Principles of Corporate Finance. Brealey and Myers. Sixth Edition. ! How to Calculate Present Values. Slides by Matthew Will.

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1 Principles of Corporate Finance Brealey and Myers Sixth Edition! How to Calculate Present Values Slides by Matthew Will Chapter 3

2 3-2 Topics Covered " Valuing Long-Lived Assets " PV Calculation Short Cuts " Compound Interest " Interest Rates and Inflation " Example: Present Values and Bonds

3 3-3 Present Values Discount Factor DF PV of $ " Discount Factors can be used to compute the present value of any cash flow.

4 3-4 Present Values Discount Factor DF PV of $ DF ( + r ) t " Discount Factors can be used to compute the present value of any cash flow.

5 3-5 Present Values PV DF C C + r DF ( + r ) t " Discount Factors can be used to compute the present value of any cash flow.

6 3-6 Present Values PV DF C t C + t r t " Replacing with t allows the formula to be used for cash flows that exist at any point in time.

7 3-7 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?

8 3-8 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? 3000 (. ) PV $2,

9 3-9 Present Values " PVs can be added together to evaluate multiple cash flows. PV C C ( + r ) ( + r ) 2

10 3-0 Present Values " Given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r 20% and r2 7%.

11 3- Present Values " Given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r 20% and r2 7%. DF.00 (+.20).83 DF 2.00 (+.07) 2.87

12 3-2 Present Values Example Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value. Year 0 50,000 Year 00,000 Year ,000

13 3-3 Present Values Example - continued Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value. Period 0 Discount Factor.0 Cash Flow 50,000 Present Value 50, (.07) , ,000 NPV Total 93, ,900 $8,400

14 3-4 Short Cuts " Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tolls allow us to cut through the calculations quickly.

15 3-5 Short Cuts Perpetuity - Financial concept in which a cash flow is theoretically received forever. Return r cash flow present value C PV

16 3-6 Short Cuts Perpetuity - Financial concept in which a cash flow is theoretically received forever. PV of Cash Flow C PV r cash flow discount rate

17 3-7 Short Cuts Annuity - An asset that pays a fixed sum each year for a specified number of years. PV of annuity C t r r r ( + )

18 3-8 Annuity Short Cut Example You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

19 3-9 Annuity Short Cut Example - continued You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease? Lease Cost (.005) 48 + Cost $2,774.0

20 3-20 Compound Interest i ii iii iv v Periods Interest Value Annually per per APR after compounded year period (i x ii) one year interest rate 6% 6% %

21 3-2 Compound Interest FV of $ % Simple 0% Compound Number of Years

22 3-22 Inflation Inflation - Rate at which prices as a whole are increasing. Nominal Interest Rate - Rate at which money invested grows. Real Interest Rate - Rate at which the purchasing power of an investment increases.

23 3-23 Inflation + real interest rate +nominal interest rate +inflation rate

24 3-24 Inflation + real interest rate +nominal interest rate +inflation rate approximation formula Real int. rate nominal int. rate - inflation rate

25 3-25 Inflation Example If the interest rate on one year govt. bonds is 5.9% and the inflation rate is 3.3%, what is the real interest rate? Savings Bond

26 3-26 Inflation Example If the interest rate on one year govt. bonds is 5.9% and the inflation rate is 3.3%, what is the real interest rate? real interest rate Savings + + real interest rate.025 Bond real interest rate.025 or 2.5%

27 3-27 Inflation Example If the interest rate on one year govt. bonds is 5.9% and the inflation rate is 3.3%, what is the real interest rate? real interest rate Savings + real interest rate.025 real interest rate.025 or 2.5% Bond Approximation or 2.6%

28 3-28 Valuing a Bond Example If today is October 2000, what is the value of the following bond? " An IBM Bond pays $5 every Sept for 5 years. In Sept 2005 it pays an additional $000 and retires the bond. " The bond is rated AAA (WSJ AAA YTM is 7.5%). Cash Flows Sept

29 3-29 Valuing a Bond Example continued If today is October 2000, what is the value of the following bond? " An IBM Bond pays $5 every Sept for 5 years. In Sept 2005 it pays an additional $000 and retires the bond. " The bond is rated AAA (WSJ AAA YTM is 7.5%). PV ,5 ( ) 2 ( ) 3 ( ) (.075) + 5 $,6.84

30 3-30 Bond Prices and Yields Price Year 9% Bond Year 9% Bond Yield

JEM034 Corporate Finance Winter Semester 2017/2018

JEM034 Corporate Finance Winter Semester 2017/2018 Lecture #1 Olga Bychkova Topics Covered Today Review of key finance concepts Present value (chapter 2 in BMA) Valuation of bonds (chapter 3 in BMA) Present