Topics (Tentative): Pre-Readings (BM Chapters)

Topic 1: Basic Concepts (BD: Chapters 1, 3-5)

MSL 708 Financial Management Topic 1a: Basic Concepts

Topic 2: Valuation of Bonds (BD: Chapter 6)

Topic 1a: Time Value of Money Time Value of Money Topic 3: Capital Budgeting (BD: Chapters 7 and 8)

Annuities and Perpetuities Topic 4: Valuation of Stocks (BD: Chapter 9)

Interest rates
Topic 5: Risk and Return (BD: Chapters 10-13)

Topic 6: Capital Structure (BD: Chapters 14-16)

Topic 7: Valuations (BD: Chapters 2, 18-19)

Topic 8: Long-Term Financing (BD: Chapters 23 and 24)

Topic 9: Short-Term Financing (BD: Chapters 26 and 27)

Time Value of Money Time Value of Money

$100 now versus $100 in one year’s time 𝐹𝑉 = 𝑃𝑉 1 + 𝑖
Dollar today ≠ Dollar in 1 year
FV: Future value
Cannot compare cash flows that occur at different points in time PV: Present value
i: Interest rate

3 4

Time Value of Money Time Value of Money

Say you have $100 How much money you will have after one year if you put $100 in a
saving account at 2 percent interest
How much money you will have after one year if you
𝐹𝑉 = 100 1.02 = $102
(a) Put $100 in a saving account at 2 percent interest
How much money you will have after one year if you invest $100 in
(b) Put $100 in a fixed deposit that gives 8 percent interest shares which gives you return of 15 percent

(c) Invest $100 in corporate bond that offers 10 percent coupon rate 𝐹𝑉 = 100 1.15 = $115

(d) Invest $100 in shares which gives you return of 15 percent

5 6

1
Time Value of Money Time Value of Money
How much you invested one year ago if the current value of your 𝑃𝑉 =
investment is $100 and you
(a) Got 2 percent interest by putting money in a saving account FV: Future value
(b) Got 8 percent interest by putting money in a fixed deposit PV: Present value
i: Interest rate
(c) Bond offered 10 percent coupon rate
: Discount factor
(d) Earned 15 percent return by investing in equities

7 8

Time Value of Money Time Value of Money

How much amount you invested one year ago if the current value of Assume that you are lending $10,000 today and that the loan will be
your investment is $100 and bank paid you 2 percent interest? repaid in two annual $6,000 payments
100 = 𝑃𝑉(1.02)
100
𝑃𝑉 = = $98.04
1.02
How much amount you invested one year ago if the current value of
your investment is $100 and you earned 15 percent return by PV of Year 1 cash flow =
,
= 5,454.55
investing in shares? .
100 = 𝑃𝑉(1.15) ,
PV of Year 2 cash flow = = 4,958.68
100 .
𝑃𝑉 = = $86.96
1.15 𝑁𝑃𝑉 = −10,000 + 5,454.55 + 4,958.68 = $413.23
9 10

Time Value of Money Example

If you invest $1,000 today, you will receive $500 at the end of each Suppose you invest in a project that requires initial investment of
of the next three years $2,000
If you could otherwise earn 10 percent per year, should you
There is net cash inflow of $200, $1,800, and $200 for the first three
undertake the investment opportunity?
years and net cash outflow of $200 and $800 in the fourth and fifth
year, respectively
-1,000 $500 500 500
0 1 2 3 Assume required return is 10 percent

500 500 500

𝑁𝑃𝑉 = −1,000 + + + = $243.43
1.1 1.1 1.1

11 12

2
Example Annuities
Series of equal cash flows (paid/received) at the end of each period

-2,000 200 1,800 200 -200 -800 Example: Mortgage payments (when the interest rate on the
mortgage is fixed)
0 1 2 3 4 5 Three types
• Ordinary Annuity
• Annuity Due
𝑁𝑃𝑉 = −2000 + + + + + = −813.66 • Deferred Annuity
. . . . .

13 14

Ordinary Annuity Ordinary Annuity

Total n payments Total 5 annual payments

CF CF CF CF 100 100 100 100 100

0 1 2 3 n 1 2 3 4 5

100 1
𝑃𝑉 = 1− = $379.08
𝐶𝐹 1 0.10 1 + 0.1
𝑃𝑉 = 1−
𝑖 1+𝑖
Value of your investment at the end of fifth year
𝑃𝑉 = 𝑃𝑉 1 + 𝑖 = 379.08 1.1 = $610.51

15 16

Annuity Due Annuity Due

Total n payments Total 5 100 100 100 100 100
annual 0 1 2 3 4 5
payments
CF CF CF CF CF 𝐶𝐹 1
0 1 2 3 (n – 1) n 𝑃𝑉 = 𝐶𝐹 + 1−
𝑖 1+𝑖
100 1
𝑃𝑉 = 100 + 1− = $416.99
𝐶𝐹 1 0.10 1 + 0.1
𝑃𝑉 = 𝐶𝐹 + 1−
𝑖 1+𝑖 Value of your investment at the end of fifth year
𝑃𝑉 = 𝑃𝑉 1 + 𝑖 = 416.99 1.1 = $671.57

17 18

3
Annuity Due Annuity Due
Suppose you won an amount of $30 million in a lottery
You can choose from: $1M $1M $1M $1M $1M $1M
(a) 30 payments of $1 million per year (starting today) 0 1 2 3 28 29 30 31
(b) A lump sum amount of $15 million today
If the interest rate is 8 percent, which option will you choose? $15M 0 0 0 0 0 0 0
0 1 2 3 28 29 30 31

19 20

Annuity Due Deferred Annuity

$1M $1M $1M $1M $1M $1M CF CF CF

0 1 2 3 28 29 30 31
0 1 2 (t – 1) t (t + 1) (t + n – 1)

Total n payments 𝐶𝐹 1
Value of annuity = 1 + 1− = $12.16 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 Starting from t 𝑃𝑉 = 1−
. . 𝑖 1+𝑖
Accept $15 million now 𝐶𝐹 1
𝑃𝑉 1−
𝑖 1+𝑖
𝑃𝑉 = =
1+𝑖 1+𝑖

21 22

Deferred Annuity
Cash flows start from the beginning of fifth year If you know present values, you can easily calculate future value
Again total 5 payments using
100 100 100 100 100
𝐹𝑉 = 𝑃𝑉 1 + 𝑖
0 1 2 3 4 5 6 7 8 9 10

100 100 100 100 100

0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7

100 1
𝑃𝑉 = 1− = $379.08
0.10 1 + 0.1
𝑃𝑉
𝑃𝑉 = = $284.81
1+𝑟
23 24

4
 Future Value of an Annuity Future Value of an Annuity
Ellen is 35 years old
10,000 10,000 10,000 10,000
She has decided to save $10,000 at the end of each year in her 0 1 2 3 30
retirement account until she is 65 35 36 37 38 65
If the account earns 10 percent per year, how much will Ellen have
saved at age 65? 𝐹𝑉 = 1+𝑖 −1

,
𝐹𝑉 = 1.1 − 1 = $1.645 Million
.

25 26

Growing Annuity Growing Annuity

Cash flows growing at the rate of g percent per year Ellen expects her salary to increase each year so that she will be able
to increase her savings by 5 percent per year
Total n payments
With this plan, if she earns 10 percent per year on her savings, how
CF CF (1 + g) CF (1 + g)2 CF (1 + g)n much will Ellen have saved at age 65?
0 1 2 3 (t – 1) t
10,000 10,000(1.05) 10,000(1.05)2 10,000(1.05)29
𝐶𝐹 1+𝑔 0 1 2 3 30
𝑃𝑉 = 1− 35 36 37 38 65
𝑟−𝑔 1+𝑟

27 28

Growing Annuity Perpetuity

10,000 10,000(1.05) 10,000(1.05)2 10,000(1.05)29 Series of equal cash flows that occur at regular intervals and last
0 1 2 3 30 forever
35 36 37 38 65

CF CF CF CF
𝑃𝑉 = 1−
( ) 0 1 2 3 ∞

, .
𝑃𝑉 = 1− = $150,463 today
( . . ) . Example: If a company pays same dividend per share

At the age of 65, Ellen will have

𝐹𝑉 = 𝑃𝑉 1 + 𝑖 = 150,463 1.1 = $2.625 million

29 30

5
Perpetuity Perpetuity
PV of an ordinary annuity with fixed number of payment: You want to endow an annual MBA graduation party at your alma
𝐶𝐹 1 mater
𝑃𝑉 = 1−
𝑖 1+𝑖
You budget $30,000 per year forever for the party
If the university earns 8 percent per year on its investments and if
If 𝑛 becomes very large then →0
the first party is in one year’s time, how much will you need to
donate to endow the party?
𝐶𝐹
𝑃𝑉 =
𝑖

31 32

Perpetuity Growing Perpetuity

Series of equal cash flows that occur at regular intervals and grow at
a constant rate forever
30,000 30,000 30,000 30,000
0 1 2 3 ∞ CF CF (1 + g) CF (1 + g)2
0 1 2 3 ∞
𝐶𝐹 30,000
𝑃𝑉 = = = $375,000 𝐶𝐹
𝑖 0.08 𝑃𝑉 =
𝑅−𝑔

33 34

Growing Perpetuity
To account for inflation, suppose you increase your payments If frequency of compounding is m, then
($30,000) at the rate of 4 percent annually Interest rate per period is 𝑖/𝑚
Number of periods 𝑚𝑛
30,000
𝑃𝑉 = = $750,000
0.08 − 0.04
For example, if annual amount is CF then
/
PV of Ordinary Annuity = 1−
/ /

35 36

6
Loan Payment Loan Payment
A biotech firm plans to buy a new equipment for $500,000 Loan Amount = 0.8(500,000) = $400,000
20 percent of the purchase price is to be paid as a down payment 𝑃𝑉 =
/
1−
/ /
Remainder to be financed using a 48-month loan with equal
payments and an interest rate of 0.5 percent per month 𝑃𝑉 =
/
1−
/ /
What is the monthly loan payment?
400,000 = 1−
. .

Monthly payment (PMT) is $9,394

37 38

Effective Annual Rate Effective Annual Rate

The effective annual rate is the actual amount of interest that will be Say the annual (nominal/quoted) interest rate is 10 percent
earned at the end of one year
If interest is compounded annually, at the end of one year
𝐹𝑉 = 100 1 + 0.10 = $110

39 40

Effective Annual Rate Effective Annual Rate

If interest is compounded semi-annually, then after six months With quarterly compounding
0.010 0.10
𝐹𝑉 = 100 1 + = $105 𝐹𝑉 = 100 1 + = $110.3813
2 4
⇒ Effectively, you are getting an interest rate of 10.3813 percent
This amount is invested for another six months
0.010 With monthly compounding
𝐹𝑉 = 105 1 + = $110.25
2 0.10
𝐹𝑉 = 100 1 + = $110.4713
.
12
(OR, we can use 𝐹𝑉 = 100 1 + = $110.25) ⇒ Effectively, you are getting an interest rate of 10.4713 percent
Effectively, you are getting an interest rate of 10.25 percent
41 42

7
Effective Annual Rate Effective Annual Rate
With daily compounding With continuous compounding
.
𝐹𝑉 = 100 1 + = $110.5156 𝐹𝑉 = lim 𝑃𝑉 1 + = 𝑃𝑉 𝑒
→

⇒ Effectively, you are getting an interest rate of 10.5156 percent where i is annual interest rate and t is time in years
.
𝐹𝑉 = 100𝑒 = $110.5171
⇒ Effectively, you are getting an interest rate of 10.5171 percent

43 44

Effective Annual Rate Effective Annual Rate

Nominal/quoted/annual percentage rate of 10 percent For a quoted rate of 6 percent
Frequency of Compounding Effective Annual Rate (percent) Annual 1+
.
− 1 = 6 percent
Annual 10
.
Semi-Annual 10.25 Semiannual 1+ − 1 = 6.09 percent
Quarterly 10.3813 .
Monthly 10.4712 Monthly 1+ − 1 = 6.1678 percent
Daily 10.5156 .
Daily 1+ − 1 = 6.1831 percent
Continuous 10.5171
As the frequency of compounding increases, effective interest rate The effective annual rate increases with the frequency of
increases compounding
45 46

Effective Annual Rate Effective Annual Rate for Period Longer than One Year
Interest rates are generally quoted as an annual rate Assume an effective annual rate of 5 percent
𝐹𝑉 = 𝑃𝑉 1 + 𝑖 In one year, a $100,000 investment grows to
Here i is the interest for a period and n is the number of periods 100000 1.05 = $105,000
Effective annual rate corresponding to quoted rate i with k After two years, it will grow to
compounding periods per year is given by
100,000 1.05 = $110,250
𝑖
1 + 𝐸𝐴𝑅 = 1 +
𝑘 Earning an effective annual rate of 5 percent for two years is
equivalent to earning 10.25 percent in total interest over the two-
year period

47 48

8
Effective Annual Rate for Periods Shorter than One Year Effective Annual Rate
Assume that you earn an effective annual rate of 5 percent interest Interest rates quoted by banks do not include the effect of
. . compounding
1+𝑟 = 1.05 = $1.0247
To compute the actual amount that you will earn in one year, convert
For each dollar invested every half-year a 5 percent effective annual
the quoted rate to an effective annual rate
rate is equivalent to an interest rate of approximately 2.47 percent
earned every six months When evaluating cash flows, use a discount rate that matches the
1 + 0.0247 = 1.05 time period of the cash flows and reflects the actual return that
could be earned over that time period
• Use effective rate to discount future cash flows

49 50

Effective Annual Rate Effective Annual Rate

Your firm is purchasing a new telephone system, which will last for Calculate effective annual rate (borrowing rate)
four years .
1+ − 1 = 5.0625 percent
You can purchase the system for an upfront cost of $150,000 or you
can lease the system from the manufacturer for $4,000 paid at the To have an effective annual rate of 5.0625 percent, monthly rate is
end of each month calculated as
𝑖
Your firm can borrow at an interest rate of 5 percent with 1+ = 1.05625
semiannual compounding 12

Should you purchase the system outright or pay $4,000 per month? That is, 1 + = 1.050625 = 1.004124

51 52

Effective Annual Rate Effective Annual Rate

𝑃𝑉 = + + ⋯+
4,000 4,000 4,000 4,000
0 1 2 3 48 𝑃𝑉 = + + ⋯+
. . .
PV of loan outstanding /
Using annuity formula, 𝑃𝑉 = 1−
/
4000 4000 4000
𝑃𝑉 = + + ⋯+
𝑖 𝑖 𝑖
1+ 1 + 12 1 + 12 𝑃𝑉 = 1− = $173,867.20
12 . .

i is annual nominal rate

53 54

9
Effective Annual Rate Loan
Thus, paying $4000 per month for 48 months is equivalent to paying Suppose you take $30,000 60-months car loan at an interest rate of
a present value of $173,867 today 6.75 percent with monthly compounding
This cost is $23,867 (173,867 - 150,000) higher than the cost of Borrowed Amount
purchasing the system PV = $30,000
Better to pay $150,000 for the system rather than lease it
PMT PMT PMT PMT
0 1 2 3 60

55 56

Loan: Example Loan: Example

Calculate monthly payments How much loan is remaining after one year?

𝑃𝑉 =
/
1− Loan outstanding after one year
/
.
= 1− .
= $24,779
. /
30,000 = 1− . Loan Outstanding
. /

𝑃𝑀𝑇 = $590.50 Monthly

0 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 12

PMT PMT PMT PMT Payments 0 1 2 5

$590.50 $590.50 $590.50 $590.50

0 1 2 3 60 Years
57 58

Loan: Example Loan: Example

How much loan is remaining after two years? How much interest did you pay on the loan in the second year?

Loan outstanding after two years

Loan outstanding at Loan outstanding at
=
.
1− = $19,195 the end of 1st year the end of 2nd year
. / .
Loan Outstanding
Monthly
0 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 12
Monthly Payments 0 1 2 5
0 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 12
Payments 0 1 2 5

Year
Year
59 60

10
Loan: Example Loan: Example
How much interest did you pay on the loan in the second year? Calculate interest paid in the 24th month
Loan outstanding at the end of first year = 24,779
Loan outstanding at the end of second year = 19,195
Principal repaid during the year = 24,779 – 19,195 = 5,584
Total payments made during the year = 590.50 (12) = 7,086
Interest paid = 7,086 – 5,584 = $1,502

61 62

Loan: Example Loan: Example

Suppose, interest rates have increased to 8 percent (after two years)
Loan outstanding at the end of 2nd year $19,195
You want to repay your loan within 3 years, as originally planned
Interest rates increased to 8 percent
How much do you need to pay every month?

$19,195 = 1− .
. /
Monthly Payments 0 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 12

0 1 2 5
𝑃𝑀𝑇 = $602
Originally supposed to make monthly payments
of $590.50 for next three years

63 64

Loan: Example Loans

Suppose you do not want to increase monthly payment rather prefer Amortizing loans: Each month you pay interest on the loan plus
to pay your loan over longer time period some part of the loan balance
• For example- for a home loan, borrower usually make equal monthly
If you continue making payment of $590.50, how long will it take for payments and the loan is fully repaid with the final payment
you to repay your loan?
Interest-only loans
.
19,195 = 1−
. / .

𝑁 = 36.76 months

65 66

11
 Interest Rates
To calculate present and future values, we need interest rates
𝐹𝑉 = 𝑃𝑉 1 + 𝑖
Interest Rates Which interest rate should be used?

67 68

Interest Rates
Government bonds (all rates are in per cent)
2016 2017
Corporate bonds Dec. 23 Dec. 22
Policy Repo Rate 6.25 6.00
Reverse Repo Rate 5.75 5.75
Certificate of Deposit (Dec 8, 2017) RANGE 6-6.49 6.21-6.65
Commercial Paper (Dec 15) RANGE 5.86-13.95 5.98-11.19
Term Deposit Rate > 1 Year 6.50/7.10 6.00/6.75
Savings Deposit Rate 4.00 3.50/4.00
91-Day Treasury Bill Yield 6.23 6.19
182-Day Treasury Bill Yield .. 6.33
364-Day Treasury Bill Yield 6.34 6.40
10-Year G-Sec Par Yield 6.63 7.45
Source: https://www.rbi.org.in/
69 70

Determinants of Interest Rates Determinants of Interest Rates

Interest rates tend to change over time Banks and other financial institutions quote nominal interest rates
Interest rates are determined in the market based on individual’s Real interest rate is obtained after adjusting for inflation
willingness to borrow or lend
Real interest rate is approximately equal to the nominal interest rate
Some of the factors that affect interest rates less the rate of inflation
• Risk, taxes, inflation, government policy, expectations of future growth, 𝑟 =𝑖 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
investment horizon

How to determine the appropriate discount rate for a set of cash

flows?

71 72

12
Interest Rates and Inflation - US Interest Rates and Inflation - US

Nominal interest rate tends

to move with inflation

Source: https://www.bls.gov/
73 74

Interest Rates and Inflation - India Interest Rates and Inflation

Nominal interest rate tends to move with inflation
Individual’s willingness to save will depend on the growth in
purchasing power they can expect (given by the real interest rate)
When the inflation is high, a higher nominal interest rate is generally
needed to induce individuals to save

75 76

India: Repo Rate Interest Rates: India Repo Rate and US Fed Funds Rate

77 78

13
Investment and Interest Rate Policy Investment and Interest Rate Policy
Interest rates also affect firms’ incentive to raise capital and invest All else equal, higher interest rates will therefore tend to shrink the
set of positive NPV investments available to firms
Consider a risk-free investment opportunity that requires an upfront
investment of $10 million and generates a cash flow of $3 million per The central banks use this relationship between interest rates and
year for four years investment to try to guide the economy
• Raise interest rates to reduce investment if the economy is “overheating”
If the risk-free interest rate is 5 percent and inflation is on the rise
𝑁𝑃𝑉 = −10 + + + + = $0.638 million • Lower interest rates to stimulate investment if the economy is slowing in
. . . . recession
If the risk-free interest rate is 9 percent
𝑁𝑃𝑉 = −10 + + + + = −$0.281 million
. . . .

79 80

Default Risk Default Risk

Why do these interest rates vary so widely?
The lowest interest rate is the rate paid on US treasury notes
Interest rates required by
US treasury securities are widely regarded to be risk free because
investors for five-year loans
there is virtually no chance the government will fail to pay the
to a number of different
interest and default on these loans
borrowers in mid-2015
Thus when we refer to the “risk-free interest rate”, we mean the rate
on US Treasuries
All other borrowers have some risk of default

81 82
Source: FINRA.org.

Default Risk Default Risk

Stated interest rate is the maximum amount that investors will Suppose the US government owes your firm $1,000 to be paid in five
receive years
Investors will receive less if the company is unable to fully repay the Assuming we can regard the government’s obligation as risk-free,
loan then we discount the cash flow using the risk-free Treasury interest
rate of 1.7 percent
To compensate for the risk that they will receive less if the firm
defaults, investors demand a higher interest rate than the rate on US 1000
𝑃𝑉 = = $919.17
Treasuries 1.017

The difference between the interest rate of the loan and the
Treasury rate will depend on investors’ assessment of the likelihood
that the firm will default
83 84

14
 Default Risk After-Tax Interest Rates
Suppose instead Gap Inc owes your firm $1,000 Why is this important?
$1000 Because investors care
𝑃𝑉 = = $787.27
1.049
If they pay less taxes on interest income than what they pay on
There is no guarantee that Gap will repay $1,000 dividend income, it might be easier for company to obtain funds by
issuing debt
The 4.9 percent interest rate of the loan is a more appropriate
discount rate to use to compute the present value in this case The actual return kept by an investor will also depend on how the
interest is taxed

85 86

Summary Summary
Nominal/quoted interest rate indicate the total amount of interest Interest rates on government securities are regarded as risk-free
earned in one year without considering the effect of compounding interest rates
Nominal interest rates tend to be high/low when inflation is high/low Because other borrowers may default, they will pay higher interest
rates on their loans
Higher interest rates tend to reduce the NPV of investment projects
The opportunity cost of capital is the best available expected return
Central banks raise interest rates to moderate investment and combat offered in the market on an investment of comparable risk and term
inflation and lowers interest rates to stimulate investment and
economic growth
Effective annual rate indicates the actual amount of interest earned in
one year and should be used for discounting future cash flows
87 88

15