Lecture # 1 EFI-FIE1B

Chapters 4, 5, 8, 9, & 10;

Book: Fundamentals of Corporate Finance

(European edition) by David Hillier

Chapters 4 & 5

Lesson 1
Source Power Point Slides:
Fundamentals of corporate finance
(European edition) by David Hillier

Future value and compounding

Future value (FV) = the amount an investment is worth after

one or more periods ( page 75)

Compounding = the process of accumulating interest on an

investment over time to earn more interest ( page 76 )

Interest on interest = interest is earned on the reinvestment

of previous interest payments ( example 4.1 )

Compounded interest = interest earned on both the initial

principal and the interest reinvested from prior periods (
example 4.2 )

Simple interest= interest earned only on the original

principal amount invested.

Future value = 1 * (1+r)t

Example

Example (contd)

Three Rules of Time Travel

Financial decisions often require combining cash

flows or comparing values. Three rules govern these
processes.

The Three Rules of Time Travel

The 1st Rule of Time Travel

A dollar today and a dollar in one year are

not equivalent.

It is only possible to compare or combine

values at the same point in time.

Which would you prefer: A gift of $1,000

today or $1,210 at a later date?

To answer this, you will have to compare the

alternatives to decide which is worth more.
One factor to consider: How long is later?

The 2nd Rule of Time Travel

To move a cash flow forward in time, you

must compound it.

Suppose you have a choice between

receiving $1,000 today or $1,210 in two
years. You believe you can earn 10% on the
$1,000 today, but want to know what the
$1,000 will be worth in two years. The time
line looks like this:

The 2nd Rule of Time Travel

(contd)

Future Value of a Cash Flow

Example

Problem

Suppose you have a choice between

receiving $5,000 today or $10,000 in five
years. You believe you can earn 10% on the
$5,000 today, but want to know what the
$5,000 will be worth in five years.

Example (contd)

Solution

The time line looks like this:

1

$5,000

x 1.10

$5, 500

x 1.10

$6,050

x 1.10

$6,655

x 1.10

$7,321

x 1.10

$8,053

In five years, the $5,000 will grow to:

$5,000 (1.10)5 = $8,053

The future value of $5,000 at 10% for five years

is $8,053.

You would be better off forgoing the gift of $5,000 today and
taking the $10,000 in five years.

Present value and discounting

The 3rd Rule of Time Travel

To move a cash flow backward in time, we

must discount it.

Present Value of a Cash Flow

PV C (1 r )

(1 r )n

Example

Example

Alternative Example

Problem

Suppose you are offered an investment that

pays $10,000 in five years. If you expect to
earn a 10% return, what is the value of this
investment today?

Alternative Example

Solution

The $10,000 is worth:

$10,000 (1.10)5 = $6,209

Applying the Rules of Time Travel

Recall the 1st rule: It is only possible to

compare or combine values at the same
point in time. So far weve only looked at
comparing.

Suppose we plan to save $1000 today, and

$1000 at the end of each of the next two
years. If we can earn a fixed 10% interest
rate on our savings, how much will we have
three years from today?

Applying the Rules of Time Travel

The time line would look like this:

Applying the Rules of Time Travel

Applying the Rules of Time Travel

Applying the Rules of Time Travel

The Three Rules of Time Travel

Example

Example

Alternative Example

Problem

Assume that an investment will pay you $5,000

now and $10,000 in five years.

The time line would like this:

$5,000

$10,000

Alternative Example

Solution

You can calculate the present value of the combined

cash flows by adding their values today.
1

$5,000
$6,209
$11,209

1.105

$10,000

The present value of both cash flows is $11,209.

Alternative Example
Solution

You can calculate the future value of the

combined cash flows by adding their values
in Year 5.
1

$5,000

x 1.105

The future value of both cash flows is

$18,053.

$10,000
$8,053
$18,053

Alternative Example
Present
Value
0

$11,209

$11,209

$18,053

1.105

x 1.105

Future
Value
5

$18,053

Valuing a Stream of Cash Flows

Based on the first rule of time travel we

can derive a general formula for valuing a
stream of cash flows: if we want to find
the present value of a stream of cash
flows, we simply add up the present
values of each.

Valuing a Stream of Cash Flows

Present Value of a Cash Flow Stream

PV

PV (C )

n 0

n 0

Cn
(1 r )n

Example

Example

Example

Problem

What is the future value in three years of the

following cash flows if the compounding rate
is 5%?
0

$2,000

$2,000

$2,000

Example
1

Solution
$2,000

$2,315
x 1.05

x 1.05

x 1.05

$2,000

$2,205
x 1.05

x 1.05

$2,000
x 1.05

Or

$2,000

$2,000
$2,100
$4,100

$2,000

x 1.05

x 1.05

$2,100
$6,620
3

$4,305
$6,305
x 1.05

$6,620

Future Value of Cash Flow Stream

Future Value of a Cash Flow Stream with

a Present Value of PV

FVn PV (1 r )n

Calculating the Net Present Value

Calculating the NPV of future cash flows

allows us to evaluate an investment
decision.

Net Present Value compares the present

value of cash inflows (benefits) to the
present value of cash outflows (costs).

Example

Example

Example

Problem

Would you be willing to pay $5,000 for the

following stream of cash flows if the discount rate
is 7%?
0

$3,000

$2,000

$1,000

Example

Solution

The present value of the benefits is:

3000 / (1.05) + 2000 / (1.05)2 + 1000 / (1.05)3 =
5366.91

The present value of the cost is $5,000,

because it occurs now.

The NPV = PV(benefits) PV(cost)

= 5366.91 5000 = 366.91

Perpetuities and Annuities

Perpetuities

When a constant cash flow will occur at

regular intervals forever it is called a
perpetuity.

Perpetuities and Annuities

The value of a perpetuity is simply the

cash flow divided by the interest rate.

Present Value of a Perpetuity

C
PV (C in perpetuity)
r

Example

Example

Example

Problem

You want to endow a chair for a female

professor of finance at your alma mater.
Youd like to attract a prestigious faculty
member, so youd like the endowment to add
$100,000 per year to the faculty members
resources (salary, travel, databases, etc.) If
you expect to earn a rate of return of 4%
annually on the endowment, how much will
you need to donate to fund the chair?

Example

Solution

The timeline of the cash flows looks like this:

This is a perpetuity of $100,000 per year. The funding

you would need to give is the present value of that
perpetuity. From the formula:

You would need to donate $2.5 million to endow the

chair.
C $100,000
PV
$2,500,000
r
.04

Perpetuities and Annuities

Annuities

When a constant cash flow will occur at regular

intervals for a finite number of N periods, it is
called an annuity.

Present Value of an Annuity

N
C
C
C
C
C
PV

...

( 1 r ) ( 1 r )2 ( 1 r )3
( 1 r )N n1 ( 1 r )n

Present Value of an Annuity

To find a simpler formula, suppose you invest $100 in

a bank account paying 5% interest. As with the
perpetuity, suppose you withdraw the interest each
year. Instead of leaving the $100 in forever, you close
the account and withdraw the principal in 20 years.

Present Value of an Annuity

You have created a 20-year annuity of $5

per year, plus you will receive your $100
back in 20 years. So:

$100 PV(20 year annuity of $5 per year) PV($100 in 20 years)

Re-arranging terms:

PV(20 year annuity of $5 per year) $100 PV($100 in 20 years)

100

100
$62.31
20
(1.05)

Present Value of an Annuity

For the general formula, substitute P for

the principal value and:
PV(annuity of Cfor N periods)
P PV(Pin period N)

P
1
P
P 1
N
N
(1 r)
(1

r)

Example

Example

Future Value of an Annuity

Future Value of an Annuity

FV (annuity) PV (1 r ) N
C
1

1
N
r
(1 r )
1
N
C
(1 r )

(1

r
)

Example

Example

Growing Cash Flows

Growing Perpetuity

Assume you expect the amount of your

perpetual payment to increase at a constant
rate, g.

Present Value of a Growing Perpetuity

C
PV (growing perpetuity)
r g

Textbook Example 4.10

Example

Alternative Example

Problem

In Alternative Example 4.7, you planned to

donate money to endow a chair at your alma
mater to supplement the salary of a qualified
individual by $100,000 per year. Given an
interest rate of 4% per year, the required
donation was $2.5 million. The University
has asked you to increase the donation to
account for the effect of inflation, which is
expected to be 2% per year. How much will
you need to donate to satisfy that request?

Alternative Example
The timeline of the cash flows looks like
this:

The cost of the endowment will start at $100,000, and

increase by 2% each year. This is a growing
perpetuity. From the formula:
PV

C $100,000

$5,000,000
r .04 .02

You would need to donate $5.0 million to endow the

chair.

Growing Cash Flows

Growing Annuity

The present value of a growing annuity with

the initial cash flow c, growth rate g, and
interest rate r is defined as:

Present Value of a Growing Annuity

1 g
1
1

PV C

(r g )
(1 r )

Example

Example

Alternative Example

Problem

You want to begin saving for your

retirement. You plan to contribute $12,000
to the account at the end of this year. You
anticipate you will be able to increase your
annual contributions by 3% each year for the
next 45 years. If your expected annual
return is 8%, how much do you expect to
have in your retirement account when you
retire in 45 years?

Alternative Example

Example

Example

Example

Example

Non-Annual Cash Flows

The same time value of money concepts

apply if the cash flows occur at intervals
other than annually.

The interest and number of periods must

be adjusted to reflect the new time period.

Example

Example

Solving for the Cash Payments

Sometimes we know the present value or

future value, but do not know one of the
variables we have previously been given
as an input.

Solving for the Cash Payments

For example, when you take out a loan

you may know the amount you would like
to borrow, but may not know the loan
payments that will be required to repay it.

Example

Example

The Internal Rate of Return

In some situations, you know the present

value and cash flows of an investment
opportunity but you do not know the
internal rate of return (IRR), the interest
rate that sets the net present value of the
cash flows equal to zero.

Example

Example

Example

Example

Solving for the Number of Periods

In addition to solving for cash flows or

the interest rate, we can solve for the
amount of time it will take a sum of
money to grow to a known value.

Example

Example

Chapters Quiz
1.

Can you compare or combine cash flows at

different times?

2.

How do you calculate the present value of a

cash flow stream?

3.

What benefit does a firm receive when it

accepts a project with a positive NPV?

4.

How do you calculate the present value of a

a.

Perpetuity?

b.

Annuity?

c.

Growing perpetuity?

d.

Growing annuity?