CHAPTER 1.

Introduction

1. FINANCE : The study of resource allocation under conditions of uncertainty.

2. SUB-AREA :

1. Corporate Finance : From the view point of Financial Manager.

 Capital Budgeting
 Dividend Policy
 Capital Structure

2. Investment : From the view point of investors.

 Risk
 Return
 Portfolio Management.

3. TYPE OF ORGANIZATION:

1. Sole Proprietorships : the business owned by one individual

Advant. : 1) Easily and inexpensively formed
2) No corporate income tax [taxed as personal income to the owner]
Disadv. : 1) Limited ability to raise large capital
2) Limited Life

2. Partnerships : two or more persons associated to conduct a noncorporate business

Advant. : 1) Easily formed
Disadv. : 1) Limited ability to raise large capital
2) Unlimited liability to debt
3) Limited Life
4) Difficulty in transferring ownerships

3. Corporations
Advant. : 1) Unlimited Life
2) Easy transfer of ownership
3) Limited liability
Disadv. : 1) State and Federal government regulation

4. GOAL OF CORPORATION ?

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 CHAPTER 4 : Net Present Value

1. FV OF PRINCIPAL
FV. of principal, P, at the end of t years is
FV=PV(1+r)N

2. VALUING LONG-LIVED ASSETS

C1
PV  DF1 x C1 
(1  r1 )
C : Cash flow at year 1
DF : Discount factor for year 1 cash flow
r : Annual rate of interest on money invested for 1 year.
Similarly, you can think of PV of 2 year CF

3. NET PRESENT VALUE (NPV)

T T
Ct Ct
NPV  C0    
t 1 (1  r ) t  0 (1  r )
t t

NPV of a project where the summations is over all the cash flows generated by the project, including initial
negative cash flows at the start of the project.
See the example on page 37.

4. PV WITH CONSTANT CF
C C C
PV0   
(1  r ) (1  r ) 2
(1  r )T
N =T
PMT=C
I/Y =r
FV =0
PV =?

5. PV WITH CONSTANT CF
C C C
PV0   
(1  r ) (1  r ) 2
(1  r )T
 1 
1  (1  r )T 
 C 
 r 
 

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6. PV OF PERPETUITIES

 1 
1  (1  r )T 
PV0  C  
 r 
 

CASH FLOWS LAST FOREVER

If T=very large number, then
C
PV0 
r

7. EXAMPLE OF PERPETUITIES
Suppose I want to endow a chair at my old university, which will provide $100,000 each year forever, given
that interest rate is 10%.
QUESTION ) How much should I donate now?

8. PV OF GROWING PERPETUITIES
C1 C2 C3
PV0    
(1  r ) (1  r ) (1  r ) 3
2

C1 C (1  g ) C1 (1  g ) 2
  1  
(1  r ) (1  r ) 2 (1  r ) 3
 C 
 1 
r  g 

9. EXAMPLE OF PV OF PERPETUITIES
 C  100,000
PV0   1    $2,000,000
 r  g  0.10  0.05

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10. CALCULATING PV (Annually)
EXAMPLE)
I want buy a car with 3 pmts. of $3,000 at the end of every year, given that int.rate=12% per year.
What is the price (i.e., PV.) of the car now?
- How to express the formula?
- Compute with a calculator. (ANSWER : $7,205)

11. CALCULATING PV (Semi-annually)

EXAMPLE)
I want buy a car with 6 pmts. of $1,500 at the end of every 6 month, given that int.rate=12% per
year. What is the price (i.e., PV.) of the car now?
- How to express the formula?
- Compute with a calculator. (ANSWER : $7,376)

12. CALCULATING PV (Quarterly)

EXAMPLE)
I want buy a car with 12 pmts. of $750 at the end of every quarter, given that int.rate=12% per year.
What is the price (i.e., PV.) of the car now?
- How to express the formula?
- Compute with a calculator. (ANSWER : $7,466)

13. CALCULATING PV
Similarly, you can compute the PV of Monthly and Daily Payment Case.
Make-up the above problem and get the answer.
ANSWER :
Monthly : $7,527
Daily : $7,557
What if hourly payment : Continuous compounding

14. COMPOUNDING INTERVALS

EXAMPLE)
12% compounded semi-annaully is equivalent to 12.36% compounded annually. (WHY ?)

Equivalent Annual Rate (EAR)

m
 r
EAR = 1    1
 m
r is quoted annual rate, compounded m times per year.

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15. NOMINAL vs. REAL INT. RATE
Suppose bank offers you 30% interest rate per year.
NOW ONE YEAR LATER
$1,000 $1,300
$1/apple $1.25/apple
1,000 apples 1,040 apples
What is the real interest rate?
(1  rN )  (1  rR )(1  inf.rate )

16. VALUATION OF BOND WITH PV

Suppose you invest in a 6% US Treasury Bond maturing September 2002. Assume the coupon is paid
annually and int.rate=6.9% per year.
What is the price (i.e., PV) of this bond now?
How to express the formula?
Compute with a calculator. (ANSWER : $963)

17. SAMPLE EXERCISE PROBLEMS

[FV, SINGLE CASH FLOW] Cleo McDermott plans to buy a cruise tickets to the Bahamas and can afford
to set aside $1,740 toward the purchase today. If the annual interest rate is 6.4%, how much can Cleo
McDermott spend in three years on the purchase? [$2096]

[FV, MULTIPLE YEARS] Compute the future value of $1,870 if the appropriate rate is 13.2% and you
invest the money for four years? [$3071]

[PV] Jack Black plans to buy a surround sound stereo for $2,220 after two years. If the annual interest rate
is 6.7%, how much money should Jack Black set aside today for the purchase? [$1950]

[PV, QUARTERLY COMPOUNDING] Bob Simpson plans to buy a piano for $1,509 after three years. If
the annual interest rate is 13.6% compounded every quarter, how much money should Bob Simpson set aside
today for the purchase? [$1010]

[FV, MULTIPLE CASH FLOW] Cary Grant proposes to set aside $9,600 toward retirement every year for
the next 11 years. If the annual interest rate is 10.9%, how much will Cary Grant have in the retirement
account in 11 years? [$186,774]

Nicole James proposes to set aside $800 toward retirement every month for the next 20 years. If the
annual interest rate is 9.1% compounded every month, how much will Nicole James have in the retirement
account in 20 years? [$541,147]

Solve all the Questions and Problems in Text book [Page 92 - 97]
- Except 4.44, 4.45, 4.46, 4.47, 4.48, 4.49, and 4.50

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 CHAPTER 5 : How to Value Bonds and Stocks
1. RETURN OF STOCK
What will be the return of the stock if I am going to receive a dividend at the end of one year and then sell
the stock?
Return =Dividend Yield + Capital Gain.
Div1 ( p1  p0 )
r 
P0 p0

2. VALUATION OF STOCK
How much should I pay today for this stock?
From the previous equation, we can get
Div1  P1
P0 
(1  r )
How much should the person who buys it from me pay for the stock in a year (ie. P1) if he is going to receive
a dividend after one year and then he is going to sell it?

Similar to the previous logic,

Div 2  P2
P1 
(1  r )

Price of the stock is the present value of the cash flows (ie, dividend) received by the investor.
Div 2  P2
Div1 
Div1  P1 (1  r )
P0  
(1  r ) (1  r )
Div1 Div 2 P2
  
(1  r ) (1  r ) (1  r ) 2
2

By extending the period to T, we can get

Div1 Div 2 PT
P0   
(1  r ) (1  r ) 2
(1  r )T

If T is really big #, the stock price can be expressed


Div t
P0  
t 1 (1  r )
t

Now the price of the stock is obviously independent of the time horizon, T.
As shown above, the present value of the terminal price becomes less important.

3. IMPLICATIONS
By considering how much a buyer will pay for the stock when it is repeatedly sold,
we find that the stock price is the PV of all future dividends.

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4. SPECIAL CASE [1]. NO GROWTH IN DIVIDEND.
- DIV1 = DIV2 = ….=DIV
- Similar to preferred stock
- Good approximation for many utility stocks
- Ordinary perpetuity

Div
P0 
r

5. SPECIAL CASE [2]:CONSTANT GROWTH RATE IN DIVIDEND

- DIV2 = DIV1(1+g)
- DIV3 = DIV2(1+g) = DIV1(1+g)2
- And so on …..
- If dividends are expected to grow at a constant rate (ie, g), the value of the stock is
Div1
P0 
rg

From the previous Equation, we can get

Div1
r  g
P0
MCR = Div.Yld + EGR in Div.

6. SPECIAL CASE [3]:SUPERNORMAL GROWTH RATE IN DIVIDEND

: Firms typically go through life cycles. During the early part of their lives, their growth is much
faster than that of the economy as a whole; then they match the economy’s growth; and finally their
growth is slower than that of the economy.

Example) UH Corporation has been growing at a rate of 20% per year in recent years. This same growth
rate is expected to last another 2 years, then it will grow at a constant rate of 6% thereafter. What is UHC’s
stock worth today, given D0=$1.60 and r=10% ? [$54.11]

Solve all the Questions and Problems in Text book [Pg 121 - 124, and Pg.133]
- Except 5.31 on Pg. 124

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 Exercise For Time Value of Money

Now 1 2 3 4 5
Option A $60 $60 $60 $60 $60+$1000
Option B ???
Q1) Given that interest rate is 2%, how much of the money should I give to you NOW so that you are indifferent between two options?
(ANSWER:$1188.54)
Q2) Given that interest rate is 15%, how much of the money should I give to you NOW so that you are indifferent between two options?
(ANSWER:$698.31)

Now 1 2 3 4 5
Option A $127.63
Option B ???
Q3) Given that interest rate is 5%, how much of the money should I give to you NOW so that you are indifferent between two options?
(ANSWER:$100)

Now 1 2 3 4 5
Option A ???
Option B $100
Q4) Given that interest rate is 5%, how much of the money should I give to you AT THE END OF YEAR_5 so that you are indifferent between
two options? (ANSWER:$127.63)

Now 1 2 3 4 5
Option A ? ? ? ? ?
Option B $100
Q5) Given that interest rate is 5%, how much of the fixed amount of money should I give to you AT THE END OF YEAR_5 so that you are
indifferent between two options? (ANSWER:$23.10)

Q6) Suppose you can buy a certificate for $78.35 which will pay you $100 after 5 years. What is the interest rate you will earn on your
investment? (ANSWER: 5%)

Q7) Suppose you know that a bond will provide a return of 5% per year, that it costs you $783.5 now, and that you will receive $1,000 at the
maturity. But you don’t know when the bond matures. (ANSWER : n=5)

Now 1 2 3
Option A $100 $100 $100
Option B ?
Q8) Given that interest rate is 5%, how much of the money should I give to you AT THE END OF YEAR 3 so that you are indifferent between
two options? (ANSWER:$315.25)

Now 1 2
Option A $100 $100 $100
Option B ?
Q9) Given that interest rate is 5%, how much of the money should I give to you AT THE END OF YEAR 2 so that you are indifferent between
two options? (ANSWER:$331.01)

Now 1 2
Option A $100 $100 $100
Option B ?
Q10) Given that interest rate is 5%, how much of the money should I give to you NOW so that you are indifferent between two options?
(ANSWER:$285.94)

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 Exercise For Time Value of Money (Continued)

Now 1 2 3 4 5
Option A 100 200 200 0 300
Option B ?
Q11) Given that interest rate is 5%, how much of the money should I give to you NOW so that you are indifferent between two options?
(ANSWER:$684.47)

Now 1 2 3 4 5
Option A $100 100 200 200 0 300
Option B ? ?
Q12) Given that interest rate is 5%, how much of the money should I give to you NOW so that you are indifferent between two options?
(ANSWER:$784.47)

Now 1 2 3 4 5
Option A 100 200 200 0 300
Option B ?
Q13) Given that interest rate is 5%, how much of the money should I give to you AT THE END OF YEAR 5 so that you are indifferent between
two options? (ANSWER:$873.58)
: You can’t get the answer of this question by using the built-in function in the financial calculator.
: You need to compute FV of each CF one by one.

Now 1 2 3 4 5
Option A 200 200 200
Option B ?
Q14) Given that interest rate is 5%, how much of the money should I give to you AT THE END OF YEAR 5 so that you are indifferent between
two options? (ANSWER:$695.13)

Now 1 2 3 4 5
Option A 200 200 200 200 Forever
Option B ?
Q15) Given that interest rate is 5%, how much of the money should I give to you NOW so that you are indifferent between two options?
(ANSWER:$4,000)

 Effective Annual Rate

 Continuous Compounding
 Semiannual (or Quarterly, or Monthly, or Dalily) Compounding and Payment

 Find the amount to which $500 will grow under each of the following conditions.
 12 percent compounded annually for 5 years
 12 percent compounded semiannually for 5 years
 12 percent compounded monthly for 5 years
 12 percent compounded daily for 5 years [Assume 1 year =360 days]
 12 percent compounded continuously for 5 years

 The First Bank pays 7% interest, compound annually, on time deposit. The Second Bank pays 6% interest, compounded
quarterly. Which bank gives you higher interest? How can you justify your choice of the bank?

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 CHAPTER 6 : Some Alternative Investment Rules

1. INTERNAL RATE OF RETURN [IRR]

IRR is the discount rate which makes NPV=0
C1 C2 CT
NPV  C0    0
(1  IRR ) (1  IRR ) 2
(1  IRR )T

2. NPV PROFILE
NPV Profile
C0 = - 4
C1 = +2
C2 = +4
Trial and Error Estimat ion.
If discount rate = 0%, then NPV =?
If discount rate = 25% then NPV = ?
If discount rate = 30%, then NPV = ?
If discount rate = 28%, then NPV = ?

3. IRR RULE
Accept the project
If IRR > Opportunit y Cost of Capital.
Looking at the NPV profile for a convent ional project, we will be accept ing projects with posit ive NPV.

4. MULTIPLE IRRs
 Example
Year 0 1 2
CF -$4 $25 -$25

 Two changes in sign of cash flows.

- Generates two IRRs : 25% and 400%
- If r < 25%, NPV < 0
- If 25% < r < 400%, NPV > 0
- If r > 400, NPV < 0.

 How does NPV profile look like ?

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5. NO IRR EXISTS
 Example
Year 0 1 2
CF $1 -$3 $2.5
 For any r > 0, the PV of CF above is posit ive.
 Therefore, should I accept this project ?
Prove it for yourself.

6. CONFLICT BETWEEN NPV AND IRR

 IRR may give the wrong decisio n with mutually exclusive projects which differ in

? Scale and Pattern of Cash Flows Over Time

Year 0 1 2 3 4
Project G -$9 $6 $5 $4 $0
Project H -$9 $1.8 every yr. forever

- Which project has higher IRR?

- Which project has higher NPV, given r=10%?
- Which project should I accept, if both projects are mutually exclusive ?

7. NPV PROFILES FOR BOTH PROJECTS

NPV

$6

Project G

20% 33.3% Discount Rate

?
Project H

8. MUTUALLY EXCLUSIVE PROJECTS

Analys is of Incremental Project [ Project H - Project G ]
Year 0 1 2 3 4
H-G $0 -$4.2 -$3.2 -$2.2 $1.8 . . .

- What is the IRR for Incremental Project [i.e., H-G] ?

- If cost of capital > 15.6%, which project should I choose?
- If 15.6% < c.o.c < 33.3 %, which project should I choose?
- If c.o.c > 33.3 %, which project should I choose?

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9. CAPITAL RATIONING
- Used when limitations on the invest ment funds exist.

NPV
profitability index [i.e. PI.] =
initial investment

Project Invest ment NPV Profit. Index.

A 10 21 2.1
B 5 16 3.2
C 5 12 2.4
Choose the project fro m highest P.I until capital exhausted

10. LIMITATIONS IN USE OF P.I. METHOD

 Capital Constraints in more than one period
Suppose firm can raise $10 millio n in each of year 0 and 1.
0 1 2 NPV@10% P. I
A -10 +30 +5 21 2.1
B -5 +5 +20 16 3.2
C -5 +5 +15 12 3.4
D 0 -40 +60 13 0.4

? If we accept B and C based on PI, we can’t accept D.

What if we take A and D? Give higher total NPV.

Solve all the Questions and Problems in Text book [Pg 156-160]
- Except 6.3 and 6.4 on Pg. 156

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