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# Present value 4 (and discounted cash flow)

Video transcript

So far, we've been assuming that
the discount rate is the same thing, no matter
how long of a period we're talking about. But we know if you go to the
bank and you say, hey, bank, I want to essentially invest in
a one-year CD, they'll say, oh, OK, one-year CD
will give you 2%. And you're like, well, what
if we give you the money for two years? So you can keep our money,
locked in for even longer. They'll say, oh, then we'll
give you a little bit more interest, because we have
more flexibility. For two years, we don't have
to worry about paying you. So instead of giving you 2%,
we'll give you 7%, because we get to keep your money
for two years. And maybe if you say, well,
you know, I actually don't even need my money for 10 years,
so let me give you the money for 10 years. They'll say oh, 10 years, if
we get to keep your money, we'll give you 12%. So in general-- and this tends
to be the case, although it's not always the case-- the longer
that you defer your money, or the longer you lock
up the money, the higher an interest rate you get. So the same thing is true when
you're doing a discount rate. Oftentimes you want to discount
a payment two years out by a higher value than
something that's only one year out. So how do you do that? So let's say the risk-free rate,
if you were to go out and get a government bond-- the
one-year rate, let's say that they're only
giving you 1%. But let's say that the
two-year rate, they'll give you 5%. So what does that mean? Well, let's take the example. So that means you could take
that $100 and essentially lend it to the federal government,
and in a year they'll give you 1% on it. So that these are
annual rates. So 1%, 1.01 times 100, that's
just $101, right? Fair enough. Now your other option is,
you could lock it in. You could lend it to the federal
government for two years and not see your money. And they say, oh, then we're
going to give you 5% a year. So then you're going
to go 5% a year. So how much do you end
up with in two years? Well, remember, this
is an annual rate. These are always quoted
in annual rates. So if you're getting 5% a year,
that's going to be equal to-- let's do it on
the calculator. That's going to be 100-- after
one year you're going to get 1.05, and after two years you're
going to get 1.05. Or you can view that as 100
times 1.05 squared. So you'd have $110.25. So you already see, not even
doing any present value, this is actually-- you can almost
view this as a future value calculation. If you take a future value,
you already know that this option is better than this
option, when you have these varying interest rates. But anyway, the whole topic of
this is to talk about present value, so let's do that. So in this circumstance,
what is the present value of the $110? Well, actually, what is the
present value of the $100? Well, we always know that. That's easy. That is $100. Present value of $100
today is $100. What is the present
value of the $110? So we take $110, and we're
going to use the two-year rate, and discount twice. And that makes sense, because
essentially you're deferring your money for two years. You're not going to
get anything, even a year from now. So you're deferring your
money for two years. So you divide it by 1-- so it's
a 5% rate, 1.05 squared. And then that is equal to--
I think that was our first problem, right? So I'll just do it again. 110 divided by 1.05 squared. That's equal to $99.77, right? That was our first problem. And now this one
is interesting. The $20 you get today-- and
this is a side note. It's very important when you're
doing this, when they talk about year one, or year
zero, just make sure-- is that today, is that a
year from now? Because if it's a year from now,
you'd have to discount it by the one-year interest rate. If it's today, you don't
discount it. So anyway, I clarified that. I was a little ambiguous about
that in the last two videos, but I clarified it. The $20 is now. So the present value of
something given you today, is the value of it. So it's $20 plus $50. Now $50, what do we use? Do we use the one-year rate
or the two-year rate? Well of course, we use the
one-year rate, because you're not deferring the pleasure of
that $50 for two years. You're actually getting
it in one year. So plus $50 divided by
the one-year rate. Divided by 1.01. Plus $35 divided by the two-year
rate-- but this is an annual rate, so you have to
discount it twice-- divided by 1.05 squared. Let's get the TI-85 out. So you get 20 plus 50 divided
by 1.01, plus 35 divided by 1.05 squared, is equal
to $101.25. So notice, the actual payment
streams I did not change in any of the three scenarios. And let me just draw a line
between them, because I got a little bit messy. So that was scenario one. This is scenario two. And this is scenario three. But in scenario one, because we
used a 5% discount rate for all-- you could say, I don't
want to use fancy words-- but for all durations out we used
a 5% discount rate. We saw that choice number
one was the best. But then if the discount rate
were to change-- if we were to change our assumption. If we had a 2% rate, for
whatever reason, we could lend money to the federal government
in the form of buying bonds from them-- we
could lend the federal government two years over
any time period at 2%. Then all of a sudden, choice
two became the best option. And then finally, if we had this
kind of-- and this is the most realistic scenario, and
even though the math is fairly simple, we're actually doing
something fairly sophisticated here. When I had a different discount
rate for my one year out cash flows and my two year
out cash flows, and it was these exact numbers. I had to play with the numbers
to get the right result. Then all of a sudden choice
three was the best option. I'll leave it to you-- I want
you to think about why this was better for choice three than
it was for choice two. And if you really understand
that, then I think you are starting to have a
lot of intuition about present values. And frankly, what we're
learning here is a discounted cash flow. What is a discounted
cash flow? I'm giving you a stream
of cash flows. $20 now, $50 a year from
now, $35 in two years. And you are essentially
discounting them back to get today's present value. So when someone says, you know,
I can use Excel to do a discounted cash flow, that's
all they're doing. They're making some assumption
about the discount rates. And they're just using this
fairly straightforward mathematics to get the
present value of those future cash flows. But it's a very powerful
technique. Because if you were to take--
if you're good at Excel, and you were to say, oh,
I have a business. And based on my assumptions, in
year one, right now, this business gives me $20. The next year it's going
to give $50. The year after that it's $35. And this risk-free is
the big assumption. But if it was risk-free, you
could discount it like that. You'd say, if these are the
interest rates, this business is worth $101.25. That's what I'm willing
to pay for it. Or, I'm neutral. If I could get it for $90,
that's a good deal for me. That's all a discounted
cash flow is. But the big learning from this
is how dependent the present value of future payments are
on your discount rate assumption. The discount rate assumption
is everything in finance. And this is where finance really
diverges from a lot of other fields, especially
the sciences. There really is no
correct answer. It's all assumption driven. All of these discounted cash
flows, and all these models, they're really just to
help you understand the dynamics of things. And frankly-- and this happens
a lot in the real world of finance-- if you ever become
an analyst at an investment bank, you'll probably
do this yourself. But you can almost justify any
present value, by picking the right discount rate. And actually the whole topic of,
how do you decide on the right discount rate? Because we assumed risk-free. Everything is risk-free. You're guaranteed
these payments. But we know in the real world,
if you're investing in pets.com and they tell you
that they're going to pay these cash flows to you,
that's not risk-free. There's some risk implicit
in that. So actually, most of finance,
and most of portfolio theory, and modern finance, is
based on figuring out that discount rate. And that is the crux of
everything, because as we see, that completely changes which of
these options is the best. But anyway, I don't want to
confuse you too much. What you have already is
a very powerful tool. If you can think of a discount
rate, you can make a very rational comparison between
three, or ten, or whatever different types of payments. And this is actually
really useful. You don't realize how
many things in the world are like this. These college payment schemes
where you pay some company $25 a year for 20 years, and then in
year 21 they're willing to pay for your college tuition, or
your kids' college tuition. You could figure out with that
really is worth, how much money are they making off
of you, by taking a discounted cash flow. And of course if you're
paying out, these become negative numbers. And when they pay you, it
becomes a positive number. Anyway. Maybe I'll do that in a couple
of videos, because I think that's a fairly useful thing
to be able to analyze. See you in the next video.