Introduction to

Corporate Finance
Pre-Class Material

Copyright Investment Banking Institute

www.ibtraining.com

Table of Contents
I. Time Value of Money
II. Discounted Cash Flow Applications
III. Cost of Capital
IV. Business and Industry Cycles

Time Value of Money

Money deposited in a bank account will earn interest income,
so most people prefer to receive money today rather than the
same amount in the future this concept is referred to as
present discounted value
The required rate of return (aka discount rate) on an
investment is determined by three main factors

Discount Rate = Risk Free Rate + Inflation Premium + Risk

Premium
Risk-Free Rate: the rate earned on a risk-less investment (U.S.
Treasury Note)
Inflation Premium: required return to account for rise in general level
of prices for goods and services (purchasing power falls)
Risk Premium: required return for being exposed to various types of
investment risk

higher risk = higher risk premium; lower risk = lower risk premium

Present Value
Present Value is todays value of a cash flow that will be
received in the future

PV = FV
(1 + r)

PV = Present Value
FV = Future Value
r = Discount Rate
N = # of years

Example:
Given a 10% discount rate, calculate the present value of a $100
cash flow that will be received in 3 years
PV = $100
= $75.13
(1+.10) 3

Future Value
Future Value is the amount to which a current cash flow will
grow over a specific period of time at a specific interest rate

FV = PV x (1 + i) N
PV = Present Value
FV = Future Value
i = interest rate
N = # of years

Example:
Calculate the FV of a $250 investment at the end of 5 years if it
earns an annual interest rate of 8%
FV = $250 x (1+.08)5 = $367.33

Perpetuity
Perpetuity is a constant stream of identical cash flows over an
infinite period of time. The formula for determining the
present value of a perpetuity is as follows

PV =

CF + CF + CF + .. = CF
(1+r)1 (1+r)2 (1+r)3
r

PV = Present Value
CF = Cash Flow
r = Discount Rate

British console bonds and most preferred stocks are examples

of perpetuities
Example:
Assume that IBMs preferred stock pays annual dividend of $5.00
and plans to continue this policy forever. Given an 8% discount
rate, what is the value of IBM preferred stock?
PV = $5.00 / 8% = $62.50

PV and FV of Uneven Cash Flow Series

It is common to evaluate cash flows streams that are not equal
from period to period
0

$0

$100

$500

$0

$300

Example
Calculate the present and future values given a 10% discount rate:
PV =
$0 + $100
+ $500 + $0 + $300 = $709.03
(1+.10)0 (1+.10)1
(1+.10)2 (1+.10)3 (1+.10)4

FV = ($0 x 1.14) + ($100 x 1.13) + ($500 x 1.12) + ($0 x 1.11) +

($300 x 1.10) = $1,038.10
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Table of Contents
I. Time Value of Money
II. Discounted Cash Flow Applications
III. Cost of Capital
IV. Business and Industry Cycles

Introduction to Capital Budgeting

Capital budgeting is a process to determine and select
profitable projects/investments that will add value to the
company
Replacement of equipment
Develop new products
Market expansion
Mandatory investments

There are several main analyses that are used for the capital
budgeting process:
Payback period
Discounted payback method
Net Present Value

Payback Period
Payback period (PBP) is the # of years it takes to recover the
initial cost of an investment

Cumulative Net Cash Flow (NCF) is the running total of the cash
flows at the end of each time period

PBP = Full years until recovery + (unrecovered cost at the

beginning of the last year / cash flow during the last year)
Example:

Compute the payback period using the cash flows below

Year

Project

NCF

-$500

-$500

200

-300

250

-50

200

150

PBP = 2 + 50 = 2.25 years

200

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Discounted Payback Period

Discounted PBP discounts the projects cash flows by the
projects discount rate

Cumulative Discounted Net Cash Flow (DNCF) is the running total

of the present value cash flows at the end of each time period

It is the # of years it takes to return its initial investment in

present value terms
Example:

Given a 10% discount rate, compute the payback period using the
cash flows below.

Year

Project

DNCF

Cum DNCF

-$500

-$500

-$500

200

182

-318

250

207

-111

200

150

38

DPBP = 2 + 112 = 2.75 yrs

150

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Net Present Value

Net Present Value (NPV) is the present value of expected cash
inflows associated with an investment / project
NPV compares the value of todays dollar to the value of that
same dollar in the future, taking inflation and required returns
into account

NPV is the present value of the cash flows less the initial outlay at
time 0

Ct = expected net cash flow at time t

N = estimated life of investment
r = discount rate

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Net Present Value (Contd)

Example

Calculate the NPV of an investment project with an initial cost of

$65,000, positive cash flows of $25,000 at the end of year 1,
$50,000 at the end of year 2, and $75,000 at the end of year 3.
Use as 15% discount rate

NPV = -$65,000 + $25,000 + $50,000 + $75,000 = $43,860

(1+.15)1 (1+.15)2 (1+.15)3

Since this has a positive NPV, the project should be accepted

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Internal Rate of Return

Internal Rate or Return (IRR) is the rate of return that equates
the PV of an investments benefits (positive cash flows) with
the PV of its costs (negative cash flows)
IRR makes the net present value of all cash flows from a
particular project equal to zero (IRR = NPV = 0)
It is the r in the NPV formula

Generally speaking, the higher a project's internal rate of

return, the more desirable it is to undertake the project
As such, IRR can be used to rank several prospective projects a
firm is considering (note that the size of the project is similar)
0 = C0 + C1 + C2 + . + C3
(1+IRR) (1+IRR)2
(1+IRR)3
There is no formula that will manually solve the IRR besides a trial
and error basis. However, calculator or a computer will do it
easily

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NPV and IRR Decision Rule

NPV Decision Rule
Accept projects/investments with a positive NPV it will increase
shareholder wealth
Reject projects with negative NPV it will decrease shareholder
wealth

IRR Decision Rule

Accept projects with an IRR that its greater than the
firm/investors required rate of return (aka hurdle rate)
Reject projects with an IRR that is less than the firm/investors
required rate of return (aka hurdle rate)

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Table of Contents
I. Time Value of Money
II. Discounted Cash Flow Applications
III. Cost of Capital
IV. Business and Industry Cycles

16

Cost of Capital
Companies raise capital to fund their business or finance their
growth
On the right side of a firms balance sheet, there are (i) debt,
(ii) preferred stock and (iii) common equity
These items are commonly referred to as capital components and
they are used to finance the companys total assets (right side of
the balance sheet)
Increase in companys total assets need to be financed through an
increase in one of the capital components

Many capital investments/project analyses which involve

discounting cash flows require calculating the correct discount
rate (aka cost of capital or Weighted Average Cost of Capital
(WACC))
WACC to be discussed in detail during the training course
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Cost of Debt
Cost of Debt (kd)

The interest rate that the company will pay to a lender for
borrowing cash
This is referred to as the before-tax cost of debt
After-tax Cost of Debt (kd (1-t)) since interest expense is tax
deductible, the true cost of debt has to be adjusted by the tax shield
t = tax rate; tax shield is the benefit gained from a lower tax bill due
to interest expense

Example
ABC Company is planning to issue new debt at an interest rate of
10% and ABC has a 38% marginal federal-plus-state tax rate. What
is ABCs after-tax cost of debt?
kd * (1-t) = 10% * (1-.38) = 6.2%

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Cost of Preferred
Cost of Preferred (Kps)

Companys dividend % rate upon issuance of new preferred stock

Kps = Dps / Pnet
Dps = preferred dividends per share
Pnet= issuing preferred price per share

Example
Loral Corp. recently issued a new preferred stock that pays $5.00
in dividends per share and the preferred stock was sold for $50.00
per share. What was Lorals cost of preferred stock?
Kps = $5.00 = 10%
$50.00

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Cost of Equity
Cost of Equity
Returns that new equity investors require upon purchase of a
companys stock
In order to calculate cost of equity, use the CAPM model
CAPM = Rf + x (RM Rf)

Rf = risk-free rate (10, 20 or 30 year treasury notes)

RM = market rate (Expected return of the market portfolio)
= Sensitivity of the stock to the market portfolio

Example
Currently, the 10 year treasury is yielding 4.5% and the expected
market rate is 11.5%. Calculate IBMs cost of equity given a
company beta of 1.2
Cost of Equity = 4.5% + 1.2(11.5% - 4.5%) = 12.9%

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Table of Contents
I. Time Value of Money
II. Discounted Cash Flow Applications
III. Cost of Capital
IV. Business and Industry Cycles

21

Business Cycle
Business Cycle is characterized by recurring and fluctuating
levels of economic activity that an economy experiences over
a long period of time

Business cycles are known to be irregular - varying in frequency,

magnitude and duration

The business cycle can be separated into 5 stages:

Recovery economy shows early signs that the recession is ending

Early Expansion recovery takes hold and the momentum of the
recovery increases
Late Expansion - recovery has continued and confidence and
momentum are high
Peak Point between the end of an economic expansion and the
start of a recession
Recession / Contraction - significant decline in economic activity
spread across the economy, lasting longer than a few months
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Industry Life Cycle

Industry Life Cycle is a process that brings a new product into
existence and follows its growth into a mature product and
into eventual critical mass and decline

Product Development includes market analysis, product design,

invention and testing
Market Introduction initial release of the product and usually
followed by high levels of advertisement
Rapid Growth sales growth accelerates with increasing sales
year over year
Maturity Phase the sales growth rate approach the average
growth rate of the economy
Decline - demand will slowly decline as newer inventions make it
obsolete

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