Financial Arithmetic

Week 1
IB125 Foundations of Financial Management
Jesús Gorrín

Key Readings: Hillier et al. Chapters 4.1-4.5; 5.1-5.3

VALUE OF AN IDEA

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SPACEX
 Elon Musk, majority owners of Tesla and currently richest man in the world, is
investing in a company for commercial space travel.

 This project requires significant investment before making profits (R&D, factories
to produce aircrafts once the technology is developed, etc.)

 Many costumers have expressed interests, so they are willing to pay for this
service. Also, potential transport companies might want to pay for the
manufacturing of the technology. They might want to offer this service also.

 Problem: Spacex must invest now and wait for an uncertain cash flow in the future. Is there a
way to measure the value of a project like this one?

 More generally, is this a good investment at all? We will learn basic tools to answer these
questions.

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TIME VALUE OF MONEY
 Money can be invested to earn interest.
 If you are offered the choice between $100 today and $100 next year, you
naturally take the money now to get a year’s interest.

 Financial managers make the same point when they say that money has a time
value or when they quote the most basic principle of finance:
 a dollar today is worth more than a dollar tomorrow.

 Future Value
 Amount to which an investment will grow after earning interest
 Compound Interest
 Interest earned on interest
 Simple Interest
 Interest earned only on the original investment

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COMPOUND GROWTH
 Invest £1 today at the risk-free interest rate of 4% per annum, compounded annually:

Time (T) 1 2 3
Value After T £1 × (1 + 0.04) £1 × (1 + 0.04)2 £1 × (1 + 0.04)3
Years = £1.04 = £1.0816 = £1.1249

 In general, £1 invested today for a period of T years at interest rate R, compounded annually,
will grow to:
 £1 × 1 + 𝑅 𝑇
 If compounded M times per year at regular intervals:
𝑅
 £1 × (1 + 𝑀)𝑀×𝑇
 If compounded continuously:
 £1 × 𝑒 𝑅×𝑇

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COMPOUND GROWTH - EXAMPLES
 What is the future value (FV) of £100 if interest is compounded annually at a rate
of 6% for five years?

FV = £100 × 1 + 𝑅 𝑇 → FV = £100 × 1 + .06 5 = £133.82

 You invest £5,000 at a stated annual interest rate of 12% per year, compounded
quarterly, for five years. What is your wealth at the end of five years?
𝑅 0.12 4×5
FV=£5,000 × (1 + )𝑀×𝑇 →FV =£5,000 × (1 + ) = =£5,000 × (1.03)20 = £9,030.50
𝑀 4

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DISCOUNT FACTORS AND PRESENT VALUES
 Conversely, in order to end up with £1 at the end of T years, today we need to invest only:
Future value after 𝑡 periods 1
PV = = £1 ×
1+𝑅 𝑇 (1+R)T

 This is the present value (PV) of £1 that we expect to receive T years from now.

 The discount factor that multiplies £1 in the above formula reflects the time value of money:
 £1 expected T years from now is not as valuable as £1 today
 if we had £1 today, we could invest it for T years and earn interest at R% per annum
 If we invest £1 in another project, we lose our “safe” interest
 Opportunity cost of the “safe” project: R% per annum

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PRESENT VALUES - EXAMPLE
 You just bought a new computer for £3,000. The payment terms are 2 years same as
cash. If you can earn 8% on your money, how much money should you set aside
today in order to make the payment when due in two years?

Future value after 𝑡 periods £3,000

PV = → PV = = £2,572
1+𝑅 𝑇 1.08 2

 Discount Factor = DF = PV of $1
 Discount factors can be used to compute the present value of any cash flow

1
DF = 𝑡
1+𝑟

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 WHY DO WE INVEST IN RISKY PROJECTS?
 Trade-off between risk and return:
 investors prefer more wealth to less wealth, but are risk averse
 hence, return required by investors:
risk-free return + risk premium
(opportunity cost ) (depends on amount of risk)
Required Return

Risk
premium
Risk-free
Return
Risk

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DISCOUNTED CASH FLOWS
 Company invests £1,000 today in machinery that is expected to generate incremental
(i.e. additional) cash flows of £300 at the end of each Years 1-5:
300 300 300 300 300

1 2 3 4 5
0
1000

 Present value of expected future cash flows:

300 300 300 300 300
PV = + 2
+ 3
+ 4
+ = 1, 137.24
1 + 0.1 (1 + 0.1) (1 + 0.1) (1 + 0.1) (1 + 0.1)5

 assuming required return of investors is 10% per annum

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NET PRESENT VALUE
 In return for some initial investment I, a typical capital project is expected to generate a
stream of future cash flows Ct, t = 1, 2, . . . , T :

 Net Present Value of project equals:

C C C C
1 2 3 T
NPV = - I + + + + ... +
1+ R (1 + R) 2 (1 + R) 3 (1 + R) T

 If NPV > 0 and capital is not rationed, then the firm should undertake the project
 because it adds value for the firm’s shareholders
 capital rationing: limitations on the investment program that prevent the
company from undertaking all such projects (e.g., positive NPV projects)

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ANNUITIES
 An annuity is a stream of N equal cash flows C:

 The annuity factor AN,R is the sum of the corresponding N present-value factors,
calculated using R as the discount rate:
1 1
A N,R = × [1 - N
]
R (1 + R)
 The present value of an annuity is the product of annual cash flow C and the annuity
factor AN,R :
PV  C  AN ,R
 In previous example, C = 300 and A5,10 = 3.7908

PV  300  3.7908  1,137.23

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PERPETUITIES
 A perpetuity is an infinite stream of equal future cash flows C:

 The present value of a perpetuity is obtained by letting N → ∞ in the annuity formula:

C
PV =
R

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PERPETUITIES EXAMPLE
 Suppose you are thinking about buying a flat in London to rent it. This flat will pay
you and your descendants £20,000 in rent every year forever. The discount rate is 10%.
What is the value of this investment?

 In this example C=$20,000 and R=10% or (0.1 when you apply the formula)

 Value of the bond:

20,000
𝑃𝑉 = = £200,000
0.1

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GROWING PERPETUITIES
 Suppose expected future cash flows grow indefinitely at constant rate G:

 Present value of stream of expected future cash flows is given by Gordon growth model:
C
PV = , R>G
R -G

 Gordon growth model can be rewritten as:

C
R= +G
PV
 i.e. “total return” = “dividend yield” + “growth” (capital gains)

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GROWING PERPETUITIES EXAMPLE
 Growing perpetuities are particularly useful for pricing equity investments. We will
discuss this much more later in the module.

 Home Depot’s stock (or share) pays a dividend of $1.5 per year. We expect this
dividend to grow at 15%. The expected equity cost of capital (discount rate) is 16%.
What should be the price of Home Depot’s share?

$1.5
𝑃= = $150
0.16 − 0.15

 i.e. “total return” =“dividend yield” + “growth” (capital gains) = $1.5/150+0.15=0.16 or

16%

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GROWING ANNUITIES
 Suppose now the expected future cash flows grow at constant rate G for N periods
only:

 Present value of the growing annuity equals the difference between two growing
perpetuities, staggered in time by N periods

C  (1  G) N  1 G  
N
C 1 C 
PV = -    1    
R - G (1  R) N R -G R -G   1  R  
 

 We recover the annuity formula when G=0

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GROWING ANNUITIES EXAMPLE
 Suppose you get a position as an investment banker next year. Your starting salary
next year is £70,000 and you expect this to grow on a yearly basis at a 10% rate. You
expect to work over 40 years at which point you will retire. Assuming a discount rate
(cost of capital) of 20%. What is the present value of this position?

70,000 (1 + 0.1)40
𝑃𝑉 = 1− = £678,445
0.2 − 0.10 (1 + 0.2)40

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BONDS
 A bond is a loan instrument that typically pays a fixed percentage C of the face value of
the loan at regular intervals until the loan expires, at which point it also repays the face
value:

C C C C 100
 Present value of the loan is: PV = + + + ... + +
1+ y (1 + y)2 (1 + y)3 (1 + y)T (1 + y)T

 Discount rate y used to calculate present value is known as the yield-to-maturity of the
bond:
 discount rate that makes net present value of the bond equal zero, i.e. that prices
the bond fairly.

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INTERNAL RATE OF RETURN
 Internal rate of return, IRR, is the value of the discount rate R that makes NPV=0.

 If a project is expected to generate a stream of positive future cash flows in return for
some initial investment I, then the graph of NPV vs. R looks like:
NPV

NPV>0 so accept IRR

R

NPV<0 so reject
hurdle rate hurdle rate

 The “NPV>0” rule for accepting capital projects is then equivalent to the rule:
 IRR > hurdle rate.

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HURDLE RATE
 The hurdle rate for a project is the minimum rate of return that the providers of the
firm’s capital require from the investment.

 Also known as the opportunity cost of capital:

 how much providers of the firm’s capital could earn from investing the money
instead in a well-diversified portfolio of financial securities of same risk as project.

 Hurdle rate is obtained from financial markets:

hurdle
rate

risk
premium
risk-free
return

risk

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INTERNAL RATE OF RETURN EXAMPLE
 A student in WBS is developing a networking app to connect students to recruiters
based on a unique matching procedure.

 To create the app she needs an investment of £100,000. She expect to sell this app for
£150,000 to Linkedin next year. The hurdle rate (opportunity cost of capital) is 20%.

𝑁𝑃𝑉 = 𝑃𝑉 − 𝐼 = 0

£150,000
− £100,000 = 0
(1 + 𝐼𝑅𝑅)

𝐼𝑅𝑅 = 50%

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CONCLUSIONS
 Time value of money:
 expected future cash flow of £1 T years from now is not as valuable as receiving
£1 for certain now
 present value of the expected future cash flow is obtained by multiplying cash flow
by discount factor 1/(1 + R)T
 Discount factor reflects both timing and risk of expected future cash flow: the
higher the risk, the greater the discount rate R

 Discount factor reflects both timing and risk of expected future cash flow: the higher
the risk, the greater the discount rate R

 Net Present Value, NPV, of stream of expected future cash flows equals the sum of the
present values of expected future cash flows, net of initial investment I

 If capital is not rationed, company should accept all capital projects with NPV> 0

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