Simple Interest.

Valuation of Money Market Instruments

Example 1
You invest in a 181-day sterling CD with a face value of £1,000,000 and a coupon of 11%. What are
the total maturity proceeds?

Example 2
You purchase some sterling Eurocommercial paper as follows:
Purchase value date: 2 July 20X6
Maturity value date: 2 September 20X6
Yield: 8.2%
Amount: £2,000,000.00
What do you pay for the paper?

Example 3
An investor seeks a yield of 9.5% on a sterling 1 million 60-day banker’s acceptance. What is the
discount rate and the amount of this discount?

Example 4
If the discount rate were in fact 9.5%, what would the yield and the amount paid for the banker’s
acceptance be?

Example 5
The rate quoted for a 91-day US treasury bill is 6.5%.
a. What is the amount paid for US$1,000,000.00 of this T-bill?
b. What is the equivalent true yield on a 365-day basis?

The Applications of the Concept of Present Value in Financial Management

The basic formula for present value used in corporate finance is as follows:

FCF1 FCF2 FCF3 FCFn
PV     ............ 
1  r  1  r  1  r 
2 3
1  r n

PV – present value of a series of cash flows
FCF – the value of the future cash flow
r – yearly interest rate (required rate of return, yield)
n – the number of periods in the series of cash flows

Value of Bonds

h Cj N
PV   
t j 1  YTM 
tj
1  YTM th
PV – present value of the bond,
YTM – yield to maturity – required rate of return,
tj –consecutive payment of coupon expressed in years
C – coupon payments,
N – face value of the bond

who agrees to buy the asset under condition of dividing the payment into 5 equal yearly installments. f C N m fi . coupon payable quarterly. What is the total value of the real estate. Example 7 Calculate the present value of a 10-year bond having the following parameters: face value: PLN 500.): 4%. Price the bond taking into account that YTM on investments in such instruments is 12%. It is impossible to calculate the future value of a perpetuity as it approaches infinity.annual coupon in percent m – number of coupon payments in a year m  i  YTM  EAR  1    1  m i . When calculating the present value of a stream of cash flows growing at a steady rate g. The first installment should be paid in one year and equal 10 mln PLN. if the cost of capital for the investor equals 10%. which will yield to its owners constant stream of cash flows in regular intervals over an indefinite time period.the annual interest rate Example 6 The face value of a bond amounts to PLN 1. we rely on the below formula: FCF 1  g  PV  rg where: FCF – the free cash flow in the first period of calculation of the steadily growing perpetuity.a. The value of perpetuity is calculated as follows: FCF PV  r This formula serves to value instruments or assets. YTM: 10%. The redemption term expires in 5 years. g – the rate of growth of the free cash flows. There is a willing buyer.000. The coupon rate is 15% and the interest is payable annually at the end of each year. Example 9 Please value an office building with the following parameters: m2 10 000 . Example 8 The company ABC has been trying to sell the real estate it currently holds on the balance sheet. coupon rate (p.

: FCFE in the forthcoming years equal: 100. The following 4 years should result in gradual stabilization of FCF. Monthly rent EURO / m 15 Monthly inflow 150 000 Monthly maintenance costs 45 000 Income tax rate 19% Income 105 000 Yearly cash flow for the owner 1 260 000 Planned rate of growth of cash flows 2% Expected rate of return on invested capital 15% Example 10 Please evaluate an investment in private residential real estate (apartment): (m 2) 55 Monthly rent 2 100 Lump-sum tax rate 8. taking into account that the rate of return required by the VC company is equal to 20%. To reduce the risk. 500.00% Planned rate of growth of rent 1% The current market price of the apartment if 7 200 zł / m2. Example 12 The following data is available regarding the financial prospects of the company WAB Sp. b) 8 years. evaluate the rate of return achieved by the investor when deciding to buy an apartment. Taking into account the above information. The long-term projections are highly uncertain. The rate of return required by the stockholders equals 11%.o. the valuator adopted an assumption of gradual decay of the FCF at the pace of 1% per year in the residual period. CAPITAL BUDGETING Simple Methods of Project Evaluation – Concept of Break Even Point Concept of Break Even Analysis Break even analysis is based on several quite material simplifications: .50% Location Warsaw Monthly income 1 922 Average number of months of occupancy per 11 year Provision for renovation 120 Expected rate of return 7. Please estimate the value of the company. 300. Example 11 An entrepreneur in currently in the process of negotiation with a VC company regarding potential purchase of his company. After 3 years the cash flows will be growing at a steady pace of 4% per year. Taking into account the presented information please estimate the value of the company’s stock and the share of residual value in the total value assuming that the projection period equals a) 3 years. The market analysis shows that in the forthcoming 4 years the FCF is expected to grow at the rate of 10% per year. z. Financial analysis of the company shows that currently the firm generates the FCF at the level of 350 thousand PLN.o.

security.· Output volume is equal to sales volume (this assumption is used in a situation when we want to base our CVP analysis on total costs. PLN 2. 110 square metres and employ three members of staff. The cost of employing one employee will be ca.000 per month. · Total costs and revenue are lineary functions of sales volume. The expected . too. The rent is ca. Example 13 An entrepreneur is considering the economic viability of opening a retail outlet in the local shopping centre where brand clothes are sold. The entrepreneur expects to apply a 30% mark-up on merchandise purchased from suppliers. this shortcoming is eliminated using variable costs). PLN 113 per meter.) are estimated at ca. · Only those products that fall within the significant output range are subject to analysis. According to his projections. he would have to rent premises with the area of ca. Other shop-related expenses (telephones. etc. · Fixed costs remain constant in significant output range. · Range of products sold is constant and unit prices of sale and variable unit costs remain constant.000 per month. PLN 3.

b) Monthly turnover at which the investment will pay off within 15 months. c) Based on experience. on the average. rf – return on zero-risk assets (e.: Treasury bills ).000.investment outlays and purchases of merchandise are to amount PLN 150. the average bill paid by customers in shops of that type is ca.measurement of the response of the rate of return on a particular share to changes on the securities market. The shop is expected to be open 280 h a month. in accordance with CAPM model: where: re – expected return on equity. b . rm –return on market portfolio (this parameter may be estimated based on the observation of the stock exchange index).000 in Profit Costs of Equity Funds and External Funds Estimation of equity costs based on CAPM model The formula to calculate the value of the rate of return required by the diversified stockholders. Please calculate: a) Turnover at which the owner will break even in each month. PLN 50.g. How many customers would have to make purchases during one average hour of shop operation to make the assumption of recovering investment within 15 months real? Calculation of Fixed Costs Break Even 10. .

500 thousand after 30 days. On contracting the credit.Assumptions of CAPM model . Example 14 Alfa and Beta companies obtain the identical result from operations (EBIT) . a lower risk as compared to investment in the market portfolio. The credit is to be repaid at equal principal installments and variable interest installment.beta VALUES ====> beta <1 => a share that is less sensitive to changes in the index.3).considerable problem with determining the market risk premium . calculate the cost of a two-year credit of the following parameters: the value of 1million zlotys.Investment RISK in respect of shares. Example 15 Please.the Stock Exchange concentration does not allow for assuming that indexes change accordingly to events of general economic nature .Sensitivity of the share value to changing values of the stock exchange index is measured by the so- called beta. being the borrower. a higher risk as compared to investment in the market portfolio. pays the income tax at the rate of 19%. paid at the end of a year). the (annual) interest rate 10%. . Shortcomings of CAPM model for estimating equity costs . Example 16 The cost of the share capital of a certain company amounts is calculated based on CAPM (risk free rate 5%.1000 mu. calculate the real cost of financing with external funds taking into consideration the tax shield effect.possibility of manipulation .structure of listed companies does not reflect the GNP.if calculated on the basis of historical data. c) the credit has the following additional parameters: 500 thousand instantly. .the . a credit in the amount of 1000 mu with the interest rate applicable on the credit in the amount of 20% annually (this is bullet interest. Estimation of weighted average cost of capital for the purpose of enterprise valuation The weighted average cost of capital (WACC) is calculated according to the following formula: where: r – cost of particular elements of capital.the MODEL assumes that the higher the risk. u – share of particular elements of capital in their total value. Alfa company is financed with own funds. while Beta company’s liabilities disclose . market premium 7%. measured by sensitivity of the value of a particular share to changes in the stock exchange index. which affect industries represented to a formidable extent on the stock exchange. Both companies pay a 40% income tax. b) the company pays the income tax at the rate of 19% but it does not pay fees and charges on the credit. fees and charges on the credit.the model does not take into consideration the specific risk . the enterprise pays a 1. . only. the higher the rate of return expected for investors. beta 1. beta >1 => a share that is more sensitive to changes in the index. installments and interest paid twice a year. The company. assuming that: a) a company does not pay the income tax. Please.5% bank fee (calculated on the credit amount). therefore indexes may change as a result of events. in addition to own funds. Observations of historical share prices and indexes serve this purpose. the model may not reflect the current risk . the nominal cost of a long-term credit amounts to 12%.

the nominal value of shares amounts to 700. the nominal value of the issued bonds: 300. that is.the number of compounding during a year PV – Present Value (single amount) FCF – Free Cash Flow at the beginning of perpetuity g – the constant grow rate . The concept of this conversion is presented in the chart below: In the case of valuation of stocks / shares of the company. nominal cost of capital raised from the issue of bonds amounts to 11%. Value Creation Process Estimation of value for shareholders – which allows to check whether the enterprise is following the strategy of maximizing value for shareholders (VBM) – implies discounting of projected free cash flows. Dług oprocentowany = Interest-bearing debt where r . this formula looks as follows: Estimation of share value Opis do rysunku: FCF1 FCF2 FCF3 FCF4 FCF5 FCFn… FCF Balance sheet of the enterprises in market values present share Aktywa value trwałe = Aktywa obrotowe = current assets Kapitały własne = Equity bringing future cash flows to present value. the nominal value of the long- term credit: 500.the annual interest rate m . Interest on the bonds is paid twice a year. please. the credit is repaid four times a year. estimate the value of WACC. On the basis of the available data and the information that the tax rate amounts to 19%. accounting for the rate of return expected by the owners. or discounting. We also know that the market value of the share capital equals 1000 mu. converting future cash flows to current value.

the firm expects its free cash flow to grow at 3% annually.Operational costs (net of depreciation) .Example 17 EF company wishes to assess the value of its AS Devision.Working capital investment + Continuing or (residual value) = FCFF Example 18 . Calculation What is being Calculation method Discount rate model calculated n FCFFt CVFCFFt V    NOA t 1 (1  WACC )t (1  WACC ) n FCFF WACC . CI – invested capital level FCFF . CVFCFF – continuation value Free Cash average cost available to owners and calculated from the standpoint of all Flow to Firm) of capital creditors) parties providing financing. bondholder. NOA – value of non-operating assets EVA n EVAt RV t Company value V  CI     NOA (Discounted t  1 (1  WACC ) t 1  WACC  t including debt (funds Economic WACC available to owners and where: V . use your finding in part b to calculate its value per share.Depreciation = Operating profit (EBIT) . leasing companies) Revenue on sales .Income tax* = Net Operating Profit After Taxes (NOPAT) + Depreciation .owners + other financing parts (banks. Its WACC is 10%. The AS Devision’s estimated free cash flow for firm (FCFF) each year 2013 through 2016 is given in the following table. Beyond 2016 to infinity. year FCFF 2013 700 000 2014 1 200 000 2015 1 100 000 2016 1 200 000 a) Use the FCF valuation model to estimate the value of entire AS Devision.Company value where: V – company value including (Discounted Weighted including debt (funds debt.Capital expenditure .company value including Value Added) creditors) debt. This division holds debt with market value of $10 000 000 and no preffered stock outstanding. c) If a AS Division is a public company having 500 000 shares outstanding. b) Use your finding in part a along with the data provided above to find this division’s common stock value. FCF in year 2016 is equal to net profit (depreciation equals investment).

However. Fixed assets 5 200 Current assets 900 Inventories 300 Accounts receivable 300 Cash 300 Total assets 6 100 Liabilities and equity OB.The management board of the ABC company is thinking of implementing a new strategy which entails making certain investment expenses. Starting value of interest-bearing debt is 2 00 thousand zloty. Stockholder's equity 5 700 Common Stock 5 000 Capital surplus / Accum. Valuation for the company without including the strategy has shown that the value of equity (MV) of the ABC company amounts to PLN 25. Tax rate = 19% . without strategy thousand E (equity) 5 300 PLN thousand D at beginning of period 200 PLN V (value of indebted company) 5 500 thousand PLN The accounting balance sheet of ABC company is presented below: Assets OB. The average expected rate of return by all capital providers (WACC) amounts to 13%. the forecast says that investment would translate into an increase of revenues. less depreciation 17 893 24 033 28 231 28 321 Depreciation 389 1 270 1 142 1 600 Investments into fixed assets 1 706 1 997 2 437 1 600 Working capital investment 1 112 505 111 3 The market value of non-operating assets (fixed assets and securities which are not needed for FCF creation) is 300 thousand. Retain earning 500 Net Incom 200 Liabilities 400 Long-term debt 200 Accounts payable 200 Total liabilities and stockholder's equity 6 100 Forecast of economic values assuming the strategy is implemented in thousand Year 1 Year 2 Year 3 Year 4 Sales revenues 21 125 28 920 33 100 33 209 Operating costs. Estimate value of one share taking into consideration that ABC issued 1 million shares. the free cash flows should reach a stable level. The market data suggests that after 4 years. On the basis of the planned results please determine if the strategy would increase company value for its owners.3 million.

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