Corporate Finance (FINA0050) 2023 Block 1 - VLongLolaII

Corporate Finance
Lectures and Seminars
21st September 2023
Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 1

Corporate Finance
Lectures and Seminars
Block 1 - Fundamentals

Real investments
• Real investments are expenditures that generate cash

in the future and, as opposed to financial investments,
like stocks and bonds, are not financial instruments
that trade in the financial markets
• This course considers two types of real investments
– Investments in companies
– Capital budgeting decisions
• Corporations create value for their shareholders by
making good real investment decisions

Real investments
• Intrinsic value of the project?
- Financial managers should use a market-based

approach to value assets, whether valuing financial
assets, like stocks and bonds, or real assets, like
factories and machines

Time-value-of-money concept
• Relationship between $1 today and $1 in the

future
- Consider the following example: A firm is

contemplating investing $1 million in a project that is
expected to pay out $200,000 per year for 9 years.
Should the firm accept the project?
à We need to know the relationship between a dollar

today and a (possibly certain) dollar in the future
before deciding on the project
Time-value-of-money concept
• Compounding and discounting

Figure 4.8 – Ross, Westerfield and Jaffe, 8th ed., page 75

Basics of capital budgeting
• Different issues need to be addressed
- What do we need to value?

We should evaluate the future cash flows that are
generated from the asset that is being valued
à cash flows ≠ income or earnings numbers
- Discount rates: the rate of return that discounts

future cash flows to the present
- Formulae that derive present values

Discounting/compounding
cash flows

Discounting and compounding
• Multi-period setting
- When r is the interest rate (or rate of return per
period) and all interest (profit) is reinvested, an
investment of P0 at date 0 has a future value at date t
of
Pt = P0 (1+r)t
- The date 0 value of an amount Pt , paid at date t, also
known as the present value or discounted value,
comes from rearranging this formula
Pt
P0 =
(1+r)t
• Multi-period setting
The value of an investment over multiple periods when
interest (profit) is reinvested
Beginning- End-of- Initial
of-Period Period Principal Interest (profit)
Date Date Balance Earned over Period End-of-Period Value
Po Por Po + Por = Po (1 + r)
0 1
Po (1 +
= r) Po (1 +
= r)r Po (1 + r) + Po (1 + r) r = Po (1 + r)2
1 2
2 3 Po (1 + r)2 Po (1 + r)2r Po (1 + r)2 + Po (1 + r)2r = Po (1 + r)3
. . . . .
. . . . .
. . . . .
t-1 t Po (1 + r)t-1 Po (1 + r)t-1r Po (1 + r)t-1 + Po (1 + r)t-1r = Po (1 + r)t

• Different types of rates

– Nominal rate: used for computing interests paid per
period, this rate is proportional to the period
• The purpose is to compute the interests paid
– (Annual) Effective rate: what you effectively get at the
end of the year
– Equivalent rate: when you convert effective rate into the
proper frequency
• The purpose is to adjust the discount rate to the
periodicity of the cash flows


end of the year
proper frequency

• Nominal rate: Interest rates on all investments

tend to be quoted on an annualized basis
- The rate quoted on a mortgage with monthly
payments is 12 times the monthly interest paid per
unit of principal
- Annualized quoted interest rates with the same r but
different compounding frequencies mean different
things
à Need to convert each rate to the same
compounding frequency
• Translating these nominal interest rates with

different compounding frequencies into interest
earned per period
Annualized Interest Rate Interest per Period Length of a Period
Quotation Basis
Annually compounded R 1 year
Semiannually compounded r /2 6 months
Quarterly compounded r /4 3 months

Monthly compounded r /12 1 month
Weekly compounded r /52 1 week
Daily compounded r /365 1
Compounded m times a r /m 1/m years
year

– (Annual) Effective rate: what you effectively get at
the end of the year
proper frequency


Example (nominal vs effective rate)
Which bank is better when we have money to invest?
Bank A: rnominal=10% (compound annually) :

1*(1+0.1)=1.10
Bank B: rnominal=10% (compound semi-annually)
1*(1+0.05)2=1.1025

• Convert nominal rates into effective rates
- A 16% annually compounded rate means that £1.00

invested at the beginning of the year has a value of
£1.16 at the end of the year.
- However, a 16% compounded semi-annually
becomes an 8% over a 6-month period. At the end of 6
months, one could reinvest the £1.08 for another 6
months and the £1.08 would have grown to £1.1664
by the end of the year, i.e. an equivalent annually
compounded rate of 16.64%

end of the year
– Equivalent rate: when you convert effective rate into
the proper frequency

• Finding equivalent rates with different

compounding frequencies
If the compounding frequency is m times a year and
the annualized rate is r, the amount accumulated from
an investment of PV after t years is
mt
" r%
Pt = PV × $1+ '
# m&
If there is a continuous compounding, so that m
becomes infinite, the formula has the limiting value
Pt = PV × e rt
Present and future value
• Value additivity
- Present values (or discounted values) and future

values obey to the principle of value additivity: that is,
the present (future) value of many cash flows
combined is the sum of their individual present
(future) values

Generalizing the present value formulae

• Perpetuity
C
PV =
r
If r is the discount rate per period, the present value of a

perpetuity with payments of C each period commencing at
date 1 is C/r

𝐶 𝐶 𝐶 𝐶
1 𝑃𝑉 = + ! + " + # +⋯
1+𝑟 1+𝑟 1+𝑟 1+𝑟
1
2 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑦 1 𝑏𝑦
1+𝑟
1 𝐶 𝐶 𝐶 𝐶
𝑃𝑉 = ! + " + # + $…
1+𝑟 1+𝑟 1+𝑟 1+𝑟 1+𝑟
Make (1)-(2)
𝑃𝑉 𝐶
𝑃𝑉 − =
1+𝑟 1+𝑟
Perpetuity
formula 𝑃𝑉 (1 + 𝑟) 𝑃𝑉 𝐶
− =
(1 + 𝑟) 1+𝑟 1+𝑟
𝐶
𝑃𝑉 =
𝑟
• Computing the value of a complex perpetuity

Example
What is the value of a perpetuity with payments of £2

every half-year commencing one-half-year from now if
r = 10 % per year with annual compounding?
(1+r)2=1.10
r=4.88%
(2/4.88%)=40.976
• Annuities
A standard annuity has payments of C from date 1 to
date T
A standard annuity can be viewed as the difference
between two perpetuities
If r is the discount rate per period, the present value of an

annuity with payments commencing at date 1 and ending
at date T is Cæ 1 ö
PV = çç1 - ÷
T ÷
r è (1 + r ) ø

Annuities
𝐶
C C C C C C
… ∞ 1 𝑃𝑉 =
𝑟
1 2 3 T T+1
0 𝐶
C C
… ∞ 2 𝑃𝑉 ∗= 𝑟
1+𝑟 *
T T+1 T+2
0
𝐶
𝐶 𝑟 𝐶 1
1 − 2 = − *
= 1− *
𝑟 1+𝑟 𝑟 1+𝑟

• Computing annuity payments

Example
Flavio has just borrowed £100,000 from his rich professor
to pay for his doctoral studies. He has promised to make
payments each year for the next 30 years to his professor
at an interest rate of 10 percent. What are his annual
payments?
Answer:
$#"
100,000 1 − 1.10
C= = £10,607 #"
𝑤𝑖𝑡ℎ 𝐴!" = = 9.427
9.427 0.10
• Growing perpetuities and annuities
- A growing perpetuity is a perpetual cash flow stream

that grows at a constant rate (denoted as g) over time:
Cash flow at date
1 2 3 4 …
C C(1+g) C(1+g)2 C(1+g)3 …
- A growing annuity is identical to a growing

perpetuity except that the cash flows terminate at date
T
• Growing perpetuities and annuities
The value of a growing perpetuity with initial

payment of C dollars one period from now is
C
PV =
r-g
A growing annuity is like the difference between two
growing perpetuities
C æ (1 + g )T ö
PV = çç1 - ÷÷
r - g è (1 + r )T ø

Valuing real assets

Real asset vs financial asset - Example
• Louisa Dice, a financial analyst at Kaufman & Broad, a

leading real estate firm, is thinking about
recommending that Kaufman & Broad invest in a piece
of land that costs $85,000. She is certain next year the
land will be worth $91,000, a sure $6,000 gain. Given
that the guaranteed interest rate in the bank is 10
percent, should Kaufman & Broad undertake the
investment in land?

Real asset vs financial asset - Example
• The present value of next year’s sales price is less than
this year’s purchase price of $85,000, present-value
analysis also indicates that she should not recommend
The amount you
purchasing the property need to put into
the bank to get
the same cash
à NPV rule: flow of $91,000
PV= 91 000/1.10 = $82 727.27
NPV = -$ 2,273
The NPV rule compares the investment cost for the land to
the investment in the financial markets Louisa should
make to get the same cash flows! This investment is called
the « tracking portfolio ».
Valuing real investments: basics
• The present value (PV) of a project is the market

price of a portfolio of traded securities that tracks the
future cash flows of the proposed project
- a project creates value for a corporation if the cost of

investing in the project is less than the cost of
investing in a portfolio of financial assets that tracks
the project’s future cash flows
à Net present value criterion

Valuing real assets:
Net present value criterion
• Present value
- To obtain a PV, you typically discount the estimated

future cash flows of a project at an appropriate rate of
return, known as the discount rate
- The appropriate discount rate will correspond to the

rate of return of the appropriate tracking portfolio

Valuing real investments
• In order to determine the market price of the

project…
… simply apply the tools used for valuing financial

assets!

Quizz
Let’s test the concepts!!

Time-value-of-money – Concept # 1
• Don Simkowitz invests $10,000 in the bank at an

insured 12 percent for two years with annual
compounding.
At the end of the two years, he would have
1. $10,000+ (0.12 x 2 x $10,000) = $12,400
2. $10, 000 + 0.12 x $10,000 + 0.12 x (1.12 x $10,000)

= $10,000 (1.12)2
= $12,544
Time-value-of-money – Concept # 1
• Don Simkowitz invests $10,000 in the bank at an

insured 12 percent for two years with annual
compounding.
At the end of the two years, he would have
1. $10,000+ (0.12 x 2 x $10,000) = $12,400
2. $10, 000 + 0.12 x $10,000 + 0.12 x (1.12 x $10,000)

= $10,000 (1.12)2
= $12,544

Time-value-of-money – Concept #2
• What is the end-of-year wealth if Jane Christine

receives a stated annual interest rate of 24 percent
compounded monthly on a $1 investment?
12
! 0.24 $
1. $1 #1+ & = $1.2682
" 12 %
2. $1 x 1.24 = $1.24

• What is the end-of-year wealth if Jane Christine

receives a stated annual interest rate of 24 percent
compounded monthly on a $1 investment?
12
! 0.24 $
1. $1 #1+ & = $1.2682
" 12 %
2. $1 x 1.24 = $1.24

• If the stated annual rate of interest, 8%, is

compounded quarterly, what is the effective annual
rate of interest?
1. 8%
2. (1+0.08/4)4-1=8.24%
3. 8%/4 = 2%

• If the stated annual rate of interest, 8%, is

compounded quarterly, what is the effective annual
rate of interest?
1. 8%
2. (1+0.08/4)4-1=8.24%
3. 8%/4 = 2%

• One individual just borrowed $10,000 to invest in a

production equipment. Debt repayment will be made
with equal semi-annual instalments during the next 3
years, at a nominal interest rate of 5.00%
compounded semi-annually. What is the amount of
these semi-annual instalments? Keep two decimals in
your intermediate calculations and round the final
value.
1. $1,815. 3. $2,150.
2. $1,970. 4. $3,500.
5. None of these answers is correct.
value.
PV= 10,000 / C= Unknown / r=5%/
rs=0.025 (5%/2) ->Compound semi-annually
T: 3*2=6
PV=(C/r)*(1-(1+r)-t)
A=((1-(1+0.025) -6)/0.025)=5.51
C=10,000/5.51=1,815

value.
1. $1,815. 3. $2,150.
2. $1,970. 4. $3,500.
Assume you want to save money to buy a car three years

from now (end-of-month) for a price of $37,000. You decide
to put $1,000 at the end of each month on a bank account
with a nominal interest rate of 2.20%, compounded monthly.
Will you be able to buy the car in three years?
1. Yes, with a residual cash of $167.
3. Yes, with no residual cash.
4. No.

èRto use= r/12
Monthly: r= 2.20%/12=0.18333%
FV=(C/r)*((1+r)t-1)
FV= $1,000*((1+0.183%)^(12*3)-1)/0.183%
FV=$37,179.37

4. No.

with a nominal interest rate of 2.20%, compounded yearly.
4. No.

è Rto use= (1+r)^(1/t)-1
Monthly=(1+2.20%)^(1/12)-1=0.18515%
FV=(C/r)*((1+r)t-1)
FV= $1,000*((1+0.18515%)^(12*3)-1)/0.18515%
FV=$37,167.39

4. No.
Discounting and valuing – Concept #1
• Suppose you are in the business of trying to determine

the value of small companies.
The firm is expected to generate net cash flows (cash

inflows minus cash outflows) of $5,000 in the first
year and $2,000 for each of the next five years. The
firm can be sold for $10,000 seven years from now.
The owners of the firm would like to be able to make
10% on their investment in the firm.

Discounting and valuing – Concept # 1
• How can we determine the value of the firm?
1. Adding the future cash flows
2. $10, 000 (sale price seven years from now)
3. Compute the present value of its future cash flows

• How can we determine the value of the firm?
1. Adding the future cash flows
2. $10, 000 (sale price seven years from now)
3. Compute the present value of its future cash

flows

• The Trojan Pizza Company is contemplating investing

$1 million in four new outlets in Los Angeles. Andrew
Lo, the firm’s Chief Financial Officer (CFO), has
estimated that the investments will pay out cash flows
of $200,000 per year for nine years and nothing
thereafter.
Mr. Lo has determined that the relevant discount rate

for this investment is 15%. This is the rate of return
that the firm can earn at comparable projects.

• Should the Trojan Pizza Company make the

investments in the new outlets? What do you need to
compare?
1. Compare the investment cost of $1,000,000 to the

sum of the future cash flows

present value of the future cash flows of the project

• Should the Trojan Pizza Company make the

investments in the new outlets? What do you need to
compare?

sum of the future cash flows
2. Compare the investment cost of $1,000,000 to

the present value of the future cash flows of the
project

Don’t forget – Continuous evaluation
Please complete Block 1 quiz by October 5th at the latest to be accounted for in
your continuous evaluation!

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Corporate Finance

Lectures and Seminars

21st September 2023

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 1

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 2

• Real investments are expenditures that generate cash

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 3

• Intrinsic value of the project?

- Financial managers should use a market-based

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 4

• Relationship between $1 today and $1 in the

- Consider the following example: A firm is

à We need to know the relationship between a dollar

• Compounding and discounting

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 6

• Different issues need to be addressed

- What do we need to value?

- Discount rates: the rate of return that discounts

- Formulae that derive present values

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 7

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 8

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 10

• Different types of rates

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 11

• Different types of rates

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 12

• Nominal rate: Interest rates on all investments

• Translating these nominal interest rates with

Quarterly compounded r /4 3 months

• Different types of rates

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 15

• Different types of rates

Bank A: rnominal=10% (compound annually) :

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 16

• Convert nominal rates into effective rates

- A 16% annually compounded rate means that £1.00

• Different types of rates

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 18

• Finding equivalent rates with different

- Present values (or discounted values) and future

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 20

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 21

If r is the discount rate per period, the present value of a

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 22

• Computing the value of a complex perpetuity

What is the value of a perpetuity with payments of £2

If r is the discount rate per period, the present value of an

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 25

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 26

• Computing annuity payments

• Growing perpetuities and annuities

- A growing perpetuity is a perpetual cash flow stream

- A growing annuity is identical to a growing

• Growing perpetuities and annuities

The value of a growing perpetuity with initial

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 29

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 30

• Louisa Dice, a financial analyst at Kaufman & Broad, a

Corporate Finance: Lectures and Seminars, HEC-Liège 2023-2024 – Marie Lambert 31

• The present value (PV) of a project is the market

- a project creates value for a corporation if the cost of

à Net present value criterion