B6005 Lecture 1 Overview and TVM Handout

B6005
Financial Management
Lecture 1
Time Value of Money
2 B6005 Dr. Siri Chutikamoltham
What is Finance?
Applications of financial and economic principles to
maximize shareholder value.
Main goals of a finance manager:
To maximize shareholder value = Max stock price
To ensure the company does not run out of cash
To max shareholder value, should firms behave
ethically?

Do firms have any responsibilities to society at large?

Is maximizing stock price good for society?,

Is maximizing stock price good for
employees, and customers?

The Three Basic Business Decisions
Investment Financing
Operations
The Process of Value Creation
Selecting and making
sound resource
commitments
Selecting and sourcing
prudent funding options
Operating resources in
a competitive, cost-
effective manner
Economic and Competitive Environment
Data Sources
Analytical framework and tools
Overall Results and Value
Creation
Investment
Effectiveness
Financing
Effectiveness
Operational
Effectiveness
8
MBA 6230
Dr. Siri Chuikamoltham
Returns
Net incremental CFs
+ Side effects
Discount Rate
WACC
K
d
YTM
K
e
CAPM
Tools
NPV
IRR
PB
Mod PB
PI
Mod IRR
Investment Decision
+ NPV projects
IRR > discount rate
Financing Decision
Use D/E that maximizes
project value and matches
the assets being financed
Financing Mix
Debt interest tax
shield, fin. distress
IPO
Seasoned equity
Derivatives
Financing Type
Liabilities match assets
Duration
Currency
Interest Rate
Business Risk
Maximize
Shareholder
Value
Dividend Decision
Return cash to shareholders
if there are not enough + NPV
projects
How Much?
Residual cash
Shareholder preferences
Signaling
What Form?
Cash dividends
Stock repurchase
What will this course teach you
to max shareholder value?
What determines a firms fundamental, or
intrinsic, value?
Intrinsic value is the sum of all the future expected
free cash flows when converted into todays dollars.
FCF = Free Cash Flows, WACC = weighted average
cost of capital

Value =
FCF
1
FCF
2
FCF

(1 + WACC)
1
(1 + WACC)

(1 + WACC)
2
+ +
Free Cash Flows (FCF)
Free cash flows are the cash flows that are available (or
free) for distribution to all investors (stockholders and
creditors).
FCF = (sales revenues - operating costs - operating
taxes ) - required investments in operating capital.
FCF = NOPAT required investments in net operating
capital.
NOPAT = net operating profit after tax

Weighted Average Cost of Capital
(WACC)

WACC = w
d
k
d
(1 - T) + w
ps
k
ps
+ w
e
k
e
debt: cost = k
d
preferred stock: cost = k
ps
equity: cost = k
e
Corporate tax rate = T
Weight of debt = w
d
Weight of preferred stock = w
ps

Weight of equity= w
e

Time Value of Money
Important Concepts
Time line
Lump sum
Annuity
Uneven cash flows (CF)
Present Value
Future
Net present value (NPV)

Compounding
Discounting
Nominal rate
Periodic rate
Effective rate
Amortization
Principle of Time Value of Money

A dollar received today is worth more than
a dollar received tomorrow.
Why?
CF
0
CF
1
CF
3
CF
2
0 1 2 3
i%
Tick marks at end of periods, so Time 0 is today; Time
1 is the end of Period 1; or the beginning of Period 2.
+CF = Cash inflow -CF = Cash outflow
Time lines show timing of cash flows.
Time line for a $100 lump sum due at the
end of Year 2
100
0 1 2 Year
i%
100 100 100
0 1 2 3
i%
Time line for an ordinary annuity of $100
for 3 years
Ordinary Annuity
PMT PMT PMT
0 1 2 3
i%
PMT PMT
0 1 2 3
i%
PMT
Annuity Due
PV FV
Ordinary Annuity v.s. Annuity Due
100 50 75
0 1 2 3
26.8%
-150
Time line for uneven CFs
-$50 now and $100, $75, and $50 at the end of
Years 1 through 3, at interest rate of 26.8% per
year
FV = ?
0 1 2 3
10%
Finding FVs (moving to the right on a time line) is called
compounding.
100
Future value of a lump sum
Whats the FV of an initial $100 after 3 years at
10% interest rate?
After 1 year:
FV
1
= PV + INT
1
= PV + PV (i)
= PV(1 + i)
= $100(1.10)
= $110.00.
After 2 years:
FV
2
= PV(1 + i)
2

= $100(1.10)
2

= $121.00.
Whats the FV of an initial $100 after 3
years at 10% interest rate?
After 3 years:
FV
3
= PV(1 + i)
3

= $100(1.10)
3

= $133.10.
In general,
FV
n
= PV(1 + i)
n

Whats the FV of an initial $100 after 3
years at 10% interest rate?
Four Ways to Find FVs
Solve the equation with a regular calculator
Use a financial calculator.
Use a spreadsheet.
Use a compounding/discounting table.
Solve this equation:
There are 4 variables. If 3 are known, the
calculator will solve for the 4th.
( ) FV PV i
n
n
= + 1 .
Equation and Regular Calculator Solution
3 10 -100 0
N I/YR PV PMT FV
133.10
Heres the setup to find FV:
Clearing automatically sets everything to 0, but for safety
enter PMT = 0.
Set: P/YR = 1, END.
INPUTS
OUTPUT
Financial Calculator Solution
Spreadsheet Solution for FV
Insert Function Financial FV OK
0.10 Rate
Nper
Pmt
PV
Type
3
-100
(must be % or decimal)
(leave blank)
(0 = end of period (default);
1 = beginning of period)
FV 133.10
Tabular Approach
Table: Future Value of $1 at the End of n
Periods
Source: Web/CD Extensions, Student Resource Disk, Chapter 2
Example: Tabular Approach
FV = PV x compounding factor
Compounding factor: Period 3, Interest rate 10% =
1.331
FV = 100 x 1.331 = $133.10

$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
0 2 4 6 8 10 12
F
u
t
u
r
e

V
a
l
u
e

o
f

$
1

Periods
Relationships among Future Value, Growth,
Interest Rate, and Time
Example 1
Find FV of an initial bank deposit of $1000, at an interest rate of
5%, the money remaining in the account for 10 years.

What is the FV if the interest rate increases to 7%?

What is the FV if the time increases to 12 years @interest 5%?
Relationship between FV, Interest rate and
Time
The longer the time, the .FV

The higher the interest rate, the .FV
20%
2
0 1 2 ?
-1
FV = PV(1 + i)
n

$2 = $1(1 + 0.20)
n

(1.2)
n
= $2/$1 = 2
nLN(1.2) = LN(2)
n = LN(2)/LN(1.2)
n = 0.693/0.182 = 3.8.
Rough estimate:
rule of 72
N = 72/i
A Common FV Application
Finding the Time to Double
10%
Present Value of a lump sum
Whats the PV of $100 due in 3 years if i = 10%?
Finding PVs is discounting, the reverse of compounding.
100
0 1 2 3
PV = ?
Whats the PV of $100 due in 3 years if i = 10%?
Equation Approach
Solve FV
n
= PV(1 + i )
n
for PV
( )
PV =
FV
1+i
= FV
1
1+i
n
n
n
n
|
\
|
.
|
( )
PV = $100
1
1.10

=

$100
0.7513
=
$75.13.
|
\

|
.
|
3

3 10 0 100
N I/YR PV

PMT FV
-75.13
Either PV or FV must be negative. Here PV = -75.13.
Put in $75.13 today, take out $100 after 3 years.
INPUTS
OUTPUT
Tabular Approach
Use Present Value Table to solve the
previous question

Spread Sheet Approach
Same as finding FV, but indicate
PV instead

20 -1 0 2
N I/YR PV PMT FV
3.8
INPUTS
OUTPUT
Financial Calculator
FV of an ordinary annuity
Whats the FV of a 3-year ordinary annuity of
$100 at 10%?
100 100 100
0 1 2 3
10%
110
121
FV = 331
3 10 0 -100

331.00
N I/YR PV PMT FV
Have payments but no lump sum PV, so enter 0 for
present value.
INPUTS
OUTPUT
Example 2
You invest $3,000 in a tax-exempt retirement account
every year for the next 35 years, with your first deposit
occurring 1 year from today. How much will you have
in the account if the annual return is 8%?

How much will you have in 10 years?
PV of an ordinary annuity
Whats the PV of this ordinary annuity?
100 100 100
0 1 2 3
10%
90.91
82.64
75.13
248.69 = PV
Have payments but no lump sum FV, so enter 0 for
future value.
3 10 100 0
N I/YR PV PMT FV
-248.69
INPUTS
OUTPUT
Whats the PV of this ordinary annuity?
A B C D
1 0 1 2 3
2 100 100 100
3 248.69
Excel Formula in cell A3:

=NPV (10%,B2:D2)
Spreadsheet Solution
Special Function for Annuities
For ordinary annuities, this formula in cell A3 gives
248.96:

=PV(10%,3,-100)

A similar function gives the future value of 331.00:

=FV(10%,3,-100)
FV and PV of an annuity due
100 100
0 1 2 3
10%
100
3 10 100 0

-273.55
N I/YR PV PMT FV
Switch from End to Begin.
Then enter variables to find PVA
3
= $273.55.
Then enter PV = 0 and press FV to find
FV = $364.10.
INPUTS
OUTPUT
Find the FV and PV if the
annuity were an annuity due.
Excel Function for Annuities Due
Change the formula to:

=PV(10%,3,-100,0,1)

The fourth term, 0, tells the function there are no other
cash flows. The fifth term tells the function that it is an
annuity due. A similar function gives the future value of
an annuity due:

=FV(10%,3,-100,0,1)

PV of an uneven cashflow
What is the PV of this uneven cash
flow stream?
0
100
1
300
2
300
3
10%
-50
4
90.91
247.93
225.39
-34.15
530.08 = PV
What is the PV of this uneven cash
flow stream?
Input in CFLO register:
CF
0
= 0
CF
1
= 100
CF
2
= 300
CF
3
= 300
CF
4
= -50
Enter I = 10%, then press NPV button to get NPV = 530.09.
(Here NPV = PV.)
Excel Formula in cell A3:

=NPV(10%,B2:E2)
A B C D E
1 0 1 2 3 4
2 100 300 300 -50
3 530.09
Spreadsheet Solution
Relationship between PV, Interest rate and
Time
The longer the time, the .. PV
The higher the interest rate, the PV
Implications:

0 1 2 3
10%
0 1 2 3
5%
4 5 6
134.01
100 133.10
1 2 3 0
100
Annually: FV
3
= $100(1.10)
3
= $133.10.
Semiannually: FV
6
= $100(1.05)
6
= $134.01.
Will the FV of a lump sum be larger or smaller if
the compounding more often, at a constant
interest rate?
3 different rates:
i
Nom
= nominal, or stated, or quoted, rate per year, the frequency
of compounding is usually given.
Examples:
8%; Quarterly
8%, Daily interest (365 days)
i
Per
= periodic rate = i
Nom
/m
m is number of compounding periods per year( m = 4 for
quarterly, 12 for monthly, and 360 or 365 for daily compounding.
Examples:
2% per quarter
8%/365 = 0.022 % per day
Must use EAR= EFF% = effective annual rate to compare.

Compounding Interest
Effective Annual Rate (EAR or EFF%)

The annual rate which causes PV to grow to the same
FV as under multi-period compounding.
Example: EFF% for 10%, semiannual:
FV = (1 + i
Nom
/m)
m

= (1.05)
2
= 1.1025.

EFF%

= 10.25% because (1.1025)
1
= 1.1025.

Any PV would grow to same FV at 10.25% annually or 10%
semiannually.
Used to compare returns on investments with different payments
per year

Or use a financial calculator.
EFF% = - 1
(1 + )
i
Nom

m
m
= - 1.0
(1 + )
0.10
2
2
= (1.05)
2
- 1.0
= 0.1025 = 10.25%.
How to find EFF% for a nominal rate of 10%,
compounded semiannually?
EAR = EFF% of 10%
EAR
Annual
=

EAR
Q
= (1 + 0.10/4)
4
- 1 =

EAR
M
= (1 + 0.10/12)
12
- 1 =

EAR
D(360)
= (1 + 0.10/360)
360
- 1 =
Self test: Example 3
A credit card balance, with interest calculated
monthly, at an annual rate of 18%. What is the
effective annual rate (EAR)?
EAR = (1 + i
nom/12
)
12
- 1
Example 4
FV of $100 after 3 years under 10% semiannual
compounding? Quarterly compounding?
= $100(1.05)
6
= $134.01.
FV
3Q
= $100(1.025)
12
= $134.49.
FV = PV 1 . +
i
m
n
Nom
mn
|
\

|
.
|
FV = $100 1 +
0.10
2
3S
2x3
|
\

|
.
|
Example 5
FV at the end of Year 3 of the following CF
stream if the quoted interest rate is 10%,
0 1
100
2 3
5%
4 5 6 6-mos.
periods
100 100
Payments occur annually, but compounding
occurs each 6 months.
So we cant use normal annuity valuation
techniques.
Example 5 (cont)
FV at the end of Year 3 of the following CF
stream if the quoted interest rate is 10%,
1st Method: Compound each CF using
periodic rate
0 1
100
2 3
5%
4 5 6
100 100.00
110.25
121.55
331.80
FVA
3
= $100(1.05)
4
+ $100(1.05)
2
+ $100
= $331.80.
2nd Method: Treat as an Annuity and
compound with EAR

1. Find the EAR for the quoted rate:
EAR = (1 + ) - 1 = 10.25%.
0.10
2
2
3 10.25 0 -100

INPUTS
OUTPUT
N I/YR PV FV PMT
331.80
2. Use EAR = 10.25% for the annual rate in your
calculator:
2nd Method: Treat as an Annuity
Self Test: Example 6
Fractional Time Periods
On January 1 you deposit $100 in an account that pays
a nominal interest rate of 11.33463%, with daily
compounding (365 days).
How much will you have on October 1, or after 9
months (273 days)? (Days given.)

I
PER
= 11.33463%/365
= 0.031054% per day.
FV=?
0 1 2 273
0.031054%
-100
Convert interest to daily rate
( )
( )
FV = $100 1.00031054
= $100 1.08846 = $108.85.

273
273
Find FV using formula
FV
n
= PV(1 + i)
n

273 -100 0

108.85
INPUTS
OUTPUT
N I/YR PV FV
PMT
I
Per
= i
NOM
/M
= 11.33463/365
= 0.031054% per day.
Calculator Solution
Amortized Loan
An amortized loan is a loan that is paid off in
equal installments over a specified period of
time.
Amortization tables are widely used--for home
mortgages, auto loans, business loans,
retirement plans, and so on. They are very
important!

Amortization
Construct an amortization schedule for a
$1,000, 10% annual rate loan with 3 equal
payments.
Step 1: Find the required payments.
PMT PMT PMT
0 1 2 3
10%
-1,000
3 10 -1000 0

INPUTS
OUTPUT
N I/YR PV FV
PMT
402.11
Step 2: Find interest charge for Year 1.
INT
t
= Beg bal
t
(i)
INT
1
= $1,000(0.10) = $100.
Step 3: Find repayment of principal in
Year 1.
Repmt = PMT - INT
= $402.11 - $100
= $302.11.
Step 4: Find ending balance after
Year 1.
End bal = Beg bal - Repmt
= $1,000 - $302.11 = $697.89.
Repeat these steps for Years 2 and 3
to complete the amortization table.
Interest portion declines as the loan gets closer to maturity.
BEG PRIN END
YR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000
Step 4: Calculation
$
0 1 2 3
402.11
Interest
302.11
Level payments. Interest declines because outstanding
balance declines. Lender earns 10% on loan outstanding,
which is falling.
Principal Payments
Step 4: Calculation
Example 7
You plan to buy a $400,000 flat. If you put
20% down, you can get a 30-year mortgage at
6%. What is your monthly mortgage payment?

If the mortgage is for 15 year?
Example 8
A. You want to have $2M when you retire 35 years
from now. You estimate that your investment in your
retirement account will give you a 12% average rate of
return. How much do you need to save a year for your
retirement?

B. Now you feel that the stock market is too risky. You
want to shift your retirement account into a safer bond
fund that gives a return of 5% per year. How much do
you need to save a year?
Self Test: Example 9
Comparing Investments
You are offered a note which pays $1,000 in 15 months
(or 456 days) for $850. You have $850 in a bank which
pays a 6.76649% nominal rate, with 365 daily
compounding, which is a daily rate of 0.018538% and
an EAR of 7.0%. You plan to leave the money in the
bank if you dont buy the note. The note is riskless.
Should you buy it?
I
PER
= 0.018538% per day.
1,000
0 365 456 days
-850
Daily time line
Three solution methods
1. Greatest future wealth: FV
2. Greatest wealth today: PV
3. Highest rate of return: Highest EFF%

1. Greatest Future Wealth
Find FV of $850 left in bank for
15 months and compare with
notes FV = $1,000.

FV
Bank
= $850(1.00018538)
456

= $924.97 in bank.
Buy the note: $1,000 > $924.97.

456 -850 0

924.97
INPUTS
OUTPUT
N I/YR PV FV
PMT
I
PER
= i
NOM
/M
= 6.76649%/365
= 0.018538% per day.
Calculator Solution to FV
Find PV of note, and compare
with its $850 cost:
PV = $1,000/(1.00018538)
456

= $918.95.
2. Greatest Present Wealth
456 .018538 0 1000

-918.95
INPUTS
OUTPUT
N I/YR PV FV
PMT
6.76649/365 =
PV of note is greater than its $850 cost, so buy
the note. Raises your wealth.
Find the EFF% on note and compare
with 7.0% bank pays, which is your
opportunity cost of capital:
FV
N
= PV(1 + I)
N
$1,000 = $850(1 + i)
456
Now we must solve for I.
3. Rate of Return
456 -850 0 1000

0.035646%
per day
INPUTS
OUTPUT
N I/YR PV FV PMT
Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.
EAR = EFF% = (1.00035646)
365
- 1
= 13.89%.
Calculator Solution
P/YR = 365
NOM% = 0.035646(365) = 13.01
EFF% = 13.89
Since 13.89% > 7.0% opportunity cost,
buy the note.
Using interest conversion
Summary
Time value of money is one of the most
important concepts in Finance.
Must know how to calculate FV, FVA, PV,
PVA, NPV, PMT, I, N, amortization schedule.
Must know the difference between APR and
EAR
Setting up cash flows is vital.
There are several approaches to solve time
value of money problems.

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