Session 123: Introduction and

Time Value of Money

MIM
Financial Management and Corporate
Finance
Fall 2022

Merih Sevilir

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 Today’s class

1. Introduction

2. Course Structure
− Grading
− Assignments
− Exams
− Course Materials

3. Structured Overview of Course Material

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Contact Information

Merih Sevilir
Professor of Finance ESMT-Berlin and Halle Institute for Economics
Research
Office 1.28
merih.sevilir@esmt.org

Research and teaching areas:

Entrepreneurship, startup creation and growth
Mergers and Acquisitions, Corporate Governance, Initial Public Offerings
Private Equity

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 Before everything else: why study finance?

Silicon Valley Needs a Few Good CFOs

WSJ, May 24, 2019
“As more startups turn into large, complex firms, many are looking to hire a finance chief who
can impose financial discipline and bring a new level of managerial expertise. A successful
candidate must have experience dealing with investors and lenders, taking companies public,
knowledge of tech-specific regulations and accounting practices….

….. among the biggest recruitment hurdles for an ambitious startup…… is finding a finance
chief who has already run the marathon of taking a company public.

…only 71% percent of 180 U.S. unicorns had CFOs as of April 17, according to PitchBook…. just
64% of startups with valuations of between $500 million and $1 billion had a finance chief…”
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Why learn finance?
Let’s go over class topics and understand their importance and implications
in real life

 Importance of finance for households

 Importance of finance for business professionals

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Why learn finance?

Your cousin is 12 years old. She will start college in 6 years. Your aunt and
uncle would like to have $100,000 in a savings account to fund her
education at that time. If the account promises to pay a fixed interest rate
of 4% per year, how much money do they need to put in the account today
to make sure they will have $100,000 in 6 years?

 How much money do they need to put in the account starting today and
in each of the next 5 years so that they will have $100,000 in 6 years?

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 Why learn finance, cont’d?

You are thinking of purchasing a house. The house costs $400,000. You
have $50,000 in cash that you can use as a down payment on the house.
You need to borrow the rest of the purchase price. The bank is offering 30-
year mortgage that requires annual payments and has an interest rate of
5% per year. What will your annual payment be if you get this mortgage?

 refinancing the mortgage if interest rates change

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Why learn finance, cont’d?

You are considering two ways of financing your spring break vacation. You
could put it on your credit card, at 12% APR (annual percentage rate),
compounded monthly, or borrow money from your parents who want an
8% interest rate every six months. Which option is better?

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Finance for business professionals

 What investments to make? What projects to undertake? How to create

value? Elon Musk acquiring Twitter?

 What is a good product/marketing strategy/ acquisition, etc?

− Cash flows, C, generated by a project

− Cost of capital (hurdle rate, discount rate, ..) for the project
− Net present value created from the project

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Time Value of Money
Present value of a new product which will generate cash flows for the next
5 years:

C1 C2 C5
Present Value  C0    ...... 
(1  discount rate) (1  discount rate) 2 (1  discount rate)5

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How do we raise capital for a new project (firm)?

 Raise (debt) capital by selling bonds (or by borrowing):

− How much do investors pay for the bond?
− Value of the bond: Present value of future cash flows from the bond

 Raise (equity) capital by selling stocks:

− How much do investors pay for the stock?
− Value of the stock: Present value of future cash flows from the stock

Raise capital for your startup! Next class in the Spring semester

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Investors buying bonds and stocks
 Investors expect to make a return from investing in bonds and stocks (expected rate of return
from….)
− What return do investors expect when they invest money in a firm?
− What return should a firm generate to meet expectations of its investors?

 Relationship between risk and return

 Diversification and Portfolio Theory
 Capital Asset Pricing Model (CAPM)

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A firm’s cost of capital
 Using CAPM to estimate a firm’s cost of capital (hurdle rate)

− Cost of equity (expected return on stock)

− Cost of debt (expected return on bonds)

− Weighted average cost of capital (WACC)

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A firm’s free cash flows (different from earnings)

Revenues
-Costs
-Depreciation
EBIT
-Taxes
EBIT(1-tC)
+Depreciation
-ΔNWC
-CAPEX
Free Cash Flows
(FCFs)

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 Putting all together

Revenues
-Costs Discounted Cash Flow (DCF) Analysis
-Depreciation
EBIT
-Taxes
EBIT(1-tC)
+Depreciation
-ΔNWC
-CAPEX
FCF

Firm Value  FCFs S B

rWACC  rS  rB (1  TC )
SB SB
discounted @ rWACC

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We will talk about some of the topics below during our class. What is
special about them?
 Modigliani-Miller Theory of Capital Structure

 Capital Asset Pricing Model

 Financial Options

 Adverse Selection and Asymmetric Information

 Market Efficiency

 Moral Hazard, Incomplete Contracts

 Financial Intermediary (Banking)

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Grading
− Class Participation: 10%
− 3 Team Assignments: 35%
− Final Exam: 55%

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Assignments

Practice Questions (for class participation grade):

• Each class ends with a practice question on the material covered that
day. Next class starts with discussion of the practice question from
previous class. You are encouraged to spend 15-30 minutes on each
practice question after class. These are individual assignments, which
won’t be submitted or graded. I will warm call at the beginning of
each class to discuss your approach and solution to the question.
Quality of participation will affect class participation grade.

• Spending time and effort on each practice question is an efficient way

of not falling behind, following class material, and preparing for the
the Final exam.

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Team Assignments

− Assignment 1: Time Value of Money (will be posted on Nov 18, 2022)

(due on Nov 21, 2022)

− Assignment 2 : Portfolio Theory and CAPM

(due on Nov 28, 2022)

− Assignment 3 : Case study

(due on Dec 6, 2022)

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 Final Exam

Final exam: December 12, 2022

In class exam. Open notes and open Excel
n
More information on the details about the exams will be provided later!

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Course Materials
Class slides

Class slides will be posted on Moodle. They are the primary source of
class material.

Practice Questions
Provided at the end of each class at the end of the slide deck
Discussion/solution provided in the beginning of next class session

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Course Materials, cont’d
Calculators:
 You will not need to use a specific calculator in the class. Instead, assignments and discussions will
be tailored to working out problems with pencil and paper and/or excel.

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Class Roadmap: Example
Topics:
Time Value of Money
• Future Value
• Present Value
• ….
• ….

Preparation before Class

•Review course material from previous class (slides posted)
•Spend time and effort on practice question from previous class, and be
ready to discuss your solution and approach in the beginning of the class

Study after Class

•Review course material and practice questions

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How to do well in this course?
 Attend classes
 Spend quality time and effort on Practice Question at the end of every class
 Make sure you spend enough time and understand every question on team assignments
 Whenever you have a question, come and see me, or send me an email as soon as possible

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Time value of money

 Are current and future cash the same thing? i.e., do they have the same value?

 Why or why not?

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Interest rates

As long as there is a non-zero (generally positive) interest rate, dollars today and dollars tomorrow
are different.

Why might there be positive interest rates?

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Determinants of interest rate levels

 Real rate of interest

− interest rate that would exist in the absence of inflation

 Nominal rate of interest

− interest rate adjusted for inflation

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Real rate of interest

 expected return on productive assets (returns on investments on productive assets)

 Individuals’ time preference for consumption

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Nominal rate of interest
− Inflation
Lenders want the interest rates to include compensation for the inflation predicted to
occur over the life of the loan

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Compounding

If you were to invest $10,000 at 5-percent interest rate for one year, your
investment would grow to $10,500.

$500 would be interest ($10,000 × .05)

$10,000 is the principal repayment ($10,000 × 1)
$10,500 is the total due. It can be calculated as:

$10,500 = $10,000×(1.05)

The total amount due at the end of the investment is called the Future
Value (FV).

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Compounding, cont’d
In Excel
= FV(rate, nper, payment, pv)
= FV(5%, 1, 0, 10,000) = $10,500

rate = interest rate per period

nper: number of periods
payment: periodic payments (more on this later this class)
pv: the amount we are investing at present time (time zero), today

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Future value

In the one-period case, the formula for FV can be written as:

FV = C0×(1 + r)

Where C0 is cash flow today (time zero), and

r is the interest rate per period.

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Multiple periods

 If you were to invest $10,000 at 5-percent interest rate for two years, what would your investment
grow to?

10,000 × (1 + 5%)2 = 11,025

In Excel
= FV(rate, nper, payment, pv)
= FV(5%, 2, 0, 10,000) = $11,025

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General formula

The general formula for the future value of an investment over many periods can be written as:
FV = C0×(1 + r)T
where
C0 is cash flow at date 0,
r is the interest rate per period, and
T is the number of periods over which the cash is invested.

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Example

Suppose you invest $1000 in an account paying 10% interest per year. How much will you have in
the account in 8 years? in 20 years? in 75 years?

𝐹𝑉 = 1000 × (1 + 10%)8 = 2,143.6

𝐹𝑉 = 1000 × (1 + 10%)20 = 6,727.5

𝐹𝑉 = 1000 × (1 + 10%)75 = 1,271,895

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Example, cont’d
Suppose you invest $1000 in an account paying 10% interest per year. How much will you have in
the account in 8 years? in 20 years? in 75 years?

In Excel
= FV(rate, nper, payment, pv)

= FV(10%, 8, 0, 1000) = $2,143.6

= FV(10%, 20, 0, 1000) =$6,727.5

=FV(10%, 75, 0, 1000) =$1,271,895

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 Power of compounding

Wall Street Journal, Aug 28, 2020

Warren Buffett and the $300,000 Haircut
There’s a reason the Oracle of Omaha is an ultrabillionaire as he turns 90: He grasped the power of compounding at the age of
10. The sooner the rest of us fully understand it, the better off we’ll be.
This Sunday, Warren Buffett turns 90.
Investing well is important, but investing well for a long time matters even more. Around the age of 10, he read a book about how
to make $1,000 and intuitively grasped the importance of time. In five years, $1,000 earning 10% would be worth more than
$1,600; 10 years of 10% growth would turn it into nearly $2,600; in 25 years, it would amount to more than $10,800; in 50 years, it
would compound to almost $117,400.

His friends and family regularly heard the young Mr. Buffett mutter things like “Do I really want to spend $300,000 for this haircut?”
or “I’m not sure I want to blow $500,000 that way” when pondering whether to spend a few bucks. To him, a few dollars spent that
day were hundreds of thousands of dollars forgone in the future because they couldn’t compound.

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Discounting
If you were to be promised $10,000 due in one year when the interest rates are
5-percent (5%), the Present Value (PV) of $10,000 will be $9,523.81 in today’s
dollars.
$9,523.81 is the amount you can borrow from a bank at present if the interest
rates are 5%.

$10,000
PV  $9,523.81 
1.05

In Excel
= PV(rate, nper, payment, fv)
= PV(5%, 1, 0, 10,000) = $9,523.81

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Present value

In the one-period case, the formula for PV can be written as:

C1
PV 
1 r

where C1 is cash flow at date 1, and

r is the interest rate per period.

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General formula
The general formula for the present value of a cash flow in T periods can be written as:

where CT
PV 
CT is cash flow at date T, (1  r )T
r is the interest rate per period.

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Example

How much would an investor have to set aside today in order to have $20,000
five years from now if the interest rate per year is 15%?
In Excel
= PV(rate, nper, payment, fv)
= PV(15%, 5, 0, 20,000) = $9,943.53

PV $20,000

0 1 2 3 4 5
$20,000
$9,943.53  5
(1.15)
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Net Present Value

The Net Present Value (NPV) of an investment is the present value of the expected cash flows, less
the cost of the investment.

Example: Suppose Amazon shares are trading at $9500 today. You expect that the price will go up
$10,000 in one year. Your interest rate is 5%. Should you buy an Amazon stock?

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Solution

$10,000
NPV  $9,500 
1.05
NPV  $9,500  $9,523.81
NPV  $23.81

The present value of the cash inflow is greater than the cost. In other
words, the Net Present Value is positive, so the stock should be purchased.

In Excel
= NPV(rate, value1, value2,…)
= NPV(5%, 10,000) -9,500 = $23.81

attention: value1 = cash flow at t=1 (not at t=0)!

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Net present value

In the one-period case, the formula for NPV can be written as:

NPV = –Cost + PV

If we had not undertaken the positive NPV project considered on the last
slide, and instead invested our $9,500 elsewhere at 5 percent, our FV would
be less than the $10,000 we will get from Amazon, and we would be worse
off in FV terms :

$9,500×(1.05) = $9,975 < $10,000

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Example: multiple cash flows

Suppose an investment advisor is offering you the following deal. You will get $200 one year from
now, with cash flows increasing by $200 per year through year 4. The interest rate is 12%.

 If the advisor offers you this deal for $1,500, should you buy it?

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Solution

0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
PV=1,432.93
NPV = -1500 + 1432.93 = -$67.07 <0. → Do Not Buy
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Solution in Excel

A1 B1 C1 D1 E1
t=0 t=1 t=2 t=3 t=4
-1500 200 400 600 800

= NPV(rate, value1, value2,…)

= NPV(5%, B1:E1 ) – A1= -$67.07

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Interest rates do not always compound yearly

Example:
 The phrase "x% per year, compounded monthly" is a way
to tell us what the interest rate per (monthly) compounding period is.

 In this case, take the "x% per year" and divide by the
number of monthly compounding periods in a year (or 12)

 The result is the ’true’ interest rate per compounding period (month in this example)

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Example

If you invest $50 for 3 years at 12% compounded semi-annually, what would your investment grow to?

Solution:
12%/2 = 6%: semi-annual interest rate
3 years = 6 semi-annual periods

23
 .12 
FV  $50  1    $50  (1.06) 6  $70.93
 2 

In excel: FV(6%, 6, 0, 50) = $70.93

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Effective annual rates of interest

A reasonable question to ask in the above example is “what is the effective annual rate of
interest on that investment?”

.12 23
FV  $50  (1  )  $50  (1.06) 6  $70.93
2

The Effective Annual Rate (EAR) of interest is the annual rate that would give us the same
FV after 3 years:

$50  (1  EAR)3  $70.93

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Effective annual rates of interest

FV  $50  (1  EAR)3  $70.93

$70.93
(1  EAR)  3

$50
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 $70.93 
EAR     1  .1236  12.36%
 $50 

So, investing at 12.36% compounded annually is the same as investing at 12% compounded semi-annually.

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Effective annual rates of interest
r : stated annual interest rate (or annual percentage rate) with m compounding intervals per year

EAR: effective annual rate of interest

𝑟
EAR = (1 + )𝑚 −1
𝑚

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Example
 Find the Effective Annual Rate (EAR) of an 18% annual rate that is compounded monthly.

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Solution
𝑟
Use the formula EAR = (1 + )𝑚 −1
𝑚
where
r = 18%
m = 12

18% 12
𝐸𝐴𝑅 = (1 + ) −1 =19.56%
12

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EAR versus effective interest rate for a T-year time interval

r : stated annual interest rate (or annual percentage rate) with m compounding intervals per year

EAR: effective annual rate of interest

𝑟𝑒𝑓𝑓,𝑇−𝑦𝑒𝑎𝑟 : Effective interest rate for a T-year time interval

𝑟
𝑟𝑒𝑓𝑓,𝑇−𝑦𝑒𝑎𝑟 = (1 + )𝑚𝑇 −1
𝑚

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Example, cont’d

Given the 18% annual rate compounded monthly, find

 Effective 2-month rate (T = 1/6)

18% 12×1
𝑟𝑒𝑓𝑓,𝑇−𝑦𝑒𝑎𝑟 = (1 + ) 6 −1= 3%
12

r=18%, m =12. T = 1/6 (2 months)

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Example, cont’d

 Effective 6-month rate (T = ½)

18% 12×1
𝑟𝑒𝑓𝑓,𝑇−𝑦𝑒𝑎𝑟 = (1 + ) 2 −1= 9.3%
12

 Effective 24-month rate (T= 2)

18% 12×2
𝑟𝑒𝑓𝑓,𝑇−𝑦𝑒𝑎𝑟 = (1 + ) −1= 42.95%
12

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 Special cash flow streams

 Perpetuity
− A constant stream of cash flows that lasts forever
 Growing perpetuity
− A stream of cash flows that grows at a constant rate forever
 Annuity
− A stream of constant cash flows that lasts for a fixed number of periods
 Growing annuity
− A stream of cash flows that grows at a constant rate for a fixed number of periods

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Perpetuity

A constant stream of cash flows that lasts forever

C C C
…
0 1 2 3

Note that the first payment comes at t=1!

C C C
PV    
(1  r ) (1  r ) (1  r )
2 3

C
PV 
r 58
Growing perpetuity
A growing stream of cash flows that lasts forever

C C×(1+g) C ×(1+g)2
…
0 1 2 3

Note that the first payment comes at t=1!

C C  (1  g ) C  (1  g ) 2
PV    
(1  r ) (1  r ) 2 (1  r ) 3
C
PV 
rg
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 Annuity

A constant stream of cash flows with a fixed maturity

C C C C

0 1 2 3 T
Note that the first payment comes at t=1!
C C C C
PV     
(1  r ) (1  r ) 2 (1  r )3 (1  r )T

C 1 
PV  
r  (1  r )T 
1

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Example

Example:
What is the present value of a four-year annuity of $100 per year that makes its first
payment two years from today if the interest rate is 9%?

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Solution

0 100 100 100 100


0 1 2 3 4 5
Note that the first payment comes at t=2

100 1 4
(1 −
9% 1.09)
𝑃𝑉 = = $297.22
1.09

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 Solution excel

Example
What is the present value of a four-year annuity of $100 per year that makes its first
payment two years from today if the interest rate is 9%?

=PV(9%, 4, 100)/(1.09) = $323.97/1.09 = $297.22

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 Growing annuity

A growing stream of cash flows with a fixed maturity

C C×(1+g) C ×(1+g)2 C×(1+g)T-1


0 1 2 3 T
Note that the first payment comes at t=1!

C C  (1  g ) C  (1  g )T 1
PV   
(1  r ) (1  r ) 2
(1  r )T

C   1 g  
T

PV  1    
r  g   (1  r )  
 
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 Example

Example
You are evaluating an income generating property. Net rent is received at
the end of each year. The first year's rent is expected to be $8,500, and
rent is expected to increase 7% each year. What is the present value of the
estimated income stream over the first 5 years if the interest rate per year
is 12%?

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 Solution

Use below formula, where C = $8500, r = 12%, g = 7%, T =5

C   1 g  
T

PV  1    
r  g   (1  r )  
 

5
8500 1 + 0.07
𝑃𝑉 = 1−
0.12 − 0.07 1 + 0.12
PV = $34,706.3

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Practice Problem

Suppose that you are 25 years old. You figure that your income will be such that you will be able to
save for the next 25 years, until age 50. At age 50, your income will just cover your expenses until
you retire at age 60. Finally, you expect live until age 81 (your last withdraw from your retirement
account will be on your 80th birthday). Suppose that you want to guarantee yourself an income of
$60,000 per year after retirement beginning at your 61st birthday. In addition, you want to have
$80,000 on your 60th birthday to use for the first year of retirement (the extra money is for a nice
long trip to Europe). How much should you put away every year, for the next 25 years, starting at
the end of this year (i.e., your first deposit will be on your 26th birthday and your last deposit will be
on your 50th birthday). Assume that the interest rate is r = 12%.

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