Corporate Finance
Lecture 1
Corporate Finance
Lecture 1 :
Concept of Time Value of Money
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Concept of Time Value of Money
! Why does $ has time value?
! Money is capable of earning return
! Money has the same value at the same time reference
Nominal Cash Flows Vs Time Value of Nominal Cash
Flows
! A $ today is worth more than a $ tomorrow
! Pre-requisite information for time value of money applications
! Direction (Inflows or Outflows) & Magnitude (How
much?) of cash flows
! Timing of cash flows
! Discount rate : Opportunity cost of capital or Required rate
of return
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Corporate Finance
Lecture 1
Time Value Terminologies & Symbols
Symbol
Description
DCF
Discounted cash flow
PMT
Equal payments or receipts with annuities
CFt
Cash flow occurring at end of period t
PV
Present value
FVn
Future value at the end of period n
PVAn
Present value of an annuity with n equal payments
or receipts
FVAn
Future value of an annuity with n equal payments
or receipts
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Time Value Terminologies & Symbols
Symbol
Description
i or I
Interest rate (or Discount rate)
n or N
Number of time periods
Reference period (e.g., t = 1, t = 2, etc.)
FVIFi,n
Future value interest factor
PVIFi,n
Present value interest factor
FVIFAi,n Future value interest factor for an annuity
PVIFAi,n Present value interest factor for an annuity
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Corporate Finance
Lecture 1
Time Value of Money Solution Methods
For the purpose of UOL, there are 2 possible methods to
solve for Time of Money problems as financial
calculator are not permitted for use in exam
I. Numerical using regular calculator without financial
functions BUT must know how to solve for the power of
n (positive & negative)
II. Interest Tables contained at Tables A-1, A-2, A-3 &
A-4 provided as handouts
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Time Line Conventions & Illustrations
! Each number represents the end of the respective periods
! Cash inflows are represented by positive numbers
! Cash outflows are represented by negative numbers
Time line for a lump sum of $100 to be received at the end of
Year 2 :
0
i%
Year
100 Cash Flow
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Corporate Finance
Lecture 1
Time Line Conventions & Illustrations
Time line for a 3-year annuity of $100 :
0
i%
100
100
100
Time line for an uneven cash flow stream of -$50 in Year 0,
$100 in Year 1, $75 in Year 2, and $50 in Year 3 :
0
i%
-50
100
75
50
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Future Value (Compounding)
Find the FV of $100 invested for 3 years in an account paying
10% p.a. interest :
0
10% p.a.
3
FV=?
(100)
FVn = PV(1+i)n
= PV(FVIFi,n)
3
= $100 (1.10)
= $100 (FVIF10%,3)
= $100 (1.3310) = $133.10
See Table A-1
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Corporate Finance
Lecture 1
Present Value (Discounting)
Find the PV of $100 to be received in 3 years if the appropriate
rate of return is 10% p.a.:
0
10% p.a. 1
100
PV = ?
PV = FVn / (1+i)n
= FVn (l+i)-n
= $100 (1.10)-3
= $100(0.7513)
= FVn(PVIFi,n)
= $100 (PVIF10%,3)
= $75.13
See Table A-2
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Solving for n in TVM Problems
How long will it take a firms sales to double, if sales are
growing at a 20% p.a.?
0
N=?
(1)
FVn = PV(1+i)n
$2 = $1(1.20)n
$2 = (1.20)n
Look in Table A-1 for FVIF20%,n = 2 n 4 periods
Note : The PV equation could be used to solve this problem too
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Corporate Finance
Lecture 1
Solving for i in TVM Problems
What growth rate does a firm need to achieve if it is to triple its
sales in 6 years?
0
i% p.a.?
N=6
3
(1)
FVn = PV(1+i)n
$3 = $1(1+i)6
$3 = (1+i)6
Look in Table A-1 for FVIFi,6 = 3 i 20% p.a.
Note : The PV equation could be used to solve this problem too
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Types of Multiple Cash Flows
Even Cash Flows
! Annuities
! Perpetuities
Uneven Cash Flows
! Multiple Single Unequal Cash Flows
! Recognising Annuities / Perpetuities within a series of cash
flows
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Corporate Finance
Lecture 1
Annuities
! Definition
Finite series of equal payments or receipts over regular
intervals
! Ordinary annuity
Equal payments or receipts occur at the end of each period
0 i% p.a.
PV
100
100
100
FV
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Annuities
! Annuity due
Equal payments or receipts occur at the beginning of each
period
0 i% p.a. 1
100
100
2
100
3
FV
PV
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Corporate Finance
Lecture 1
Future Value of an Ordinary Annuity
What will an investment of $100 p.a. for 3 years accumulate to if
the expected rate of return is 10% p.a.?
Time Line Approach :
0
10% p.a. 1
100 x 1.1
100
x
1.12
3
100
110
121
$331
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Future Value of an Ordinary Annuity
! Additive Principle
! Future Value of a Series of Cash Flows = Aggregate
Future Values of each Cash Flow in the Series
! If the series of cash flows is even then a simplified
mathematical formula can be derived with the use of the
concept of Arithmetic Progression series
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Corporate Finance
Lecture 1
Future Value of an Ordinary Annuity
Numerical Approach :
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Future Value of an Ordinary Annuity
Interest Table Approach :
FVAn = PMT (FVIFAi,n)
= $100 (FVIFA10%,3)
= $100 (3.3100)
= $331 Table A-4 contains FVIFAi,n factors
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Corporate Finance
Lecture 1
Present Value of an Ordinary Annuity
What is the value of an investment that provides an income of
$100 p.a. for 3 years if the required return is 10% p.a.?
Time Line Approach :
0
$ 90.91
82.64
75.13
$248.68
10% p.a. 1
1.1-1 100
100
100
1.1-2
1.1-3
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Present Value of an Ordinary Annuity
! Additive Principle
! Present Value of a Series of Cash Flows = Aggregate
Present Values of each Cash Flow in the Series
! If the series of cash flows is even then a simplified
mathematical formula can be derived with the use of the
concept of Arithmetic Progression series
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Corporate Finance
Lecture 1
Present Value of an Ordinary Annuity
Numerical Approach
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Present Value of an Ordinary Annuity
Interest Table Approach :
PVA
= PMT (PVIFAi,n)
= $100 (PVIFA10%,3)
= $100 (2.4869)
= $248.69 Table A-3 contains PVIFAi,n factors
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Corporate Finance
Lecture 1
Perpetuities
! Infinite series of equal payments or receipts over regular
intervals
0
100
100
100
! Since perpetuities are infinite series, it is only possible to
determine the PV
If i = 10% p.a., then PV of the perpetuity is
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Perpetuities
! To derive the formula, lets revisit the PV of an annuity
For very large n -> (1 + i)n becomes infinity as long as i > 0
&
tends to 0 & therefore
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Corporate Finance
Lecture 1
Growing Perpetuities
! If the payments or receipts are not equal but they grow by a
constant rate g such that
PMT
0
!
PMT(1+g) PMT(1+g) 2
PMT1 = PMT, PMT2 = PMT(1+g)1, PMT3 = PMT(1+g)2,
, PMTn = PMT(1+g)n-1,
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Uneven Cash Flow Stream
0
0
$ 90.91
247.93
225.39
(34.15)
$ 530.08
1.1-1
100
300
300
-50
1.1-2
1.1-3
1.1-4
0
$ 90.91
473.32
(34.15)
$ 530.08
10% p.a.
10% p.a.
100
300
300
-50
$520.65
$300 (1.7355)
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