Lecture 5_Discounted CF II

Lecture 5_Discounted CF II - Session 5: Discounted Cash...

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1 Session 5: Discounted Cash Flow II Financial Management 3320 Fall 2010 Indraneel Chakraborty SMU Cox School of Business Financial Management SMU Cox School of Business © 2010 Indraneel Chakraborty 2 A review of last class Annuities Ordinary annuity : a series of identical cash flows occurring at the end of each period for some fixed number of periods Examples: consumer loans (e.g. car loans), home mortgages, etc. Annuity due : an annuity for which the cash flows occur at the beginning of each period Perpetuities Important special case of annuities: a series of identical cash flows which continues forever
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2 3 Annuity and perpetuity These formulas are very important ! Ordinary annuity: Perpetuity: r r C FV r r C PV t t 1 ) 1 ( ) 1 ( 1 1 r C PV Financial Management SMU Cox School of Business © 2010 Indraneel Chakraborty 4 A review of last class: one more example You want to have $1 million to use for retirement in 35 years. If you can earn 1% per month, how much do you need to deposit on a monthly basis if the first payment is made in one month? Formula for FV of ordinary annuity : Calculator: N = FV = I/YR = Then click PMT = 50 . 155 $ 1 ) 01 . 1 ( 01 . 0 000 , 000 , 1 that so 01 . 0 1 ) 01 . 1 ( 000 , 000 , 1 420 12 * 35 C C Financial Management SMU Cox School of Business © 2010 Indraneel Chakraborty
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5 A review of last class: one more example (continued) What if the first payment is made today? Formula for FV of annuity due : Calculator: Set Begin (you should see it on your display) N = 420 FV = 1,000,000 I/YR = 1 Then click PMT = -$153.96 Remove Begin from your display 96 . 153 $ 01 . 1 1 1 ) 01 . 1 ( 01 . 0 000 , 000 , 1 that so ) 01 . 1 ( 01 . 0 1 ) 01 . 1 ( 000 , 000 , 1 420 12 * 35 C C Financial Management SMU Cox School of Business © 2010 Indraneel Chakraborty 6 Perpetuity again … The PV of a perpetual cash flow stream has a finite value (as long as r > 0). Here’s a question for you: How can an infinite number of cash payments have a finite value? Hint : suppose you are considering the purchase of a consol, which promises to pay the holder $100 per year forever. If your opportunity rate is 10%, what is the most you would pay for the bond today? One more question : Assume you are offered a bond identical to the one described above, but with a life of 50 years. What is the difference in value between the 50-year bond and the consol? Financial Management
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Lecture 5_Discounted CF II - Session 5: Discounted Cash...

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