Recap of Lecture 2

Given the financial statements below,

XYZ Inc. XYZ Inc.
Balance Sheet 2020 Income Statement 2020
Cash 11,982 Sales 74,889
Accounts Receivable 14,229 Depreciation 5,492
Inventory 14,978 Other Costs 58,413
Current Assets 41,189 EBIT 10,984
Fixed Assets 49,427 Interest 306
Total Assets 90,616 Taxable Income 10,678
Accounts Payable 11,982 Taxes 3,737
Debt 4,500 Net Income 6,941
Total Liabilities 16,482
Equity 74,134 Dividends 2,082
Total Liabilities & Equity 90,616 Addition to RE 4,858
 Recap of Lecture 2
Answer the following review questions:

1. Suppose the firm is expected to grow 18% in 2021 and

the tax rate and the payout ratio remain unchanged,
what will be the net new financing in 2021, following the
percent of sales method?

2. What is the projected internal growth rate and

sustainable growth rate in 2021?

2
 Chapter 3

• Valuation Principle

• Time Value of Money

• Future Values and Compounding

• Present Values and Discounting

• Multiple Cash Flows

3
 Valuation Principle
• Cost-Benefit Analysis
– Any decision in which the value of the benefits exceeds the costs
will increase the value of the firm.
– To compare the costs and benefits, we first need to convert them
to a common unit.

• Role of Competitive Markets

– A competitive market is one in which a good can be bought and
sold at the same price.
– In a competitive market, the market price determines the value of
the good.

4
 Valuation Principle
• Valuation Principle
– The value of a commodity or an asset to the firm or its investors
is determined by its competitive market price.
– When the value of the benefits exceeds the value of the costs,
the decision will increase the market value of the firm.

• Law of One Price

• In competitive markets, the same goods must trade at the same
price. More generally, financial securities that produce exactly
the same cash flows must have the same price.
• In practice, market imperfections lead to price discrepancies.

5
 Time Value of Money

• An Old Question
– Borrow $1000 today, return $1000 in 10 years – Yes/no?
– $1,480 in 10 years, $2,191 in 20 years, $3,243 in 30
years … (given a 4% annual interest rate)

• Time Value of Money

– A dollar received today is worth more than a dollar
received tomorrow.
– The value of cash flows received at different times can
never be directly compared.
6
 Time Value of Money

• The economic value of a dollar depends on the

time at which it is received or disbursed.
• The time-value concept forms the basis for
valuation.
• Compounding: translation of current dollars (PV)
into economically equivalent future dollars (FV)
• Discounting: translation of future dollars (FV)
into economically equivalent current dollars (PV)
7
 Future Value

• Future value is the amount to which an

investment will grow after earning interest.

• Interest can be of two types:

– Simple interest: Interest is earned only on the
original investment
– Compound interest: Interest is earned on the
interest.

8
 Future Value
• Example 1:
– You invest $100 in an account paying simple interest
at the rate of 6% per year.
– How much will the account be worth in 5 years?

Today Year 1 Year 2 Year 3 Year 4 Year 5

Starting balance $100

Interest earned $6 $6 $6 $6 $6
Ending balance $106 $112 $118 $124 $130
9
 Future Value
• Answers:
– You earn interest only on the original investment
– Interest earned per year = $100 x 6% = $6.00
– Total interest earned over 5-year period = $6.00 x 5 =
$30.00
– Balance in account at end of Year 5 = $100 + $30 =
$130

• Formula:
– FV = PV x (1+ t x r) = $100 x (1+ 5 x 6%) = $130

10
 Future Value
• Example 2:
– You invest $100 in an account paying compound
interest at the rate of 6% per year.
– How much will the account be worth in 5 years?

Today Year 1 Year 2 Year 3 Year 4 Year 5

Starting balance $100

Interest earned $6 $6.36 $6.74 $7.15 $7.57
Ending balance $106 $112.36 $119.10 $126.25 $133.82

11
 Future Value
• Answers:
– You earn interest on interest
– Interest earned per year = Previous year’s balance x
interest rate
– Interest earned in Year 1 = $100.00 x 6% = $6.00
– Interest earned in Year 2 = $106.00 x 6% = $6.36
– Interest earned in Year 3 = $112.36 x 6% = $6.74
– Interest earned in Year 4 = $119.10 x 6% = $7.15
– Interest earned in Year 5 = $126.25 x 6% = $7.57

• Formula:
– FV = PV x (1+ r ) t = $100 x (1+ 6%) 5 = $133.82
12
 Future Value
• Compound interest:
= $133.82 - $100 = $33.82

• Simple interest:
= $130 - $100 = $30

• The power of compounding:

– Compound interest yields $3.82 more.

• Most financial problems you will deal with will

involve compound interest.

13
 Future Value
• Example 3:
– You invest $100 in an account, compounded at an
annual rate of 10%.
– How much will the account be worth in 5 years?
– What about in 10 years, in 20 years, and in 30 years?

• Answers:

14
 Calculator Method
• Five keys on your financial calculator
N: number of periods
I/Y: interest rate
PV: present value
FV: future value
PMT: annuity cash flow
• Always remember to clear previous TVM before
a new calculation
– Click “2ND” + “FV” to clear TVM on TI BA II Plus
• Read textbook page 131-133
15
 Future Value
• In Example 3:
Don’t forget “-”
PV = -$100
FV = ???
N = 5 years Input 10, not 0.10
I/Y = 10 % per year
PMT = 0

Therefore, FV= ???

16
 Future Value
• Example 4:
– A super-rare Pokémon card,
Japanese Illustrator Pikachu,
was sold at an auction for
$220,000 in 2019.
– Suppose the original card
costed $1 in 1998.
– What was the annual compound
rate of return if the original
owner sold the card in 2019?

17
 Future Value
• Answers
FV = PV x (1+ r ) t
$220,000 = $1 x (1 + r)2019-1998
$220,000 = $1 x (1 + r)21
220,000 = (1 + r)21

Solve for r: (1 + r)21 = 220,000

r = (220,000)1/21 - 1 = 79.64%

The compound return was 79.64% per year from 1998

to 2019.
18
 Future Value
• In Example 4:
Don’t forget “-”
PV = -$1
FV = $220,000
N = 21 years
I/Y = ??? % per year
PMT = 0

Therefore, I/Y = 79.64% per year

19
 Present Value
• Let’s turn things around…
– How much do you need to invest today into an
account paying compound interest at the rate of 6%
per year, in order to receive $133.82 at the end of five
years?
Today Year 1 Year 2 Year 3 Year 4 Year 5
6% 6% 6% 6% 6%

$133.82
?

PV FV
20
 Present Value

Today Year 1 Year 2 Year 3 Year 4 Year 5

6% 6% 6% 6% 6%

$133.82
?

PV FV

PV = FV / (1+ r ) t Simply invert the

= $133.82 / (1+ 6%) 5 formula for FV:
= $100 FV = PV x (1+ r ) t

21
 Future Value vs. Present Value

• PV and FV are related!

FV = PV x (1 + r)t PV = FV x 1/(1 + r)t

= $100 x (1 + 6% )5 = $133.82 x 1/ (1 + 6% )5
= $133.82 = $100

22
 Future Value vs. Present Value

• FV = PV x (1+ r ) t • PV = FV / (1+ r ) t
– FV = Future Value – FV = Future Value
– PV =Present Value – PV =Present Value
– r = compounding – r = discounting rate,
rate, “the return” “the return”
– t = number of – t = number of
periods periods
– (1 + r) t = – 1/(1 + r ) t =
compounding factor discounting factor

23
 Present Value
• Example 5:
– Assume you need $1,000,000 to retire, how much do
you need now if you plan to retire at 60 and you are
20 now. Your expect your rate of return to be 8%
annually.
– What if you are 30 now?

• Answers

24
 Present Value

• Example 6:
– Assume the total cost of a university education will be
$75,000 when your child enters university in 18 years.
Grandparents have given you $7,000 to invest.
– What rate of return must you earn on your investment
to cover the total cost?

25
 Present Value
• Answers
FV = PV x (1+ r ) t
$ 75,000 = $ 7,000 x (1 + r)18
10.71 = (1 + r)18

Solve for r: (1 + r)18 = 10.71

r = (10.71)1/18 - 1 = .1408 = 14.08%

The required rate of return is 14.08% per year.

26
 Present Value
• Example 7:
– If you can earn 12% per year compounded annually,
how long would it take to double your money?

• Answers
– FV = PV x (1+ r ) t
Rule of 72:
– FV/PV = (1+ r ) t
– 2 = ( 1+12%) t Year to double ~
72/interest rate in %
– log 2 = log 1.12 t
– log 2 = t log 1.12
– t = 6.1163 years
27
 Present Value
• In Example 7:

PV = -$1
FV = $2
Type in 12, not 0.12
N =??? years
I/Y= 12 % per year
PMT = 0

Therefore, N=6.1163 years

28
 Multiple Cash Flows

• Future Value
– Example 8:
You deposit $1,200 in your bank account today;
$1,400 one year later; and $1,000 two years from
today. If your bank offers you an 8% interest rate on
your account, how much money will you have in the
account three years from today?

29
 Multiple Cash Flows

0 1 2 3
8% 8% 8%

$1,200 $1,400 $1,000

$1,000x(1+0.08)1=$1,080.00

$1,400x(1+0.08)2=$1,632.96

$1,200x(1+0.08)3=$1,511.65

FV = $4,224.61

30
 Calculator Method
• CF buttons on your financial calculator
CF: cash flows starting from t=0
NPV: net present value or net future value

• Always remember to clear previous CF

worksheets before a new calculation
– Click “CF”, then “2ND” + “CE|C” to clear work on TI
BA II Plus

31
 Multiple Cash Flows
• In Example 8:
– First click “CF”:
CF0 = $1200
C01 = $1400
F01= 1 (frequency of C01)
C02 = $1000 This is very important
to get FV at t=3
F02= 1 (frequency of C02)
C03 = $0
F03= 1 (frequency of C03)
– Then click “NPV”:
I= 8 % per year
NFV =??? (click “CPT”)
32
 Multiple Cash Flows

• Present Value
– Example 9:
Your auto dealer gives you the choice to pay $15,500
cash now, or make three payments: $8,000 now and
$4,000 at the end of the following two years.
If your investment has a rate of return of 8%, which do
you prefer?

33
 Multiple Cash Flows
• Problem definition
– Option 1: $15,500 today

– Option 2: $8,000 today; $4,000 at the end of one

year; and $4,000 at the end of two years

Cash flows can be compared only at the same point

in time. Thus, we need to find the PV of Option 2.

34
 Multiple Cash Flows
• PV of Option 2:
0 1 2
8% 8%

$8,000 $4,000 $4,000

$4,000/(1+0.08)=$3,703.70

$4,000/(1+0.08)2=$3,429.36
PV = $15,133.06

• PV of Option 1: $15,500.00
• Which option costs you less?
35
 Multiple Cash Flows
• In Example 9:
– First click “CF”:
CF0 = $8000
C01 = $4000
F01= 2 (frequency of C01)

– Then click “NPV”:

I= 8 % per year
NPV =??? (click “CPT”)

36