When we discuss the valuation of a company, we may be referring to any of the following: •

Enterprise value: Valuing the company ’ s productive activities. • Equity: Valuing the shares of a
company, whether for the purpose of buying or selling a single share or valuing all of the equity for
purposes of a corporate acquisition. • Debt: Valuing the company ’ s debt. When debt is risky, its
value depends on the value of the company that has issued the debt. • Other: We may want to value
other securities related to the company—for example, the fi rm ’ s warrants or options, employee
stock options, etc. In Chapters 2–6 of Financial Modeling , we discuss the fi rst two of these topics,
leaving the valuation of debt and other securities for later chapters. 1 2.2 Four Methods to Compute
Enterprise Value (EV) The key concept in corporate valuation is enterprise value . The enterprise
value (EV) of the fi rm is the value of the fi rm ’ s core business activities and forms the basis of most
corporate valuation models. We distinguish between four approaches to computing the enterprise
value: 1. Valuation of risky bonds is discussed in Chapter 23. The valuation of derivative securities is
discussed in Chapters 15–19, 29, and 30. 54 Chapter 2 • The accounting approach to EV moves items
on the balance sheet so that all operating items are on the left-hand side of the balance sheet and all
fi nancial items are on the right-hand side. Although most academics sneer at this approach, it is
often a useful starting point for thinking about the enterprise value

1.8 Continuous Compounding Suppose you deposit $1,000 in a bank account which pays 5% per year.
This means that at the end of the year you will have $1,000*(1.05) = $1,050. Now suppose that the
bank interprets “5% per year” to mean that it pays you 2.5% interest twice a year. Thus after 6
months you ’ ll have $1,025, and after 1 year you will have $, * . 1 000 1 $, . 0 05 2 1 050 625 2 + ⎛ ⎝
⎞ ⎠ = . By this logic, if you get paid interest n times per year, your accretion at the end of the year
will be $, * . 1 000 1 0 05 + ⎛ ⎝ ⎞ n ⎠ n . As n increases this amount gets larger, converging (rather
quickly, as you will soon see) to e0.05 , which in Excel is written as the function Exp . When n is infi
nite, we refer to this as continuous compounding . (By typing Exp(1) in a spreadsheet cell, you can
see that e = 2.7182818285. …) As you can see in the next display, $1,000 continuously compounded
for 1 year at 5% grows to $1,000* e0.05 = $1,051.271 at the end of the year. Continuously
compounded for t years, it will grow to $1,000* e0.05*t , where t need not be a whole number (for
example, when t = 4.25 then the accumulation factor e0.05*4.25 measures the growth of the initial
investment at 5% annually, continuously compounded for 4 years and 3 months). 1 2 3 4 5 6 7 A B C
tseretnI %8 Annual retirement withdrawal 30,000.00 Years of withdrawal 8 tisoped fo sraeY 5 Present
value of withdrawals 117,331.98 <-- =-PV(B2,B4,B3)/(1+B2)^B5 Annual deposit 29,386.55 <--
=PMT(B2,B5,-B6) A RETIREMENT PROBLEM 39 Basic Financial Calculations 1 2 3 4 5 6 7 8 9 10 11 12
13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 A B C tisoped laitinI 000,1 etar
tseretnI %5 Number of compounding periods per year 2 Interest per compounding period 2.500% <--
=B3/B4 raey eno ni noiterccA 4B^)5B+1(*2B= --<-- =B2*EXP(B3) Compounding periods per year End-
year accretion 1 52A^)52A/3$B$+1(*2$B$= --<-- =B5*EXP(-$B$2*A5) 2 200 170.429 <-- =B6*EXP(-
$B$2*A6) 3 300 235.988 4 400 290.460 5 500 335.160 Present value 1,124.348 <-- =SUM(C5:C9)
CONTINUOUS DISCOUNTING 41 Basic Financial Calculations 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
A BC tisoped laitinI 000,1 End-of-year value 1,200 Number of compounding periods 2 Implied annual
interest rate 19.09% <-- =((B3/B2)^(1/B4)-1)*B4 Continuous return 18.23% <-- =LN(B3/B2) Number
of compounding periods Rate 19.09% <-- =B5, data table header 1 20.00% 2 19.09% 4 18.65% 8
18.44% 20 18.32% 1,000 18.23% CALCULATING RETURNS FROM PRICES Implied annual interest rate
with n compounding periods Why Use Continuous Compounding? All of this may seem somewhat
esoteric. However, continuous compounding/ discounting is often used in fi nancial calculations. In
this book, it is used to calculate portfolio returns (Chapters 8–13) and in practically all of the options
calculations (Chapters 15–19). There ’ s another reason to use continuous compounding—its ease of
calculation. Suppose, for example, that your $1,000 grew to $1,500 in 1 year and 9 months. What ’ s
the annualized rate of return? The easiest—and most consistent—way to do this is to calculate the
continuously compounded annual return. Since 1 year and 9 months equals 1.75 years, this return is:
1 000 1 75 1 500 1 1 75 1 500 1 000 , *exp * . , 23 1694 . ln , , [ ] r r = ⇒= . % ⎡ ⎣ ⎢ ⎤ ⎦ ⎥ = 42 Chapter 1
1.9 Discounting Using Dated Cash Flows Most of the computations in this chapter consider cash fl
ows which occur at fi xed periodic intervals. Typically we look at cash fl ows which occur on dates 0,
1, … , n , where the period indicates an annual, semi-annual, or other fi xed interval. Two Excel
functions, XIRR and XNPV , allow us to do computations on cash fl ows which occur on specifi c dates
that need not be at even intervals. 7 In the following example we compute the IRR of an investment
of $1,000 made on 1 January 2014 with payments on specifi c dates: 7. If you do not see these
functions, add them in by going to Tools|Add-ins on the toolbar and checking Analysis ToolPak . 1 2 3
4 5 6 7 8 9 AB C Date Cash flow 01-Jan-14 -1,000 03-Mar-14 150 04-Jul-14 100 12-Oct-14 50 25-Dec-
14 1,000 IRR 37.19% <-- =XIRR(B3:B7,A3:A7) USING XIRR TO COMPUTE THE ANNUALIZED INTERNAL
RATE OF RETURN The function XIRR outputs an annualized return. It works by computing the daily
IRR and annualizing it, XIRR daily IRR = + ( ) 1 1 − 365 . XNPV computes the net present value of a
series of cash fl ows occurring on specifi c dates: 43 Basic Financial Calculations 1 2 3 4 5 6 7 8 9 10
11 12 13 AB C Annual discount rate 12% Date Cash flow 01-Jan-14 -1,000 03-Mar-15 100 04-Jul-15
195 12-Oct-16 350 25-Dec-17 800 Net present value 16.80 <-- =XNPV(B2,B5:B9,A5:A9) USING XNPV
TO COMPUTE THE NET PRESENT VALUE Note that XNPV has a different syntax from NPV! XNPV
requires all the cash flows, including the initial cash flow, whereas NPV assumes that the first cash
flow occurs one period hence. Fixing Bugs in XNPV and XIRR Both XNPV and XIRR have bugs, which
Microsoft has not fi xed in several versions of Excel. The fi le with this chapter includes functions that
fi x these bugs, called NXNPV and NXIRR . 8 • XNPV doesn ’ t work with zero or negative interest
rates. • XIRR does not identify multiple internal rates of return. The XNPV relates to the failure of this
function to correctly deal with zero or negative discount rates. 8. These bug fi xes were d

1.7 A Pension Problem—Complicating the Future Value Problem A typical exercise is the following:
You are currently 55 years old and intend to retire at age 60. To make your retirement easier, you
intend to start a retirement account: • At the beginning of each of years 1, 2, 3, 4 (that is, starting
today and at the beginning of each of the next four years), you intend to make a deposit into the
retirement account. You think that the account will earn 8% per year. 34 Chapter 1 • After retirement
at age 60, you anticipate living 8 more years. 5 At the beginning of each of these years you want to
withdraw $30,000 from your retirement account. Your account balances will continue to earn 8%.
How much should you deposit annually in the account? The following spreadsheet fragment below
shows how easily you can go wrong in this kind of problem—in this case, you ’ ve calculated that in
order to provide $30,000 per year for 8 years, you need to contribute $240,000/5 = $48,000 in each
of the fi rst 5 years. As the spreadsheet shows, you ’ ll end up with a lot of money at the end of 8
years! (The reason—you ’ ve ignored the powerful effects of compound interest. If you set the
interest rate in the spreadsheet equal to 0%, you ’ ll see that you ’ re right.) 1 2 3 4 5 6 7 8 9 10 11 12
13 14 15 16 17 18 19 20 21 A BC D E F tseretnI %8 Annual deposit 48,000.00 Annual retirement
withdrawal 30,000.00 =$B$2*(C7+B7) Year Account balance, beginning of year Deposit at beginning
of year Interest earned during year Total in account, end year 1 7B+7C+7D= --