1

FUNDAMENTAL PRINCIPLES
FUNDAMENTAL PRINCIPLES
OF CORPORATE FINANCE
OF CORPORATE FINANCE
Topic #2
2
What is time value of money? (I)
What is time value of money? (I)

Most financial decisions involve costs and

benefits that are spread out over time

Time value of money allows comparison of cash

flows from different periods

Usin T!M we can offer answers to "uestions

such as#
$Would it be better for a company to invest
%1&&'&&& in a product that would return a total of
%2&&'&&& in one year' or one that would return
%(&&'&&& after two years?)
*
What is time value of money? (II)
What is time value of money? (II)

T!M concept
T!M concept
# + dollar today is worth more than a
# + dollar today is worth more than a
dollar tomorrow
dollar tomorrow
due to#
due to#

Time means means real interest rate real interest rate and and inflation inflation

,is-

.! .resent !alue' that is' the value today/

0! 0uture !alue' or the value at a future date/

$t) the number of time periods between .! and 0!

$r) the discount rate

.! .! 0! 0!
& 1 2 * t
1
0uture values and compoundin
0uture values and compoundin

2ou deposit %1&& today at 1&3 interest/ 4ow much

will you have in ( years?
you are interested in findin the 0! for five years of
the %1&& today (5.!)
0!(%1&&' 1&3' (y) 5 %1&& (1/1)
(
5 %161/&(
0!
t'r
5 .! 7 (18r)
t
0uture value factor (0!0)
(
9imple interest vs/ compound interest
9imple interest vs/ compound interest

:rowth of %1&&
oriinal amount at
1&3 per year

;ar-er shaded area

represents the
portion of the total
that results from
compoundin of
interest/
6
9imple versus compound interest
9imple versus compound interest
2ou have <ust won a %1 million <ac-pot in the
lottery/

2ou can buy a ten year certificate of deposit

which pays 63 compounded annually/

+lternatively' you can ive the %1 million to

your brother=in=law' who promises to pay you
63 simple interest annually over the ten year
period/
Which alternative will provide you with more
money at the end of ten years?
>
The power of compoundin
The power of compoundin
?
.resent values and discountin
.resent values and discountin

The process of obtainin the .! is the inverse of

the one which ives the 0!

9uppose you need %2&'&&& in three years to pay

your collee tuition/ If you can earn ?3 on your
money' how much do you need today?
.! 5 %2&'&&& 1@(1/&?)
*
5 %1('?>6/61
.!
t'r
5 0! 1@(18r)
t
;iscount factor or .resent value factor (.!0)
A
The power of discountin
The power of discountin
1&
The case of multiple cash flows
The case of multiple cash flows

0! of a set of cash flows is the sum of 0!s for

the individual cash flows
11
The case of multiple cash flows
The case of multiple cash flows

.! of a set of cash flows is the sum of .!s for

the individual cash flows
12
+ shortcut = perpetuities
+ shortcut = perpetuities

.erpetuity
.erpetuity 5 financial concept in which a
cash flow is received forever

B7ample
B7ample# 9uppose you receive %1'&&& per year
forever/ 2our opportunity rate is 63/ What is the
value today of this set of cash flows?
r
C
r
flow Cash
ity) .!(perpetu
%16'666/66
&/&6
%1'&&&
ity) .!(perpetu
1*
:rowin perpetuities
:rowin perpetuities

Imaine an apartment buildin where cash flows to

the landlord after e7penses will be %1&&'&&& ne7t
year/ These cash flows are e7pected to rise at (3
p/a/ and the discount rate is 1&3/

If this continues indefinitely

growing perpetuity
growing perpetuity
= r
C
) perpetuity .!(rowin
2'&&&'&&&
&/&( &/1=
1&&'&&&
) perpetuity .!(rowin
11
0ew points concernin rowin perpetuities
0ew points concernin rowin perpetuities
1/ The numerator (C) is the cash flow one
period hence' not at date &
2/ The discount rate (r) must be reater than
the rowth rate for the formula to wor-
*/ Timin assumption formula assumes cash
flows are received and disbursed at reular
and discrete points in time
1(
+ shortcut = annuities
+ shortcut = annuities

+nnuity
+nnuity 5 a stream of reular payments that lasts for a
fi7ed number of periods

The payments are assumed to be received at the end

of each period

+ ood e7ample of an annuity is a lottery' where the

winner is paid over a number of years
PV(annuity) A
1
r

1
r(1+ r)
n

1
]
1
A PVAF(r,n)
FV(annuity) A
(1+r)
n
r

1
r

1
]
1
AFVAF(r,n)
16
Calculatin .! of an annuity
Calculatin .! of an annuity

9uppose you need %('&&& each year for the

ne7t three years to ma-e your tuition
payments/ 2ou need the first %('&&& in one
year/ 2ou can place money in a savins
account yieldin (3 compounded annually/
4ow much do you need to have in the
account today?
Calculatin .! of an annuity
Calculatin .! of an annuity
1>
PV(5,000; 3y; 5%) 5,000
1
0.05

1
0.05(1.05)
3

1
]
1
5,0002.7232 13,616
Calculatin 0! of an annuity
Calculatin 0! of an annuity

+ssume you deposit %2'&&& per year in a

savins account at 13 p/a/' compounded
annually' for ( years/ The first payment is
made one year from now/ 4ow much money
will you have in the account after ( years?
1?
Calculatin 0! of an annuity
Calculatin 0! of an annuity
1A
FV(2,000; 5y; 4%) 2,000
(1.04)
5
0.04

1
0.04

1
]
1
2,0005.416310,832.6
+nnuity duration
+nnuity duration

+ssumin that you owe %2'&&& to your ban-'

and the interest rate re"uired is 23 per
month/ If you can ma-e monthly payments of
%(&' how lon will it ta-e you to pay the debt/
2&
+nnuity duration
+nnuity duration
21
2,000 50
1
0.02

1
0.021.02
n

1
]
1
5.0 1.02
n
n 81.3 months 6.78 yars
+nnuity value
+nnuity value

2ou would li-e to have %*'&&& in a savins

account 12 months from now/ If this account
pays an annual interest rate of A3'
compounded monthly/ 4ow much should you
deposit monthly in order to reach your oal?
22
+nnuity value
+nnuity value
2*
3,000 A
(1.0075)
12
0.0075

1
0.0075

1
]
1
A 3,000 12.5075 23!.85
:rowin annuities
:rowin annuities

2ou have <ust been hired by a company that

offers an annual wae of %(&'&&&/ 2our
contract states that you annual wae will
increase by (3 annually/

9uppose you intend to wor- for this company

for 1& years' what is the current present
value of your wae' considerin ?3 the
appropriate annual discount rate?
21
:rowin annuities
:rowin annuities
2(
PV("ro#in" annuity) A
1
r$"

1
r "

1+ "
1+ r

_
,

1
]
1
1
FV("ro#in" annuity) A
1+ r
( )
n
1+ g
( )
n
r$"

1
]
1
1
:rowin annuities
:rowin annuities
26
PV(10y; 8%; 5%) 50,000
1
0.08$0.05

1
0.08 0.05

1+ 0.05
1+ 0.08

_
,

10

1
]
1
1
40!,177.6!
Using Annuities
Using Annuities

;elayed annuities

9pecial (advanced) annuities

Infre"uent annuities

B"ualin the .! of two annuities

Doan amortiEation

!aluin bonds
2>
Delayed annuities
Delayed annuities

Fohn will receive %(&& annually for four

years' startin with the end of the si7th year/
What is the current present value of these
payments' at 1&3 annual discount rate?
2?
Delayed annuities
Delayed annuities
.! (annuity' today) 5 %A?1/1*
& 1 2 * 1& ( 6 > ? A 1
%(&& %(&& %(&& %(&&
.! (annuity' 1y)5 %1'(?1/**
9pecial annuity
9pecial annuity

+ndy <ust won the lottery and is oin to

receive %(&'&&& annually for 2& years/ The
receives the first payment today/

The lottery announced the winnin of

%1'&&&'&&& (%(&'&&&72&5 %1/&&&/&&&)/

If the annual interest rate +ndy can et to his

savins account is ?3' what is the actual
value of his winnins?
*&
9pecial annuity
9pecial annuity

The previous formulae of annuities (FV

and PV) assume the the first payment is
one period from the present
ANNUITY IN A!A"

If the first payment is made today

ADVAN#!D ANNUITY
*1
PV(annuity) 1+ r
( )
A
1
r

1
r(1+ r)
n

1
]
1
1+ r
( )
A PVAF(r,n)
FV(annuity) 1+r
( )
A
(1+r)
n
r

1
r

1
]
1
1+r
( )
AFVAF(r,n)
9pecial annuity
9pecial annuity
*2
PV 50,000 + 50,000 PVAF(1!;8%) %530,180
+ndyGs lottery priEe
Infre$uent annuities
Infre$uent annuities

Maria receives %(&& every two years/ This

annuity will be paid to her throuhout 1&
years/ The first payment is made two years
from now/ What is the present value of these
payments' considerin 1&3 annual discount
rate?
**
Infre$uent annuities
Infre$uent annuities
.!(%(&&' 213' ( periods) 5%1'162/AA
Two years disount rate 5 1/1 1/1 = 1 5 21/&3
& 1 2 * 1& ( 6 > ? A 1
%(&& %(&& %(&& %(&& %(&&
1&3 1&3 1&3 1&3
HHHHHHHHHHHHHHHHH/
0irst determine the discount rate for two consecutive
payments
!$ualing the PV of t%o annuities
!$ualing the PV of t%o annuities

Mi-e and Daura want to start savin for their

new born son education/ They estimate
spendin %*&'&&& per year when their son
beins university studies 1? years from now/

The annual interest rate is estimated at 113

for the ne7t decades/ What is the amount
they should deposit each year for 1> years in
order to be able to finance their sonGs four
years collee education?
*(
!$ualing the PV of t%o annuities
!$ualing the PV of t%o annuities
&'
& 1 2 21 1> 1? 1A 2&
;eposit
1
Dast
deposit
9pendin

%*&'&&&
;eposit
2
.! today (.!
1>
' 113' 1> years) 5A'122/A1
.!
1>
of spendins .! studies today
+nnual deposit 5 1'1>?/(A
5
113
9pendin

%*&'&&&
9pendin

%*&'&&&
9pendin

%*&'&&&
(oan amorti)ation
(oan amorti)ation

,osie borrowed %6'&&&' at 1&3 annual

interest rate' for four years/ +t the end of
each of the followin four years she will ma-e
e"ual payments so as the loan will be
completely amortised in four years/

4ow much is ,osie oin to pay each year?

*>
(oan amorti)ation
(oan amorti)ation
*?
6, 000 AnnualPayment PVAF(4;10%)
AnnualPayment %1, 8!2.74
!aluin bonds
!aluin bonds

If today is ;ec/ 1
st
2&1*' what is the price of the
followin bond?

IIM bond that pays an annual coupon rate of 11/(3

(annual coupon %11() for ( years/ In 2&1? the bond will
also pay the nominal value %1'&&&/

InvestorsG re"uired return is currently at >/(3 annually/

*A
PV
115
1.075
+
115
1.075
2
+... +
115
1.075
5
+
1000
1.075
5
%1,161.84
PV annuity (*++,- , years- ./,0)
PV (1urrent pri1e)
Valuing 2onds
Valuing 2onds

ephrasing3 if the 1urrent pri1e of the

I45 2ond is *+-+'6/76- %hat is
investors8 1urrent return9
6:
1,161.84
115
(1+r)
+
115
(1+r)
2
+... +
115
(1+r)
5
+
1,000
(1+r)
5
r 7.5%
YI!(D T; 5ATUITY (YT5)
<
#oupon rate = YT5 premium 2ond
<
#oupon rate > YT5 discount 2ond
<
#oupon rate ? YT5 2ond at par
11
Compoundin more fre"uently than annually
Compoundin more fre"uently than annually

Compounding more frequently than annually

results in a higher effective interest rate because
you are earning interest on interest more
frequently

+s a result' the effective interest rate is reater

than then the nominal (annual) interest rate

The effective rate of interest will increase the

more frequently interest is compounded
12
Compoundin more fre"uently than annually
Compoundin more fre"uently than annually

What would be the difference in future value if you

deposit %1&& for ( years and earn 123 annual
interest compounded (a) annually' (b)
semiannually' (c) "uarterly' and (d) monthly?
+nnually 1&& 7 (1 8 &/12@1)
51
5 %1>6/2*
9emiannually 1&& 7 (1 8 &/12@2)
52
5
%1>A/&A
Juarterly 1&& 7 (1 8 &/12@1)
54
5 %1?&/61
Monthly 1&& 7 (1 8 &/12@12)
512
5 %1?1/6>
1*
Kominal and effective rates
Kominal and effective rates

The
nominal interest rate
nominal interest rate (sometimes denoted
+., L from
annual percentae rate
annual percentae rate) is the
stated or contractual rate of interest chared by
a lender or promised by a borrower (r)

The
effective annual rate
effective annual rate
(B+,)
(B+,) is the rate you
actually pay or earn

B+, M +., whenever compoundin occurs

more than once per year
1
m
r
1 B+,
m

1
]
1

,
_

+
11
Kominal and effective rates
Kominal and effective rates

What is the B+, on your credit card if the

nominal rate is 1?3 p/a/' compounded
monthly?

+nswer#
B+, 5 (1 8 &/1?@12)
12
L 1 5 1A/(63

What if compounded "uarterly?

+nswer#
B+, 5 (18 &/1?@1)
1
L 1 5 1A/2(3
1(
Compoundin periods' +.,s and B+,s
Compoundin periods' +.,s and B+,s
Compoundin Compoundin
period period
Kumber of times Kumber of times
compounded compounded
Bffective annual Bffective annual
rate (3) rate (3)
2ear 1 1&/&&&&&&
Juarter 1 1&/*?12?A
Month 12 1&/1>1*&>
Wee- (2 1&/(&61>A
;ay *6( 1&/(1((>?
4our ?'>6& 1&/(1>&2A
Minute
9econd
(2('6&&
*1'(*6'&&&
1&/(1>&A1
1&/(1>&A2
16
Continuous compoundin
Continuous compoundin

The number of compoundin periods per year

approaches infinity

The 0! e"uation becomes#

What is the future value of a %1&& deposit after (

years if interest of 123 is compounded
continuously?
0!(('12) 5 %1&& e
&/12(
5 %1?2/22
2/>1?*
0!(t'r) 5 .! e
rt