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Old 06-05-2009, 09:41 AM   #41
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Maurice,
Inflation is one of the core parts in building a 'discount rate', Cost of capital, Inflation, Risk. There is a good article on building a discount or cap rate:

The art and science of business ... - Google Book Search

While this is for valuing property, business, or your own NPV, the same principles apply. You are discounting a future stream of income. I concur that tips or I bonds are not the rate to use, but treasuries is a good starting or safe rate and as explained in the article, inflation is accounted for in it's rate.

I still profess that the best way to arrive at the answer Nords was seeking is to do a discounted cash flow for each of his streams of income and add the results together. There may be different discount rates for each stream based on risk, but not on inflation. It matters not if the income stream is cola or not as you will place a different amount in each year based on weather it is or is not cola. Then the stream is discounted back at a safe rate + an allowance for risk. Therefore the military pension stream should have a lower discount rate than his expected stream from investments.

Based on the fact that his cola'd pensions come from the government, and therefore, IMHO, could be discounted at a safe rate, and his investments would be higher, I believe his conclusion that the current down turn in the market does not have as big of an effect on his NPV as one might expect by looking at his statements or listening to the news. If you want to quibble that his SS has a risk factor, I would not put up much of an argument. That is for each individual to decide.
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Old 06-05-2009, 10:19 AM   #42
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Originally Posted by Maurice View Post

For example, pretend you have a single payment of 1000 due to you in one year, if and only if you are alive at that time. Say that we consult the actuarial tables and determine that you have a 98.5% chance of being alive in one year. Therefore we consider the 'expected' payment amount to be $985. We would then discount the 985 back to today using the standard discounting curve I described above. You would continue that process with each future cash flow, using the appropriate 'survival probability' to compute the 'expected value' of each payment, prior to discounting it back to today.
I would agree with you if this was a portfolio... but like Schrodinger's Cat, you are either alive or dead.... you can not be 98.5% alive... (well, I guess that can be debated, but you either are getting the payments or you are not)

So, I think you have to make an assumption (yes, I know )... that you are either dead or alive.... and if you are a bit younger, it really does not make that much difference in the outlying years....
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Old 06-05-2009, 01:28 PM   #43
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I can see in the future government pensions carrying a time limit of 25 or 30 years
in the future. State and federal gov cannot possibly afford what will happen in the
next decade for retirement. Social Security will most likely be moved back to at least
65 for early withdrawal and 68 or something of the sort for full benefit.
JMHO
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Old 06-05-2009, 02:26 PM   #44
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Rustic - your book says to take into account 'inflation + real interest rates'. Sounds like nominal interest rates to me.
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Old 06-05-2009, 02:31 PM   #45
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I would agree with you if this was a portfolio... but like Schrodinger's Cat, you are either alive or dead.... you can not be 98.5% alive... (well, I guess that can be debated, but you either are getting the payments or you are not)

So, I think you have to make an assumption (yes, I know )... that you are either dead or alive.... and if you are a bit younger, it really does not make that much difference in the outlying years....


That's true, but then a high yield bond is either going to default or it isn't. But before the fact, one can't know which will happen, so the market prices it based on probabilities. Calculating PVs is all about calculating market prices, is it not?

Having said that, of course for ER planning purposes one should assume the 'worse case' scanario that one lives a long time...
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Old 06-05-2009, 02:32 PM   #46
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I can see in the future government pensions carrying a time limit of 25 or 30 years
in the future. State and federal gov cannot possibly afford what will happen in the
next decade for retirement. Social Security will most likely be moved back to at least
65 for early withdrawal and 68 or something of the sort for full benefit.
JMHO

I think before they put a time limit on them they'll be means tested. That's one reason SS doesn't show up in any of my spreadhseets.
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Old 06-05-2009, 02:50 PM   #47
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I would agree with you if this was a portfolio... but like Schrodinger's Cat, you are either alive or dead.... you can not be 98.5% alive... (well, I guess that can be debated, but you either are getting the payments or you are not)
Maurice is right.

The calculation is no different than asking "What is the fair value of a 50% chance to win one dollar?" The correct answer is $0.50. If you were then to ask, "What is the fair value of a 50% chance to win one dollar one year forward" the correct answer would be .5 / (1 + i) where "i" equals your discount rate.

While you're right that you'll either end up with one dollar or zero, not $.50, the market would value that cash flow stream as described. Any other valuation would result in arbitrage profit opportunities (in a robust and efficient market).
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Discounted Cash Flow
Old 06-05-2009, 03:17 PM   #48
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Discounted Cash Flow

attached is a simple 25 year discounted cash flow spreadsheet. I think I used an assumption of 3.5% constant inflation for the numbers, and a 7% constant return on the investment numbers. Not real sophisticated but it should give you an idea how to build one to suit your needs.
Attached Files
File Type: zip networth.zip (5.6 KB, 2 views)
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Old 06-05-2009, 03:38 PM   #49
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Again, you don't use inflation to discount a known cash flow. Use an appropriate risk-free interest rate.
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Old 06-05-2009, 04:10 PM   #50
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Here's Wiki's take, if anyone's interested.

Discrete cash flows

The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.
Thus the discounted present value (for one cash flow in one future period) is expressed as:
where
  • DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt;
  • FV is the nominal value of a cash flow amount in a future period;
  • i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full;
  • d is the discount rate, which is i/(1+i), ie the interest rate expressed as a deduction at the beginning of the year instead of an addition at the end of the year;
  • n is the time in years before the future cash flow occurs.
Where multiple cash flows in multiple time periods are discounted, it is necessary to sum them as follows:

for each future cash flow (FV) at any time period (t) in years from the present time, summed over all time periods. The sum can then be used as a net present value figure. If the amount to be paid at time 0 (now) for all the future cash flows is known, then that amount can be substituted for DPV and the equation can be solved for i, that is the internal rate of return.
All the above assumes that the interest rate remains constant throughout the whole period.
(1+i)^(-t) can of course also be expressed as exp(-it).
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Old 06-05-2009, 04:25 PM   #51
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If your point of view is that inflation should not be considered in the discount rate, we will just have to agree not to agree. My guess is we are not communicating our point of view and it is not worth the time and effort to continue this further.
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Old 06-05-2009, 05:05 PM   #52
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Well, market interest rates presumably take inflation expectations into account, so maybe our disagreement is mere semantics.
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Old 06-05-2009, 07:41 PM   #53
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As Barbie says "Math is hard"

My new plan is to spend it all,when I run out. Go out like David Caraddine in a state of bliss.
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Old 06-05-2009, 08:04 PM   #54
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If your point of view is that inflation should not be considered in the discount rate
The way I understand it, his point of view (and mine too) is that the inflation assumption is already embedded in the nominal discount rate. As in . . . "Real Rate" + Inflation = Nominal Rate . . . or . . . TIPS rate + Inflation = Treasury Rate

So if you use the treasury rate to discount a nominal future cash flow, you are already using an inflation assumption that is determined by an efficient market. So there is no need for you to make any assumptions about inflation whatsoever.
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Old 06-05-2009, 09:15 PM   #55
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yrs to go,
I agree completely, and figured semantics was at the heart of our discussion. An example I would use is the cost of money, historically, is a percent to a percent and a half. (I don't have any proof of that just a quotes from several professors) Likewise the long term inflation rate in the U.S. is about 3.5%, again not source. Add the two together and you get 5%, or close. This represent a 'safe rate' if 'inflation' is expected to be 'normal'. However, few expect the inflation rate to be that low over the coming years, yet the current treasury rates, (and I have not looked recently) I believe would lead one to believe that higher than normal inflation is not currently priced into the 'safe' discount rate.

My point in trying to bring out the components of a discount rate, is that each of us have our idea of what inflation, and risk might be in our future income flows. Also to point out the ease of which excel makes calculating discount cash flows. As risk can effect the discount rate more than inflation and cost of capital, it is the determination of risk that separate good appraisers from hacks. And, it is the ability to assess risk in ones own portfolio that will make the biggest difference in ones net worth.
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Old 06-06-2009, 01:47 AM   #56
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Couple of questions for Nords:
1. Does the US government fund its military pensions (a) as a going concern, or is it held to the more stringent actuarial standard of (b) possible "dissolution"?
2. Where is the pension fund invested? (a) Gummint bonds (owned by millions of Chinese people)? (b) Equities and other market instruments?
3. If 1(b) and 2 (a) or (b) is true, does Nords' risk tolerance change at all?
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Old 06-06-2009, 07:17 AM   #57
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yrs to go,
I agree completely, and figured semantics was at the heart of our discussion. An example I would use is the cost of money, historically, is a percent to a percent and a half. (I don't have any proof of that just a quotes from several professors) Likewise the long term inflation rate in the U.S. is about 3.5%, again not source. Add the two together and you get 5%, or close. This represent a 'safe rate' if 'inflation' is expected to be 'normal'. However, few expect the inflation rate to be that low over the coming years, yet the current treasury rates, (and I have not looked recently) I believe would lead one to believe that higher than normal inflation is not currently priced into the 'safe' discount rate.

My point in trying to bring out the components of a discount rate, is that each of us have our idea of what inflation, and risk might be in our future income flows. Also to point out the ease of which excel makes calculating discount cash flows. As risk can effect the discount rate more than inflation and cost of capital, it is the determination of risk that separate good appraisers from hacks. And, it is the ability to assess risk in ones own portfolio that will make the biggest difference in ones net worth.

I think you're conflating this with project finance. When valuing fixed income products you don't need to develop a view of risk. The market gives it to you. And 'cost of capital' is irrelevant. And there's no need to develop a view on inflation, you just discount using the risk-free interest rate.

Anyway, I'm beating a dead horse here.
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Old 06-06-2009, 07:22 AM   #58
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In one sense this problem is trivially simple - we're talking about how Nords should value cash flows from the government.


To value your IBM stock, all you need to know is the current price of IBM stock.

To value cash flows from the government, all you need to know is the current price of cash flows from the government. That's what interest rates are.
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Old 06-06-2009, 10:50 AM   #59
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Couple of questions for Nords:
1. Does the US government fund its military pensions (a) as a going concern, or is it held to the more stringent actuarial standard of (b) possible "dissolution"?
2. Where is the pension fund invested? (a) Gummint bonds (owned by millions of Chinese people)? (b) Equities and other market instruments?
3. If 1(b) and 2 (a) or (b) is true, does Nords' risk tolerance change at all?
i believe 1 is (a) but if it was like federal civilian pensions/SS, the "Gummint bonds" it would be invested in would be owned by the fund not the "Chinese people"
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Old 06-06-2009, 02:10 PM   #60
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However, few expect the inflation rate to be that low over the coming years, yet the current treasury rates, (and I have not looked recently) I believe would lead one to believe that higher than normal inflation is not currently priced into the 'safe' discount rate.

My point in trying to bring out the components of a discount rate, is that each of us have our idea of what inflation, and risk might be in our future income flows.
Fair enough.

But your approach yields a result that reflects your personal opinion about what the present value is. Using the market rate yields a market value.
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