TUI University Shane R. Wagner FIN 501 Case Assignment #2 8 August 2011 Coordinating Professor: Dr.

Glen Tenney

Strategic Corporate Finance 2 Introduction The foundation of any theory or principle revolves around a primary equation or fact allowing more complex theory or principles to be resolved. Present value of money, as it relates to corporate finance, is part of the foundation for financial theory and business strategy, both short and long term (Agarwal, 2009). As the economic and corporate worlds use present value to compare cash flows as it relates to time, I will demonstrate in this paper how the basic calculations for present value form part of the foundation of Strategic Corporate Finance. Subsequently, I will provide supported reasoning to why many Finance professors instill the theory of present value as one of the first objectives in their courses. This paper will not focus on the definition of what present value is, however, a brief understanding is required to build upon throughout this paper. Therefore, what is the bottom line definition for present value?

Present Value Defined Present Values definition is a simple formula to calculate what a future value of money is worth in the present day. This concept is extremely important to financial calculations both for corporations and personal portfolios. According to Investopedia (2010), present value is defined as The current worth of a future sum of money or stream of cash flows given a specified rate of return. This concept is often misunderstood by many people and can be devastating when not considered for future financial planning. To illustrate, I will use a common scenario to show how the knowledge of present value of money compares to the future value, and how money can be either gained or loss if not properly analyzed. The present value of money can make what seems to be a good financial decision actually a poor one in the absence of its analysis. It is a proven economical fact that any

Strategic Corporate Finance 3 financial obligation should be satisfied later, rather than today to allow the money to be used to satisfy the debt to potentially earn more money (assuming contractual obligations allow for this) (Darwin, 2011). This can be illustrated by looking at a common mortgage payment strategy.

Present Value Example One of the most common financial mistakes is the misunderstanding of what money promised in the future is actually worth today. Lets consider if you were offered to save $36,000 in interest payments over the life of your mortgage by utilizing company Xs mortgage payment program, and lets say the program costs you $5,000 to utilize. Spending $5,000 to save $36,000 sounds like a good deal right? Well, lets see; if we use an interest rate of 3.75% and a 30 year mortgage, the present value (PV) of the $36,000 is:

PV = $11,930 If we instead took that $5,000 and invested in a portfolio earning a modest 8% per year (assuming interest rate stays constant over the 30 years), we come up with:

FV = $50,313.28 Therefore, as you can see, the $5,000 investment to save $36,000 (or $11,930 PV) would be a bad financial move if you could earn 8% on the $5,000 investment yielding over $50K! The question then becomes, how is this concept important to corporate finance?

Strategic Corporate Finance 4 Foundation for Corporate Finance Corporations investment decisions and other long-term financial considerations incorporating fixed assets and capital structure are founded on the present value. Most, if not all of large corporations utilize present value techniques (or discounted cash flow) in budget analysis and financial planning (Harold, 2010). Considering the example above, a corporation must examine what can be saved or earned from delaying purchasing or obligation payments to benefit the financial status of the business. Present value is at the center of the analysis as money today is more useful than money in the future, but not always more valuable (Biger, 2008). Without this understanding of present value, very poor business financial decisions or advice can lead to the failure of companies to achieve strategic goals, thus demonstrating why many Professors of Financial Management classes teach the present value of money before moving on to more complex financial management theories. Now lets examine some problems to illustrate: Future Value Calculations a. $14,000 if invested for five years at a 9% interest rate FV = PV * (1 = r)t FV = $14,000 * (1+ 9%)5 FV = $14,000(1.5386) FV = $21,540.74 b. $29,500 if invested for three years at a 5% interest rate FV = PV * (1 = r)t FV = $29,500 * (1+ 5%)3 FV = $29,500(1.157625) FV = $34,149.94

Strategic Corporate Finance 5 c. $29,900 if invested for seven years at an 3% interest rate FV = PV * (1 = r)t FV = $29,900 * (1+ 3%)7 FV = $29,900 (1.2299) FV = $36,773.23 d. $18,500 if invested for ten years with a 1.9% interest rate FV = PV * (1 = r)t FV = $18,500 * (1+ 1.9%)10 FV = $18,500 (1.2071) FV = $22,331.28 Present Value Calculations a. $27,500 to be received three years from now with a 1% Interest rate PV = FV * 1/ (1 + r)t PV = $27,500 * 1/(1+1%)3 PV = $27,500/.9706 PV = $26,691.23 b. $43,000 to be received five years from now with a 7% interest rate PV = FV * 1/ (1 + r)t PV = $43,000 * 1/(1+7%)5 PV = $30,658.41 c. $125,000 to received two years from now with a 11% interest rate PV = FV * 1/ (1 + r)t PV = $125,000 * 1/(1+11%)2

Strategic Corporate Finance 6 PV = $101,452.80 d. $550,000 to be received eight years from now with a 2% interest rate. PV = FV * 1/ (1 + r)t PV = $550,000 * 1/(1+2%)8 PV = $469,419.70 Annuity Calculations Suppose you are to receive a stream of annual payments (also called an "annuity") of $200,000 every year for three years starting this year. The interest rate is 5%. What is the present value of these three payments? Solution: Since the annuity payments start this year, I used the annuity due formula. Doing this, I subtracted one year from the 3 years and calculated the annuity discount factor: PVAF (r, n-1) = 1/r 1/r(1+r)n-1 PVAF (5%,2) = 1/.05 1/ .05*(1.05)2 PVAF (5%,2) = 1.8594 Annuity due: PV = $200,000 + 1.8594($200,000) PV = $571,880 Future Value Word Problem Suppose you are to receive a payment of $220,000 every year for three years. You are depositing these payments in a bank account that pays 3% interest. Given these three payments and this interest rate, how much will be in your bank account in three years? Solution: Assuming each deposit will accrue a full years interest, the interest for the first $220,000 must be calculated using the Future Value Formula. That total will then have the

Strategic Corporate Finance 7 second $220,000 added to it for the Cash Value for the 2nd years Future Value calculation; same process for the third year. Each year FV is subscripted: FV = PV * (1 = r)t FV1 = $220,000 * (1.03)1 = $226,000 FV2 = ($226,000 + $220,000) * (1.03)1 = $459,998 FV3 = ($459,998 + $220,000) * (1.03)1 = $700,397.94

Conclusion An understanding of the value of a future sum of money today is the core concept every financial manager must understand. It forms part of the core of Strategic Corporate Finance in that businesses must understand the value of revenues and liabilities both today and in the future. This paper has demonstrated through equations and simple examples that the present value of a sum of money in the future may not always be a good investment. Present value allows one to calculate assets today for analysis for the future, thus, why it is taught early in financial scholastic studies. Once the foundation of present value is established, more complex financial planning can be taught.

Strategic Corporate Finance 8 References: Agarwal, O.P. (2009). Corporate financial policy [pp. 10-15]. Retrieved from http://site.ebrary.com/lib/tourou/docDetail.action?docID=10416227&p00=why%20present %20value%20important%20corporate%20finance Anonymous, . (2010). Present value. Retrieved from http://www.investopedia.com/terms/p/presentvalue.asp Biger, N. (2008). Explanation of present values and net present values. Darwin, . (2011, January 17). Darwin's money: financial evolution for the masses. Retrieved from http://www.darwinsmoney.com/present-value-of-money-explained/ Econedlink.org (2011). The time value of money. Retrieved July, 2011, from http://www.econedlink.org/lessons/index.cfm?lesson=EM37 Harold, B. (2010). Introduction to accounting and managerial finance : a merger of equals [pp. 15-25]. Retrieved from http://site.ebrary.com/lib/tourou/docDetail.action Studyfinance.com (2011). Time value of money: Self paced overview. Retrieved July, 2011, from http://www.studyfinance.com/lectures/timevalue/index.mv