Week 1: FNCE10002 Principles of Finance

Overview of Principles of Finance and

Introduction to Financial Mathematics I
Asjeet S. Lamba, Ph.D., CFA
Head, Department of Finance
Room 11.026, Faculty of Business and Economics
8344-7011
asjeet@unimelb.edu.au
1.1
Overview of Principles of Finance
❖ Asjeet S. Lamba (Lecturer 1 and Subject Coordinator: Weeks 1 – 7 inclusive)
❖ Phone: 8344-7011
❖ Email: asjeet@unimelb.edu.au
❖ Office: Room 11.026, 198 Berkeley Street (The Spot)
❖ Office Hours: Via Zoom and by prior appointment
❖ A bit about me…
❖ Head of the Department of Finance, University of Melbourne
❖ PhD in Finance, University of Washington, Seattle
❖ MBA in Finance, University of Michigan, Ann Arbor
❖ BA (Honours) in Economics, University of Delhi, India
❖ Chartered Financial Analyst (CFA) charterholder
❖ Fun fact: I’ve successfully grown the hottest chillies in the world
1.2
Overview of Principles of Finance
❖ Mrinal Mishra (Lecturer 2: Weeks 8 – 12 inclusive)
❖ Phone: TBA
❖ Email: mrinal.mishra@unimelb.edu.au

❖ Office: Room 12.0644, 198 Berkeley Street (The Spot)

❖ Office Hours: Via Zoom and by prior appointment

❖ Senior Lecturer in the Department of Finance

❖ PhD in Finance from the University of Zürich and Swiss Finance Institute
❖ Worked as a post-doctoral researcher at the University of Zürich funded by a grant from
data.org.
❖ Masters from IIM Indore, India
❖ Bachelor of Technology (Honours) from IIT Kharagpur, India

1.3
Overview of Principles of Finance
❖ Assessment 1: This assessment consists of four peer reviewed tasks spaced out over the
semester that will contribute 15% to your overall grade.
❖ Note that there are no extensions possible for this piece of assessment given the nature
of the tasks involved and their timing during the semester
❖ Three out of four tasks need to be completed for full credit (see details in the next slides)

❖ Assessment 2: A mid semester exam which will contribute 25% to your overall grade. It
will be of 60 minutes duration. The mid semester exam will be held during Week 7 of the
semester, that is, the week beginning 15 April
❖ Assessment 3: An end-of-semester final examination which will contribute 60% to your
overall grade. It will be of 120 minutes duration
❖ Note: There are no hurdle requirements associated with any piece of assessment
❖ Subject time commitment: Around 3 – 4 times the in-class time, or around 108 – 144 hours

1.4
Overview of Principles of Finance : Assessment 1 Details
Answer Review
Task Released
Task Type Task Coverage Submission Submission
Date
Date Date
Practice Task Lecture 1 Tuesday 27 Feb Tuesday 5 Mar Tuesday 12 Mar
Task 1 Lectures 1 – 3 Tuesday 12 Mar Tuesday 26 Mar Tuesday 9 Apr
Task 2 Lectures 4 – 5 Tuesday 9 Apr Tuesday 23 Apr Tuesday 30 Apr
Task 3 Lectures 6 – 7 Tuesday 30 Apr Tuesday 7 May Tuesday 14 May
Task 4 Lectures 8 – 9 Tuesday 14 May Tuesday 21 May Sunday 26 May

▪ Make a genuine attempt at answering the assigned questions

▪ Scan and upload your handwritten answers using the Feedback Fruits platform (which is
integrated into Canvas) before the due date/time
▪ Review your answer against the rubric provided and comment on your answer
▪ Anonymously review the work of another student, marking their work against the rubric provided
▪ Provide a comment on the work submitted by an anonymous classmate 1.5
 Overview of Principles of Finance : Assessment 1 Details
Percent of 5
Activity Stage Marks
Awarded
Making a genuine attempt at the questions and Answer 60%
uploading them to the platform before the due submission
date/time
Completing the self-assessment of your own work Review 20%
(available as soon as you submit the tasks) submission
Assessing another student’s work according to the Review 20%
rubric provided submission

1.6
Overview of Principles of Finance : Assessment 1 Details
❖ You will only be able to access the solution if you submit an answer
❖ You should handwrite your answers to simulate exam conditions
❖ Zero marks are awarded (deducted) for actually getting the answer correct (incorrect). All
marks are linked to genuine participation in the activities
❖ If you believe that the work you review does not represent a genuine attempt at the question,
we ask you to make note of this in your comments and we will follow up. If we agree, then 0
marks will be awarded for the submission
❖ The system closes off to participating in a task after the first stage of the activity. That is, you
will not be able to participate in the review process if you do not upload work in the first stage.
If you miss out on the submission phase you will miss out on both sets of marks
❖ There is no facility for late submission as the system randomly and automatically distributes
uploaded work to participating students immediately following the due date/time
❖ All comments/reviews are conducted anonymously but the academic staff can view who said
what
1.7
Overview of Principles of Finance
❖ All lecture notes and additional readings are available on the subject’s LMS page
❖ Required Textbook
❖ Graham, J. R., Adam, C. and Gunasingham, B., Corporate Finance: Asia-Pacific
Edition, 3rd ed., Cengage Learning, 2020. [658.15 GRAH – Referred to as GRAH, Link
to Booktopia]
❖ Link to the book’s print and eBook versions:
https://www.cengagebrain.com.au/shop/isbn/9780170364331
❖ Use the discount code WOW10 to get 10% resources purchased from the Cengage
website.
❖ Read the financial press on a regular (daily!) basis

1.8
Subject Objectives
❖ Use financial mathematics to solve basic financial problems
❖ Explain the role of risk and return in the asset allocation decision and the
pricing of risky assets
❖ Distinguish between the different sources of financing including short term
debt, long term debt and equity
❖ Apply alternative capital budgeting techniques for project evaluation
purposes
❖ Discuss the issues and choices involved in a firm’s capital structure decision
❖ Discuss the issues and choices involved in a firm’s distribution decision
❖ Explain how options can be used to manage basic financial risks

1.9
Subject Content and Focus
❖ Finance is the study of how individuals, businesses and institutions acquire, spend
and manage financial resources (see next slide)
❖ Major areas of finance
❖ Investment analysis and management
❖ Corporate finance
❖ Capital markets and financial institutions
❖ International finance
❖ Personal finance
❖ Real estate finance
❖ Financial intermediation
❖ Behavioral finance and neurofinance
❖ This subject provides an introduction to investment analysis and corporate finance
1.10
Subject Content and Focus
Not covered in this subject

Focus of this subject

Source: Mishkin, F. S. and Eakins, S. G., Financial Markets and Institutions, 9 th ed., 2018 1.11
Subject Content and Focus
❖ Investment analysis is mainly concerned with where and how to invest and how to
finance these investments (first half of this subject)
❖ Valuation of bonds, equities and derivatives
❖ Modern portfolio theory
❖ Asset pricing and market efficiency
❖ Extended in FNCE30001 Investments and FNCE30007 Derivative Securities
❖ Corporate finance is mainly concerned with the decisions of companies and their
management (second half of this subject)
❖ Capital budgeting – what investments to make
❖ Capital structure – how to finance these investments
❖ Payout policy – what to payout to shareholders
❖ Extended in FNCE20005 Corporate Financial Decision Making

1.12
Our Offerings Beyond This Subject
❖ Related to corporate finance
❖ FNCE20005 Corporate Financial Decision Making
❖ FNCE30006 Entrepreneurial Finance
❖ FNCE30011 Essentials of Corporate Valuation
❖ Related to investment analysis and management
❖ FNCE30001 Investments FNCE30003 International Finance
❖ FNCE30010 Algorithmic Trading FNCE30012 Foundations of FinTech
❖ FNCE30013 Essentials of Sustainable Investing
❖ Related to derivatives and risk management
❖ FNCE30007 Derivative Securities
❖ Related to personal financial management
❖ FNCE20003 Introductory Personal Finance
1.13
Subject Content and Focus
❖ Weeks 1 – 2 Introduction to Financial Mathematics
❖ Weeks 3 – 4 Debt and Equity Markets and Securities
❖ Weeks 5 – 6 Portfolio Theory and Asset Pricing
❖ Week 7 Mid Semester Exam (No lecture)
❖ Weeks 8 and 9 Capital Budgeting
❖ Weeks 10 – 12 Introduction to Capital Structure, Payout Policy and
Derivatives (Options)

1.14
Subject Philosophy

“Everything should be made as simple as possible,

but not simpler.”
Albert Einstein
“Any fool can know. The point is to understand.”
Albert Einstein
“If you don’t do finance, finance will be done to
you.”
1.15
Introduction to Financial Mathematics I
1. Provide an overview of the types of firms
2. Examine the main goal of firms and managers
3. Examine the time value of money and interest rates
4. Compare simple interest with compounded interest
5. Calculate present and future values of cash flows
6. Calculate present and future values of a series of cash flows

These notes have been prepared by Asjeet S. Lamba, Department of Finance, University of Melbourne for
use by students enrolled in FNCE10002 Principles of Finance. Please let me know if you find any typos or
errors. This material is copyrighted by Asjeet S. Lamba and reproduced under license by the University of
Melbourne (© 2017-24)
1.16
Required Readings: Weeks 1 – 2
❖ Week 1
❖ GRAH, Ch. 1 and Ch. 3 (Sec. 3.1 – 3.5a and 3.6a)
❖ Lamba, A. S., 2024, Teaching Note 1: Introduction to Financial Mathematics, Sec. 1 –
2. The notation used in this teaching note will be used in class. You should read this
teaching note after reading Graham et al. The reading is available via the LMS
❖ Varian, H., 1993, A Portfolio of Nobel Laureates: Markowitz, Miller and Sharpe,
Journal of Economic Perspectives 7(1), pp. 159-169. The reading is available via the
LMS
❖ Week 2
❖ GRAH, Ch. 3 (Sec. 3.5 – 3.6)
❖ Lamba, A. S., 2024, Teaching Note 1: Introduction to Financial Mathematics, Sec. 3.
You should read this teaching note after reading Graham, et al

1.17
1.1 Why Focus On Corporations?

Source: Berk and DeMarzo, Figure 1.1. The data are for the US market. 1.19
Listed, Publicly-Traded Corporations
❖ A corporation is a legal entity separate from its owners
❖ Ownership is represented by shares of stock. An owner of these shares is
referred to as a shareholder, stockholder or equity holder
❖ Shareholders are created when a company issues shares via an initial public
offering (IPO)
❖ Shareholders are entitled to (discretionary) dividend payments
❖ Direct control is via an elected Board of Directors and day-to-day control via
the senior management led by the Chief Executive Officer (CEO)
❖ The finance manager (CFO) is typically responsible for the firm’s investment,
financing and cash management decisions
❖ Note that this separation of ownership and control can lead to agency problems
(more on this in future lectures)
1.20
Key Stakeholder Groups in Publicly-Traded Corporations

Which stakeholders
are managers
concerned with?

How do managers
act on behalf of those
Focus of this subject
stakeholders?

Source: Introduction to Corporate Governance and Other ESG Considerations, Exhibit 1, Learning
Module 2, CFA Program Level I, 2023 1.21
What Managers Say

Source: Graham, et al, Finance in Practice, Ch 1. Survey of CFOs conducted following the 2007-08 Global
Financial Crisis. A score of 0 (100) means focus purely on shareholders (other stakeholders) 1.22
Market Value Maximization
❖ Shareholders are the stakeholders that managers focus on with the goal of
maximizing the market value of their shareholdings
❖ To examine the above, we need to understand three important concepts in Finance…
1. The time value of money and interest rates
2. Riskless arbitrage and the law of one price
❖ The idea that the same asset (for example, gold) trading in two different markets must
trade at the same price
3. The role of information and capital market efficiency
❖ The idea that the market prices we observe reflect all relevant information available
at that point in time
❖ What do we mean by “relevant” information?
❖ What role do market expectations play in determining market prices?
❖ More on 2 and 3 in future lectures as well
1.23
Case Study 1: Nvidia Smashes Record
Nvidia adds more than $250 billion in value in one day to smash record
❖ 24 Feb 2024: American businessman Jensen Huang surged up the list of the
world’s richest people after adding $10 billion to his net worth on Friday (AEDT).
The CEO of AI chipmaker Nvidia (Nasdaq: NVDA) was the biggest individual
winner as his company added more than $250 billion in stock market value – the
largest one-day gain in Wall Street history. Described by Goldman Sachs’ trading
desk as “the most important stock on planet Earth”, Nvidia’s surge had a
staggering impact on global markets. The Dow Jones index finished above 39,000
for the first time, finishing at 39,069.11, up 1.2 per cent. The broadbased S&P 500
jumped 2.1 per cent to 5,087.03, also a record, while the tech-rich Nasdaq
Composite Index surged 3.0 per cent to 16,041.62, leaving it about 15 points short
of an all-time high.
1.24
Case Study 1: Nvidia Smashes Record
❖ The Wall Street Journal declared Nvidia is enjoying “one of the quickest rises in
corporate history” after its shares surged 16.4 per cent, lifting its market value to
almost $2 trillion. It came after Huang reported quarterly profits had soared to
$12.3 billion on record high revenue driven by demand for its technology to power
artificial intelligence. “Nvidia shows that AI is here to stay,” said Adam Sarhan of
50 Park Investments. “It’s a tipping point where AI is going to go mainstream and
get mass adoption and it’s going to be very bullish.”

1.25
Case Study 1: Nvidia Smashes Record
❖ Nvidia controls about 80 per cent of the high-end chip market, which has seen
soaring demand from companies rushing to upgrade their AI offerings. “The
people who made the most money in the gold rush of the mid-1800s were the ones
providing the tools to get the job done, not those hunting for the precious metal,”
said Russ Mould, investment director at AJ Bell. “Nvidia is effectively playing the
same role today in this tech revolution.” Prior to Nvidia’s results, stocks had been
under pressure in recent days as investors shifted their expectations on monetary
policy, now eyeing later Federal Reserve interest rate cuts. But those concerns
were outweighed Thursday by the buzz over AI.
Source: https://www.news.com.au/finance/money/wealth/ceos-net-worth-increases-by-10-billion-in-one-day-
after-wild-result/news-story/

1.26
 Case Study 1: Nvidia Smashes Record
Nvidia’s Price S&P 500 Index
$800 5,100

$750 Nvidia’s price:

5,000
21 Feb 24: US$674.72
$700 22 Feb 24: US$785.38
$650
4,900 Return: (785.38 –
674.72)/674.72) = 16.4%
$600 4,800

$550 S&P500 index:

4,700
21 Feb 24: 4981.8
$500 22 Feb 24: 5087.0
$450
4,600 Return: (5087.0 –
4981.8)/4981.8) = 2.1%
$400 4,500

NVDA S&P 500

Daily share prices and index values of Nvidia (Nasdaq: NVDA) and S&P500 during Jan – Feb 2024 1.27
1.2 Time Value of Money and Interest Rates
❖ Most finance problems deal with examining the costs and benefits of decisions
involving cash flows at different points in time
❖ The basic valuation principle states that if the value of benefits exceed the value
of costs, then the decision will increase the value of the firm
❖ Some questions…
❖ How are benefits defined?
❖ How are costs defined?
❖ Does it matter if the benefits and costs occur at different points in time?

1.28
Time Value of Money and Interest Rates
❖ Illustration: An investment opportunity will cost you $100,000 today (that is,
year 0) with a benefit of $105,000 in one year’s time. Assume that the cash flow
in year 1 is riskfree (that is, it is certain to occur). You also have the opportunity
to putting these funds in a bank and earn a riskfree interest rate (r) of 8% per
annum. What should you do and why?

0 1

–$100,000 $105,000

r = 8%

1.29
Time Value of Money and Interest Rates
❖ The naïve (and incorrect!) approach…
❖ Benefits – Costs = 105000 – 100000 = $5,000 > 0
❖ This ignores the opportunity cost associated with putting this $100,000 in a
bank account and earning a (riskfree) interest rate of 8%…
❖ Value of $100,000 in one year = 100000(1 + 0.08) = $108,000
❖ The difference between the value of money today and money in the future is
called the time value of money
❖ The riskfree interest rate measures the rate of exchange over time
❖ By depositing money in a bank account (that is, lending money to the bank) you
can convert money today into money in the future
❖ By borrowing money from a bank you can exchange money in the future for
money today

1.30
Time Value of Money and Interest Rates
❖ The correct approach always takes the time value of money into account
❖ We can value the investment in year 1 (that is, its future value)…
❖ Future value of the benefit (year 1) = $105,000
❖ Future value of the cost (year 1) = 100000(1 + 0.08) = $108,000
❖ Future value of net benefits = 105000 – 108000 = –$3,000 < 0
❖ More typically, we value the investment today (that is, its present value)…
❖ Present value of the benefit (year 0) = 105000/(1 + 0.08) = $97,222.22
❖ Present value of the cost (year 0) = $100,000
❖ Present value of net benefits = 97222.22 – 100000 = –$2,777.78 < 0
❖ Note: The present value of net benefit is also referred to as the net present value
❖ How are the present and future values of the investment related to each other?

1.31
1.3 Simple Versus Compounded Interest
❖ Simple interest is the value of a cash flow calculated without including any
accrued (that is, earned) interest to the amount you invest (that is, the principal)
❖ Example: If you invest $1,000 at 8% p.a. earning simple interest for 5 years what
amount will you have in your bank account at the end of that time period?
❖ Interest earned in each of the five years = 1000  0.08 = $80
❖ Interest earned over five years = (1000  0.08)  5 = $400
❖ Future value at the end of year 5 = 1000 + 400 = $1,400
❖ We can do the calculation in a single step as…
❖ Future value at the end of year 5 = 1000(1 + 5  0.08) = $1,400
❖ Future value using simple interest, FVn = PV0(1 + n  r)

1.32
Simple Versus Compounded Interest
❖ Example (continued): If your goal was to accumulate $1,400 at the end of 5 years
and you could earn simple interest at 8% p.a. what amount would you need to
save today?
❖ We know that the future value using simple interest is…
❖ FVn = PV0(1 + n  r)
❖ So, the present value today of a given future amount using simple interest is…
❖ PV0 = FVn/(1 + n  r)
❖ PV0 = 1400/(1 + 5  0.08) = $1,000
❖ Note that in most situations we will be concerned with compounded interest rather
than simple interest

1.33
Simple Versus Compounded Interest
❖ Compounded interest
❖ Interest accrued (that is, earned) is added back to the principal and is reinvested
❖ The (future) value of a cash flow is calculated based on the principal and interest
accrued
❖ This compounding of interest over time is referred to as interest on interest
❖ Here’s what Albert Einstein (allegedly) said about compound interest…
❖ “Compound interest is the eighth wonder of the world. He who understands it,
earns it ... he who doesn’t ... pays it.”

1.34
Simple Versus Compounded Interest
❖ Example: If you invest $1,000 at 8% p.a. earning compounded interest for 5 years
what amount will you have in your account at the end of that time period?
❖ Future value at the end of year 1 = 1000.00(1.08) = $1,080.00
❖ Future value at the end of year 2 = 1080.00(1.08) = $1,166.40
❖ Future value at the end of year 3 = 1166.40(1.08) = $1,259.71
❖ Future value at the end of year 4 = 1259.71(1.08) = $1,360.49
❖ Future value at the end of year 5 = 1360.49(1.08) = $1,469.33
❖ Alternatively, we can do the calculation in a single step…
❖ Future value at the end of year 5 = 1000(1.08)5 = $1,469.33
❖ Note: $1,469.33 = $1,000 + $400 + $69.33 (see next slide)
❖ The amount of $69.33 is due to the compounding of interest (or “interest on interest”)
❖ The next slide shows you the future values up to the end of year 20
1.35
Simple Versus Compounded Interest
$5,000

$4,500

$4,000

$3,500
Calculation in
$3,000 previous slide
Future Value

$2,500

$2,000

$1,500

$1,000

$500

$0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Original Amount Interest on Original Amount Interest on Interest
1.36
Simple Versus Compounded Interest
So, what’s the big deal?
Compounded
End of year, n Simple interest interest Difference
1 $1,080.00 $1,080.00 $0.00
2 $1,160.00 $1,166.40 $6.40
3 $1,240.00 $1,259.71 $19.71
4 $1,320.00 $1,360.49 $40.49
5 $1,400.00 $1,469.33 $69.33
20 $2,600.00 $4,660.96 $2,060.96
50 $5,000.00 $46,901.61 $41,901.61
100 $9,000.00 $2,199,761.26 $2,190,761.26
1.37
1.4 Future and Present Value of a Single Cash Flow
❖ The future value (FVn) at r% p.a. of an amount (PV0) today is the dollar value to
which it grows at the end of time period n
❖ FVn = PV0(1 + r)n
0 1 2 3 n

PV0 FVn = PV0(1 + r)n

Cash flows occur at the end of the period
End of the year End of the quarter End of the month
31 Dec 2019 31 Mar 2022 30 Sep 2022
31 Dec 2020 30 Jun 2022 31 Oct 2022
31 Dec 2021 30 Sep 2022 30 Nov 2022
31 Dec 2022 31 Dec 2022 31 Dec 2022
1.38
Future Value of a Single Cash Flow
❖ Example: You decide to invest $1,000 for different time periods. What is the
future value of this $1,000 in 5, 20 and 100 years at an interest rate of (a) 6% and
(b) 8%?
❖ At r = 6% p.a.
❖ FV5 = 1000(1 + 0.06)5 = $1,338.23
❖ FV20 = 1000(1 + 0.06)20 = $3,207.14
❖ FV100 = 1000(1 + 0.06)100 = $339,302.08
❖ At r = 8% p.a.
❖ FV5 = 1000(1 + 0.08)5 = $1,469.33
❖ FV20 = 1000(1 + 0.08)20 = $4,660.96
❖ FV100 = 1000(1 + 0.08)100 = $2,199,761.26

1.39
Future Value of a Single Cash Flow
$7,000
10%

$6,000

$5,000
8%
Future Value

$4,000

6%
$3,000

4%
$2,000

$1,000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
End of year 1.40
Present Value of a Single Cash Flow
❖ The present value (PV0) at r% p.a. of an amount (FVn) at the end of time n is the
amount which invested today would grow to FVn in time n
❖ PV0 = FVn/(1 + r)n
❖ Note: The amount 1/(1 + r) is referred to as the one-year discount factor

0 1 2 3 n

PV0 = FVn/(1 + r)n FVn

Cash flows occur at the end of the period

1.41
Present Value of a Single Cash Flow
❖ Example: If you needed $10,000 in (a) five years and (b) twenty years how much
would you need to save and invest today if the interest rates were (a) 6% and (b)
8%?
❖ The present value today of $10,000 in five years…
❖ At 6% p.a.: PV0 = 10000/(1 + 0.06)5 = $7,472.58
❖ At 8% p.a.: PV0 = 10000/(1 + 0.08)5 = $6,805.83
❖ The present value today of $10,000 in twenty years…
❖ At 6% p.a.: PV0 = 10000/(1 + 0.06)20 = $3,118.05
❖ At 8% p.a.: PV0 = 10000/(1 + 0.08)20 = $2,145.48

1.42
Present Value of a Single Cash Flow
$10,000

$9,000

$8,000

$7,000
Present Value

$6,000

$5,000
4%
$4,000

$3,000 6%

$2,000 8%
10%
$1,000

$0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
End of year 1.43
Factors Influencing Present and Future Values
❖ The present and future values of a cash flow depend on the following factors
❖ The time period, n
❖ Future value increases as n increases
❖ Present value decreases as n increases
❖ The interest rate, r
❖ Future value increases as r increases
❖ Present value decreases as r increases
❖ The method of computing interest (examined in later lectures)
❖ Future value increases as the compounding frequency increases
❖ Present value decreases as the compounding frequency increases
❖ Let’s test our understanding…

1.44
Four Rules to Remember
❖ Rule 1: You can only compare or combine cash flows at the same point in time
❖ Rule 2: To move cash flows forward in time you must compound them
❖ Rule 3: To move cash flows back in time you must discount them
❖ Rule 4: The interest rate used to compound or discount cash flows must match the
periodicity of those cash flows (more on this in week 3)

1.47
1.5 Present and Future Values of a Series of Cash Flows
❖ A series of cash flows can be valued using the value additivity principle which
states…
❖ The present (future) value of a series of cash flows is equal to the sum of the present
(future) values of each cash flow
❖ The net present value of an investment resulting in a series of cash flows is defined
as the present value of the cash inflows (benefits) minus the present value of the
cash outflows (costs)
❖ NPV = PV(Cash inflows) – PV(Cash outflows)
❖ Note that the typical cash outflow is the initial investment
❖ Decision rule: Accept the investment if the NPV is positive and reject it if it is negative
❖ We will discuss the net present value in much greater detail in future weeks

1.48
Present Value of a Series of Cash Flows
❖ Example: You have been offered an investment opportunity which involves investing
$10,000 today to receive $500 at the end of year 1, $1500 at the end of year 2 and
$10,000 at the end of ten years. What is the present value and the net present value of
the investment if the interest rate is 6% p.a.? Should you accept the investment
opportunity? How does your answer change if the interest rate is 2% p.a.? What about
the case where the interest rate is 2.16%? What is the future value of the cash inflows at
the end of year 10 at 6% p.a.? Recalculate the investment’s NPV using this future value

0 1 2 3 10

-$10,000 +$500 +$1,500 +$10,000

Cash flows occur at the end of each period

1.49
Present Value of a Series of Cash Flows
❖ At 6%, the net present value of the investment is…
500 1500 10000
𝑁𝑃𝑉 = + 2
+ 10
− 10000 = −$2,609.36 < 0
(1 + 0.06) (1 + 0.06) (1 + 0.06)

❖ At 2%, the net present value of the investment is…

500 1500 10000
𝑁𝑃𝑉 = + 2 + 10 − 10000 = $135.43 > 0
(1 + 0.02) (1 + 0.02) (1 + 0.02)

❖ At 2.16%, the net present value of the investment is…

500 1500 10000
𝑁𝑃𝑉 = + 2
+ 10
− 10000 = $2.57 ≈ $0.00
(1 + 0.0216) (1 + 0.0216) (1 + 0.0216)

❖ Note: 2.16% is called the internal rate of return of the investment

1.50
Future Value of a Series of Cash Flows
FV10 = 500(1 + 0.06)9
Future value over 9 years
FV10 = 1500(1 + 0.06)8
Future value over 8 years
0 1 2 3 10

-$10,000 +$500 +$1,500 +$10,000

Cash flows occur at the end of each period
❖ Using the value additivity principle, we can get the future value of the cash inflows as…

𝐹𝑉10 = 500(1 + 0.06)9 + 1500(1 + 0.06)8 + 10000 = $13,235.51

❖ At 6% the net present value of the investment is the same as before…

13235.51
𝑁𝑃𝑉 = − 10000 = −$2,609.36 < 0
(1 + 0.06)10
1.51
Key Concepts: What We’ve Done This Week
❖ Managers aim to maximize the value of the firm’s shares by taking on
profitable investments.
❖ Using simple interest, the value of a cash flow is calculated without including
any accrued interest to the amount invested or principal
❖ Using compounded interest, the value of a cash flow is calculated based on the
principal and interest accrued
❖ The present and future values of a cash flow depend on the time period, the
interest rate and the method of computing interest
❖ The net present value of an investment is present value of the cash inflows
minus the present value of the cash outflows

1.52
What’s Next?
❖ In lecture 2 we will build on lecture 1 and examine the present and future values of
a series of equal, periodic cash flows
❖ In lecture 3 we will apply the concepts covered in lectures 1 and 2 to price/value
home mortgages and debt securities
❖ In lecture 4 we will apply the concepts covered in lectures 1 and 2 to price/value
equity securities like preference shares and ordinary shares

1.53
Formula Sheet
❖ Future value of a single cash flow using simple interest
❖ FVn = PV0(1 + n  r)
❖ Present value of a single cash flow using simple interest
❖ PV0 = FVn/(1 + n  r)
❖ Future value of a single cash flow
❖ FVn = PV0(1 + r)n
❖ Present value of a single cash flow
❖ PV0 = FVn/(1 + r)n

(Note: The formula sheets on the mid semester and final exams will contain all the formulas
covered in lectures but without the descriptions)
1.54