Basic Financial

Concepts
Time

Value of Money
Investment Decision Making
Risk and Return

Corporate Finance

People have been running business for

thousands of years.
Corporate Finance is few decades old.
Principles of Corporate Finance are
commonsense and have changed very
little over time.
It tried to provide some structures, mainly
on detailing.

Corporate Finance

Maximizing Value

Tools

Time Value
Risk & Return

Applications

Investment Decisions
Financing Decisions
Dividend Decisions

Leasing
Short Term Financial Management
Mergers and Acquisitions
Derivatives
International Finance

Time Value of Money

The Interest Rate

Which would you prefer -- Rs. 10,000
today or Rs. 10,000 in 5 years?
years
Obviously, Rs. 10,000 today.
today
You already recognize that there is TIME
VALUE TO MONEY!!
MONEY

Why TIME?
Why is TIME such an important
element in your decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.
INTEREST

Types of Interest

Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).

Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).

Simple Interest Example

Assume that you deposit Rs. 1,000 in

an account earning 7% simple interest
for 2 years. What is the accumulated
interest at the end of the 2nd year?

SI

= P0(i)(n)
= Rs. 1,000(.07)(2)
= Rs. 140

Simple Interest (FV)

What is the Future Value (FV)

FV of the
deposit?
FV

= P0 + SI
= Rs. 1,000 + Rs. 140
= Rs. 1,140

Future Value is the value at some future

time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.

Simple Interest (PV)

What is the Present Value (PV)

PV of the
previous problem?
The Present Value is simply the
Rs. 1,000 you originally deposited.
That is the value today!

10

Present Value is the current value of a

future amount of money, or a series of
payments, evaluated at a given interest
rate.

Future Value
Single Deposit (Graphic)
Assume that you deposit Rs. 1,000
at a compound interest rate of 7%
for 2 years.
years

7%

Rs. 1,000
FV2
11

Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1

= Rs. 1,000 (1.07)

= Rs. 1,070

Compound Interest
You earned Rs. 70 interest on your Rs.
1,000 deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
12

Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1

= Rs. 1,000 (1.07)

= Rs. 1,070

FV2 = FV1 (1+i)1

= P0 (1+i)(1+i) = Rs. 1,000(1.07)(1.07)
1,000
2
= P0 (1+i)2
= Rs. 1,000(1.07)
1,000
= Rs. 1,144.90
You earned an EXTRA Rs. 4.90 in Year 2 with
compound over simple interest.
13

General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:

FVn = P0 (1+i)n
or
14

FVn = P0 (FVIFi,n) -- Exhibit 1

Using Future Value Tables

FVIFi,n
FVIF is found on Exhibit 1
FV2

15

= Rs. 1,000 (FVIF7%,2)

= Rs. 1,000 (1.145)
= Rs. 1,145 [Due to Rounding]
Period
6%
7%
8%
1
1.060
1.070
1.080
2
1.124
1.145
1.166
3
1.191
1.225
1.260
4
1.262
1.311
1.360
5
1.338
1.403
1.469

Example
You want to know how large your deposit of
Rs. 10,000 today will become at a
compound annual interest rate of 10% for 5
years.
years

10%

Rs. 10,000

FV5
16

Solution
Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = Rs. 10,000 (1+ 0.10)5
= Rs. 16,105.10
Calculation based on Table:
FV5 = Rs. 10,000 (FVIF10%, 5)
= Rs. 10,000 (1.611)
= Rs. 16,110
[Due to Rounding]

17

Present Value
Single Deposit (Graphic)
Assume that you need Rs. 1,000 in 2 years.
Lets examine the process to determine how
much you need to deposit today at a discount
rate of 7% compounded annually.

7%

Rs. 1,000
PV0
18

PV1

Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2 = Rs. 1,000 / (1.07)2
= FV2 / (1+i)2 = Rs. 873.44

7%

Rs. 1,000
PV0
19

General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.

General Present Value Formula:

PV0 = FVn / (1+i)n
or
20

PV0 = FVn (PVIFi,n) -- Exhibit 2

Valuation Using Table

PVIFi,n is found on Exhibit 2
Period
1
2
3
4
5
21

6%
.943
.890
.840
.792
.747

7%
.935
.873
.816
.763
.713

8%
.926
.857
.794
.735
.681

Using Present Value Tables

PV2

22

= Rs. 1,000 (PVIF7%,2)

= Rs. 1,000 (.873)
= Rs. 873 [Due to Rounding]
Period
6%
7%
8%
1
.943
.935
.926
2
.890
.873
.857
3
.840
.816
.794
4
.792
.763
.735
5
.747
.713
.681

Example
You want to know how large of a deposit to make
so that the money will grow to Rs. 10,000 in 5
years at a discount rate of 10%.

10%

5
Rs. 10,000

PV0
23

Solution

Calculation based on general formula:

PV0 = FVn / (1+i)n
PV0 = Rs. 10,000 / (1+ 0.10)5
= Rs. 6,209.21

Calculation based on Table I:

PV0 = Rs. 10,000 (PVIF10%, 5)
= Rs. 10,000 (.621)
= Rs. 6,210.00 [Due to Rounding]

24

Types of Annuities

25

An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.

Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.

Annuity Due:
Due Payments or receipts
occur at the beginning of each period.

Examples of Annuities

26

Student Loan Payments

Car Loan Payments

Insurance Premiums

Mortgage Payments

Retirement Savings

Parts of an Annuity
(Ordinary Annuity)
End of
Period 1

1
Rs. 100

Today
27

End of
Period 2

End of
Period 3

2
Rs. 100

3
Rs. 100

Equal Cash Flows

Each 1 Period Apart

Parts of an Annuity
(Annuity Due)
Beginning of
Period 1

Rs. 100

Today
28

Beginning of
Period 2

Beginning of
Period 3

Rs. 100

Rs. 100

Equal Cash Flows

Each 1 Period Apart

Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

. . .

i%
R

R = Periodic
Cash Flow

FVAn = R(1+i) + R(1+i)

... + R(1+i)1 + R(1+i)0
n-1

29

n-2

FVAn

n+1

Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

Rs. 1,000

Rs. 1,000

7%
Rs. 1,000

Rs. 1,070
Rs. 1,145
FVA3 = Rs. 1,000(1.07)2 +
Rs. 1,000(1.07)1 + Rs. 1,000(1.07)0
= Rs. 1,145 + Rs. 1,070 + Rs. 1,000
= Rs. 3,215
30

Rs. 3,215 = FVA3

Valuation Using Exhibit 3

31

FVAn

= R (FVIFAi%,n)

FVA3

= Rs. 1,000 (FVIFA7%,3)

= Rs. 1,000 (3.215) = Rs. 3,215

Period
1
2
3
4
5

6%
1.000
2.060
3.184
4.375
5.637

7%
1.000
2.070
3.215
4.440
5.751

8%
1.000
2.080
3.246
4.506
5.867

Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

n+1

. . .

i%
R

R
R = Periodic
Cash Flow

PVAn

PVAn = R/(1+i)1 + R/(1+i)2

+ ... + R/(1+i)n

32

Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

$1,000

$1,000

7%
$934.58
$873.44
$816.30

$1,000

$2,624.32 = PVA3

PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 + $1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32

33

Valuation Using Table 4

PVAn
PVA3

34

= R (PVIFAi%,n)
= $1,000 (PVIFA7%,3)
= $1,000 (2.624) = $2,624
Period
6%
7%
8%
1
0.943
0.935
0.926
2
1.833
1.808
1.783
3
2.673
2.624
2.577
4
3.465
3.387
3.312
5
4.212
4.100
3.993

Amortizing a Loan Example

Sunil is borrowing Rs. 10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1:Payment
PV0 = R (PVIFA i%,n)
Rs. 10,000
= R (PVIFA 12%,5)

35

Rs. 10,000
= R (3.605)
R = Rs. 10,000 / 3.605 = Rs. 2,774

Amortizing a Loan Example

End of
Year
0

Payment

Interest

Principal

---

---

---

Ending
Balance
$10,000

$2,774

$1,200

$1,574

8,426

2,774

1,011

1,763

6,663

2,774

800

1,974

4,689

2,774

563

2,211

2,478

2,775

297

2,478

$13,871

$3,871

$10,000

[Last Payment Slightly Higher Due to Rounding]

36

Exercises

37

1. You just turned 35 and have been saving for an around-theworld vacation. You want to take the trip to celebrate your
40th birthday. You have set aside, as of today, $15,000 for
such a trip. You expect the trip will cost $25,000. The financial
instruments you have invested the $15,000 in have been
earning, on average, about 8%. (You may ignore income
taxes)

Will you have enough money in that vacation account on

your 40th birthday to take the trip? What will be the surplus,
or shortfall, in that account when you turn 40?

If you had to, you could further fund the trip by making,
starting today, five annual $500 contributions to the account.
If you adhere to such a plan, how much will be in the account
on your 40th birthday?

2. Your company has been offered a contract for the development and
delivery of a solar powered military troop transport vehicle. The request for
proposal provides all the necessary technical specifications and it also
stipulates that two working, economically feasible prototypes must be
delivered in four years, at which time you will receive your only customer
paymenta single final payment of $50 million. Assume a reinvestment
interest rate of 18% for all the monies received over the next four years.
(You may ignore income taxes.)

38

a. What lump-sum dollar amount would you be willing to accept today

instead of the $50 million in four years?

b. Alternatively, what four yearly receipts, starting a year from now, might
you be willing to accept?

39

3. The aged but centrally located golf course you manage does not
have an in-ground automated water sprinkling system. Instead, to
properly water the course, sprinklers and hoses must be repeatedly
set, moved, and put away by some of the grounds crewa tedious
and laborious task. If over the next 12 years you project annual
savings of about $40,000 from having an automated system, what is
the maximum price you would be willing to pay today for an
installed, automated golf course sprinkler system? (Assume an
interest rate of 6%, and you may ignore income taxes.)

a. Redo your calculation using a 10-year time period and $48,000 in

annual savings.

b. Redo your initial calculation one more time using $50,000 in

annual savings for the first six years and $30,000 in annual savings
for the next six years.

40

4. The cafeteria you operate has a regular clientele for all three
meals, seven days a week. You want to expand your product line
beyond what you are currently able to offer. To do so requires the
purchase of some additional specialty equipment costing $45,000,
but you project a resultant increase in sales (after deducting the
cost of sales) of about $8,000 per year for each of the next eight
years with this new equipment. Assuming a required rate of return
(i.e., a hurdle rate) of 8%, should you pursue this opportunity?
Why or why not? Do the analysis under two conditions:

a. You are part of an income-tax-exempt enterprise

b. The enterprise you are part of is subject to a 40% corporate

income tax rate and the straight-line, depreciable life of the
equipment you are contemplating purchasing is five years.

41

5. You are contemplating the purchase of a one-half interest in a corporate

airplane to facilitate the expansion of your business into two new
geographic areas. The acquisition would eliminate about $220,000 in
estimated annual expenditures for commercial flights, mileage
reimbursements, rental cars, and hotels for each of the next 10 years. The
total purchase price for the share is $6 million, plus associated annual
operating costs of $100,000. Assume the plane can be fully depreciated, on
a straight-line basis, for tax purposes over 10 years. The companys
weighted average cost of capital (WACC) is 8%, and its corporate tax rate
is 40%. Does this endeavor present a positive or negative net present
value (NPV)? If positive, how much value is being created for the company
through the purchase of this asset? If negative, what additional annual
cash flows are needed for the NPV to equal zero? To what phenomena
might those additional positive cash flows be ascribable?

42

6. The final tally is in: This years operating costs were

down $100,000, a decrease directly attributable to the
$520,000 investment in the automated materials handling
system put in place at the beginning of the year. If this level
of annual savings continues for five more years, resulting
in six total years of annual savings, what compounded
annual rate of return will that represent? If these annual
savings continue for nine more years, what compounded
annual rate of return will that represent? (You may ignore
income taxes.)

Name:
Roll no: 123

= Unit place digit of your roll no

= Tenth place digit of your roll no

You

plan to buy a property when your age would be: 30 + X

Your

present age: 20 + Y

Cost

of the property at present: Rs (40 +X) lakhs

The

property cost is expected to increase @ 8% per year

Your

current savings: Rs (20 + Y) lakhs

Earning
How

43

from your investments: 10% per year

much you must save per year (at the end of the year) so that you can buy the property.