Given two bonds identical but for maturity, the price
of the longer-term bond will change more (in
percentage terms) than that of the shorter-term bond,
for a given change in market interest rates.
Given two bonds identical but for coupon, the price of
the lower-coupon bond will change more (in
percentage terms) than that of the higher-coupon
bond, for a given change in market interest rates.
Quick Quiz
1. Under what conditions will the coupon
rate, current yield, and yield to maturity
be the same?
SAMPLING
Objectives
Sample
Definition
Part or portion of
population chosen for
study
Characteristics and
Symbols
Parameters
Population size = N
Population mean =
Population standard
deviation =
Statistics
Sample size = n
Sample mean = x
Sample standard deviation
=
Types of sampling
Non random or judgement
Random or probability
Biased sample
Methods of sampling
Sampling is the fundamental method of inferring
information about an entire population without
going to the trouble or expense of measuring
every member of the population. Developing the
proper sampling technique can greatly affect the
accuracy of your results.
Random sampling
Members of the population are
chosen in such a way that all have an
equal chance to be measured.
Other names for random sampling
include representative and
proportionate sampling because all
groups should be proportionately
represented.
Some concepts
Census
Clusters
Cluster sampling
Judgement sampling
Precision
Sampling fraction
Statistical inference Making
inference from samples
Sampling Distributions
Ex. If we take n no. of sample of 25
adults in a city with population of 10000
and we compute mean height and
standard deviation of that sample, mean
and SD for each sample would be
different.
A probability distribution of all possible
means of the samples is a distribution of
the sample means also called sample
distribution of the mean
Sampling Distributions
S No.
Population
Water in a river
A Team
Parts manufactured
in a process
Sample
Sample
Statistics
Sampling
Distribution
Mean no. of
parts of
mercury per
million parts
water
Sampling
distribution
of mean
Median Height
Sampling
distribution
of median
Proportion
defective
Sampling
distribution
of
proportion
Group of 5 players
50 of each part
REGRESSION CORRELATION
Objectives
Relationship between two or more
variables
Scatter diagrams
Regression analysis
Method of least squares
Regression
Definition
Regression Equation
Regression
Definition
Regression Equation
Given a collection of paired data, the regression
equation
y = a+ bx
algebraically describes the relationship between the
two variables
Regression Line
y = mx +b
Assumptions
1. We are investigating only linear
relationships.
2. For each x value, y is a random variable
having a normal (bell-shaped) distribution. All
of these y distributions have the same
variance. Also, for a given value of x, the
distribution of y-values has a mean that lies on
the regression line. (Results are not seriously
affected if departures from normal distributions
and equal variances are not too extreme.)
Correlation
Correlation exists between
two variables when one of
them is related to the other
in some way
Assumptions
1. The sample of paired data
(x,y) is a random sample.
2. The pairs of (x,y) data have
a
bivariate normal
distribution.
Scatter diagram
Scatterplot (or scatter
diagram)
is a graph in which the
paired (x,y) sample data
are plotted with a
horizontal x axis and a
vertical y axis. Each
x
(a) Positive
x
(b) Strong
positive
(c) Perfect
positive
x
(d) Negative
x
(e) Strong
negative
(f) Perfect
negative
No Linear Correlation
y
x
(g) No Correlation
Correlation Analysis
Statistical tool to describe the degree to
which one variable is linearly related to
another
Often used in conjunction with regression
analysis
Three measures
Coefficient of determination
Covariance
Coefficient of correlation
TIME SERIES
Objectives
Understanding four components of
time series
Compute seasonal indices
Regression based techniques
Time series
Group of data or statistical
information accumulated at regular
intervals
Cyclical fluctuation
Seasonal variation
Irregular variation
Secular Trend
Cyclical Trend
Seasonal
Trend analysis
To describe historical patterns
Past trends will help us project future
LINEAR PROGRAMMING
Objectives
Understanding Linear programming
basics
Graphic and Simplex methods
Linear Programming
Mathematical technique used to
allocate limited resources among
competing demands in an optimal
way
E.g. resource and marketing
constraints
Certain Working capital requirements
Capacity constraints
Labour availability
Raw materials availability
Linear Programming
Problem formulation if
All equations are linear if 4 persons
produce 1 unit, for 3, 12 persons are
needed
Constraints are known and deterministic
probability of occurrence is taken as
1.0
Variables should have non negative
values
Decision values are also divisible
Types of LP problems
Maximisation - Profit
Minimisation - Costs
Transportation- to minimise cost of
shipping products and at the same time
maximise shipping m units to n
destinations
Decision making
For Sensitivity of results
Goal programming Objective function
Financial Budgeting
Simulation
Simulation
Studying effects of changes in real world
through models
Advantages:
Experiments can be conducted before real
system is operational, reduces costs
substantially
Appropriate to situations where size and
complexity of problem make use of techniques
difficult
Training needs
Sensitivity analysis
Simulation
Disadvantages:
Time consuming
Requires substantial computer
experience and expertise
Chances of overlooking seemingly
difficult scenarios
More art than science
Simulation Applications
Simulation Methodology
Start
Define Problem
Construct simulation model
Specify values of parameters and variables
Run simulation
Evaluation of results
Propose new experiment
Stop
Simulation - Features
Model representative of system?
Time incrementing procedure fixed
time or variable