FINA 5120

FINA 5120
Corporate Finance
Veronique LAFON-VINAIS
Associate Professor of Business Education, Dept of
Finance
Fall 2022
In this section we will learn about…
• The conceptual framework: cost benefits analysis,
valuation principle and law of one price
• APR and EAR
• Fundamentals of DCF
• DCF continued: valuing streams of cash flows
FINA 5120 – Learning Objectives

THE FRAMEWORK: FINANCIAL DECISION
MAKING & LAW OF ONE PRICE
Cost-Benefit Analysis Real world?
• Quantifying Costs and Benefits

– Any decision in which the value of the benefits exceeds the
costs will increase the value of the firm
• Role of Competitive Markets
– A competitive market is one in which a good can be bought
and sold at the same price
– In a competitive market, the price determines the value of the
good
• Personal opinion of the “fair” price is irrelevant
Copyright ©2015 Pearson Education, Inc. All rights reserved.
FINA 5120 – Cost-Benefit Analysis

Valuation Principle
• The value of a commodity or an asset to the firm or its
investors is determined by its competitive market price
• The benefits and costs of a decision should be evaluated
using those market prices
• When the value of the benefits exceeds the value of the
costs, the decision will increase the market value of the firm
• If Value of Benefits (at competitive market price)>
Value of Costs (at competitive market price) = positive
for the firm
FINA 5120 – The Valuation Principle

Law of One Price Real world?
• Law of One Price

– In competitive markets, securities with the same
cash flows must have the same price
• Arbitrage
– The practice of buying and selling equivalent goods
to take advantage of a price difference
• Arbitrage Opportunity
– Any situation in which it is possible to make a profit
without taking any risk or making any investment
FINA 5120 – Law of One Price

Arbitrage with Transactions Costs
• What consequence do transaction costs have for no-
arbitrage prices and the Law of One Price?
– When there are transactions costs, arbitrage keeps prices of
equivalent goods and securities close to each other.
– Prices can deviate, but not by more than the transactions cost
of the arbitrage.
FINA 5120 – Arbitrage

Illustration
• Problem
– Assume that a kilogram of silver costs 575 USD in New York
and 9,800 MXN in Mexico City.
– If the Peso/Dollar exchange rate is 17.16 MXN/1 USD, is
there an arbitrage opportunity if the average transaction cost
is $8 per kilogram of silver?

Solution
• The cost of silver in MXN needs to be converted to
USD.
• At an exchange rate of 17.16 MXN/1 USD, the USD
cost is 9,800/17.16 = 571 USD.
• Thus, the difference in USD between the price of a
kilogram of silver in New York and Mexico City is $4.
• Because this is less than the transaction cost of $8 per
kilogram, there is no arbitrage opportunity.

INTEREST RATES
(QUOTES AND ADJUSTMENTS)
Key Concepts
• APR
• EAR
• Conversion from APR to EAR
Interest Rate Quotes and Adjustments
• Simple Interest
– Interest earned without the effect of compounding
• Annual Percentage Rates (APR)
– Indicates the amount of simple interest earned (as % of
principal) in one year – neglecting time value of money
FINA 5120 – IR Quotes and Adjustments

– E.g. If the face value of a 5-year bond is $1000, the coupon
rate is 10% in APR (semiannual payment).
– Coupon payment as follows:
Jan June Dec
+50 +50
– Coupon rate in APR: 10%
– Simple interest earned in a year: $1000 * 10% = $100
– Payment periods per year: 2 (semiannual payment)
– Coupon: $100 / 2 = $50
APR
Interest Rate per Compounding Period 
m
(m  number of compounding periods per year)

• The Effective Annual Rate
– Indicates the compounded amount of interest that will be
earned at the end of one year
– Also referred to as the effective annual yield (EAY) or annual
percentage yield (APY)
NOT the
same as
APR!

Interest Rate Quotes and Adjustments (cont'd)
• E.g. Is earning 5% every six months return the same

as earning a 10% annually?
– No – as it should involve the compounded interest.
– The actual interest rate is (1+5%)^(2)-1
• EAR: Adjusting the Discount Rate to Different

Time Periods
• General Equation for Discount Rate Period Conversion
Equivalent n-Period Discount Rate  (1  r ) n  1

Illustration
Problem:
• Suppose your bank account pays interest monthly with an effective
annual rate (EAR) of 5%. What rate of interest will you earn each
month?

Solution
Execute:
Equivalent n-Period Discount Rate = (1 + r)n – 1
• A 5% EAR is equivalent to earning (1.05)1/12 – 1 = 0.4074% per month.
• The exponent n in this equation is 1/12 because the period is 1/12th of a
year (a month).

• Converting an APR to an EAR (Effective Annual Rate)
– Once the interest earned per compounding period is
computed, the equivalent interest rate for any other time
interval can be computed
m
 APR 
1  EAR  1  
 m 
(m = number of compounding periods per year)
*The EAR increases with the frequency of compounding.
• Continuous compounding is compounding every instant.

Effective Annual Rates (EAR) for a 6% APR with
Different Compounding Periods
FINA 5120– IR Quotes and Adjustments

Key Formulas Takeaway
Equivalent n-Period Discount Rate = (1 + r)n – 1
APR
Interest Rate per Compounding Period 
m
(m  number of compounding periods per year)
m
 APR 
1  EAR  1  
 m 
(m = number of compounding periods per year)
FINA 5120 – IR conversion Key Formulas

Your Turn!
• If you want to deposit money, at
which bank will you deposit?
A) Bank 1: 7.95 % annually
compounded
B) Bank 2: 7.90 % monthly
compounded
C) Bank 3. 7.80 % weekly
compounded
D) Bank 4: 7.70 % daily
compounded
Answer B
FINA 5120 – PRS Questions

Solution
Bank 1: EAR = 7.95 %

12
 7.90% 
Bank 2: EAR = 1  12   1  8.19%
 
52
 7. 80 % 
Bank 3: EAR =  1    1  8.11 %
 52 
365
 7.70% 
Bank 4: EAR = 1    1  8.00%
 365 
Bank 2 offers the highest EAR and thus you will get the
highest return.
FINA 5120 – Questions
In real life in Hong Kong…confusing terminology
• What rate is used to calculate your payment if you

borrow a personal loan from your bank?
FINA 5120 – APR v. EAR

TIME VALUE OF MONEY AND DCF
BASICS
Key Concepts
• Time Value of Money
• Introducing 4 of the 5 key variables of DCF:
– Future Value (FV)
– Present Value (PV)
– Interest Rate (i or r or YTM)
– Time Period (N)
FINA 5120 – Time Value of Money

In Practice: Important things to know before we
start
• In this section, unless otherwise indicated, interest rates are yearly
(annual) interest rates (in the markets, we use the term “per annum” or
“p.a.”)
• Financial institutions are generally required to indicate the interest rates
they charge on an annual percentage rate (APR) basis so that
consumers can compare prices
• The way we calculate interest payments differs depending on the
financial instrument we use. You need to verify the applicable conditions
in the contract!
• In particular, debt contracts of less than one year and money market
securities use simpler formulas

Time Value of Money Real world?
• The concept of discounted value is based on the notion (assumption)

that a dollar of cash flow paid to you some time from now is less
valuable to you than a dollar paid to you today: “a dollar is worth more
today than tomorrow” or the time value of money
– Why? This notion has been GENERALLY true because you could
invest the dollar in a savings account that earns interest
– BUT we live in a new era of NEGATIVE interest rates so this is no
longer true everywhere
• We will learn basic pricing of financial instruments under the
assumption of positive interest rates. Negative interest rates change
significantly our allocation of resources and distort financial markets.

Cash Flow Timelines Why is it
important?
– Identifying Dates on a Timeline
• Date 0 is today, the beginning of the first year
• Date 1 is the end of the first year
– Distinguishing Cash Inflows from Outflows (negative signs
indicate outflows)
– Representing Various Time Periods

• Just change the label from “Year” to “Month” if monthly
The Interest Rate: An Exchange Rate Across Time
• The rate at which we can exchange money today for

money in the future is determined by the current
interest rate (r, or i).
– Suppose the current annual interest rate is 7%. By investing
or borrowing at this rate, we can exchange $1.07 in one year
for each $1 today.
– We can interpret
1 1
  0.93458
1  r 1.07
– as the price today of $1 in one year. The amount
1/1+r is called the one-year discount factor

Discount Factors and Rate
• Risk–Free Interest Rate (Discount Rate), : The interest
rate at which money can be borrowed or lent without
risk. There is no such thing,
– Interest Rate Factor = 1 + but the closest is
– Discount Factor = 1 / (1 + ) government securities
• The risk-free rate is also referred to as the discount

rate for a risk-free investment.
Warning! The biggest difficulty we will face is one of

terminology, as many different terms are used for
the same variable” interest rate, market rate,
discount rate, yield….

Future Value and Interest
• Future value (FV) is the value on a later date of an
investment today.
– $100 invested today at 6% interest gives $106 in a year. So the
future value of $100 today at 6% interest is $106 one year from now.
– The $100 yields $6, which is why interest rates are sometimes
called a yield or yield to maturity.
– This is the same as a simple loan of $100 for a year at 6% interest.
0 1
-100 +106

Future Value and Interest
• The present value (PV) is $100, the interest rate (r) is 6%,
so the future value (FV) in one year is:
 $100 + $100 x 0.06 = $106
• The higher the interest rate, the higher the future value.
• FV = PV + (PV x r) = PV x (1 + r)

Present Value
• Financial instruments promise future cash payments.
Valuing those payments under the same or consistent
assumptions enables us to compare several alternatives.
• Present value is the value today of a payment to be made
in the future.
• Present value is the equivalent amount to invest today in
order to be equal to a specific amount on a given future
date.

Present Value for 1 Period
• Knowing the Future Value, we can find easily the Present
Value:
FV = PV x (1+r), so
PV =
• This is just the future value calculation inverted.

Present Value for n Periods
 We can generalize the process as we did for future value.

 Present Value of one payment credited n years in the future,
but calculated at the end of each year:
PV =

Present Value of $100 Payment
PV PV PV • Higher interest rates
Rate/Tenor (Yr) 1 5 10 are associated with
1.00% $ 99.01 $ 95.15 $ 90.53 lower PV no matter
2.00% $ 98.04 $ (0.97) $ 90.57 $ (4.57) $ 82.03 $ (8.49) what the timing of the
3.00% $ 97.09 $ 86.26 $ 74.41 payment.
4.00% $ 96.15 $ 82.19 $ 67.56
5.00% $ 95.24 $ 78.35 $ 61.39 • At any interest rate, an
6.00% $ 94.34 $ (0.90) $ 74.73 $ (3.63) $ 55.84 $ (5.55)
increased tenor reduces
7.00% $ 93.46 $ 71.30 $ 50.83
8.00% $ 92.59 $ 68.06 $ 46.32 PV.
9.00% $ 91.74 $ 64.99 $ 42.24
10.00% $ 90.91 $ (0.83) $ 62.09 $ (2.90) $ 38.55 $ (3.69)
•For 1% interest rate
11.00% $ 90.09 $ 59.35 $ 35.22 variation, the difference
12.00% $ 89.29 $ 56.74 $ 32.20 in PV varies with rate
13.00% $ 88.50 $ 54.28 $ 29.46 and tenor: Convexity
14.00% $ 87.72 $ 51.94 $ 26.97
15.00% $ 86.96 $ (0.76) $ 49.72 $ (2.22) $ 24.72 $ (2.26)
Difference Difference Difference

Present Value as a Function of Tenor
Present Value of $100 at 6% as a Function of Tenor
$100.00
PV (0 years) = $100
Please note the convexity of the curve!
$75.00
PV (10 years) = $55.84

Present Value ($)
$50.00
PV (20 years) = $31.18
$25.00
PV (30 years) = $17.41
$-
0 5 10 15 20 25 30
Years to Payment

Present Value: THE Basis for DCF
• The present value is higher:
– The higher future value of the payment,
– The shorter time period until payment, n
– The lower the interest rate, r
• Present value is the single most important relationship
in our study of financial instruments. It is THE basis for
Discounted Cash Flows analysis.

Future Value and Compound Interest
• The higher the interest rate, the higher the future value.
• The higher the amount invested, the higher the future
value.
• Most financial instruments are not so simple, so what
happens when time to repayment varies?
• When using one-year interest rates to compute the
value repaid more than one year from now, we must
consider compound interest.
– Compound interest is the interest on the interest.

• What if you leave your $100 in the bank for two years at 6%
yearly interest rate?
 Yearly: Calculated and credited at the end of each year!
• The future value is:
$100 + ($100 x 0.06) + ($100 x 0.06) + ($6 x 0.06) = $112.36
$100 x 1.06 x 1.06 = $100 x (1.06)2
• In general
FVn = PV x(1 + r)n

Future Value of $100 at 6.00% annual interest
Nbr Years Calculations Future Value
1 $100 × ሺ1 + 6%ሻ $ 106.00

2 $100 × ሺ1 + 6%ሻ2 $ 112.36
3 $100 × ሺ1 + 6%ሻ3 $ 119.10
4 $100 × ሺ1 + 6%ሻ4 $ 126.25
5 $100 × ሺ1 + 6%ሻ5 $ 133.82
6 $100 × ሺ1 + 6%ሻ6 $ 141.85
7 $100 × ሺ1 + 6%ሻ7 $ 150.36
8 $100 × ሺ1 + 6%ሻ8 $ 159.38
9 $100 × ሺ1 + 6%ሻ9 $ 168.95
10 $100 × ሺ1 + 6%ሻ10 $ 179.08

The Composition of Interest over Time
FINA 5120 – Compounding

The Three Rules of Valuing Cash Flows

Your Turn!
• You own 1,000 shares of Newstar
Financial stock, currently trading at
$57 per share. You are offered a
deal where you can exchange these
stocks for 900 shares of Amback
Financial Group stock, currently
trading at $63 per share. What is the
value of this trade, if you choose to
make it?
A) -$320
B) -$340
C) -$300
D) $300
Answer C
Your Turn!
• If the rate of interest (r) is
9%, then you should be
indifferent about receiving
$750 in one year or
________.
A) $688.07 today
B) $750 today
C) $825.68 today
D) None of the above
Answer A
VALUING STREAMS OF CASH
FLOWS
Key Concepts
• Valuation of a stream of cash flows
• The 5th DCF variable: Cash flow (C)
• Perpetuities
• Annuities
• Growing Perpetuities
• Growing Annuities
• Solving for variables other than PV or FV:
– C - Cash flow
– i or r or YTM - Rate (the IRR calculation)
– N - Periods
FINA 5120 – Valuing a Stream of Cash Flows 47

Using a Financial Calculator for Valuing a Stream
of Cash Flows
• Financial calculators and spreadsheets (Excel) have the
formulas pre-programmed to quicken the process (see
tutorials on Canvas!)
• There are five variables used in DCF calculations:
– N (number of periods)
– PV (present value)
– PMT (periodic payment/cash flows)
– FV (future value)
– I/Y (interest rate)
The trick is to identify the variables! One of the challenges we commonly face is
terminology. We will be using different terms throughout the course,
particularly for “interest rate” so it can get a bit confusing!
FINA 5120 – Valuing a Stream of Cash Flows
Valuing a Stream of Cash Flows
• The present value of a cash flow stream is the sum of
the present values of each cash flow

Illustration (1)
Problem:
• You have just graduated and need money to buy a laptop
• Your aunt will lend you the money so long as you agree to pay her back
within six years.
• You offer to pay her the rate of interest that she would otherwise get by
putting her money in a savings account.
• Based on your earnings and living expenses, you think you will be able to
pay her $70 next year, $85 in each of the next two years, and then $90 each
year for years 4 through 6.
• If your aunt would otherwise earn 0.5% per year on her savings, how much
can you borrow from her?

Key Steps
• Cash flow timeline
• What variable are we solving for?
• Which variables do we have?
• Are we missing any information? Or do we have
information we don’t need?
Solution : Present Value of a Stream of Cash Flows
• The cash flows you can promise your aunt are as follows:
• She should be willing to give you an amount equal to these payments in present
value terms.
• We solve the problem using the equation
– the present value of a series of cash flows is the sum of the present values of
each of the cash flows; so we calculate the present value of each cash flow and
add up all the present values Copyright ©2015 Pearson Education, Inc. All rights reserved.

Solution : Present Value of a Stream of Cash Flows
(cont’d)
Execute:
• We can calculate the PV as follows:
70 85 85 90 90 90
PV      
1.005 1.005 1.005 1.005 1.005 1.0056
2 3 4 5
 $69.65  $84.16  $83.74  $88.22  $87.78  $87.35

 $500.90

Illustration (2)
Part 2
• Now, suppose that your aunt gives you the money, and then deposits
your payments in the bank each year.
• How much will she have six years from now?

Solution : Future Value of a Stream of Cash Flows
• We need to compute the future value of the yearly deposits.
• One way is to compute the bank balance each year.

Solution : Future Value of a Stream of Cash Flows
(cont’d)
Execute:
• To verify our answer, suppose your aunt kept her $500.90 in the bank
today earning 0.5% interest.
• In six years she would have:
FV = $500.90×(1.005)6= $516.11 in 6 years

Illustration (3)
Problem:
• We plan to save $1,000 today and at the end of each of the next two
years.
• At a fixed 6% interest rate, how much will we have in the bank three
years from today?

Solution : Computing the Future Value (cont’d)
• We’ll start with the timeline for this savings plan:
0 1 2 3
$1,000 $1,000 $1,000 ?
– First we’ll compute the present value of the cash flows.

– Then we’ll compute its value three years later (its future value).

Solution : Computing the Future Value (cont’d)
Execute:
0 1 2 3
$1,000.00 $1,000 $1,000 ?

$943.40
÷1.06
$890.00
This is how $2,833.40
÷1.062
we’ve done it
so far – this 0 1 2 3
works no
matter the cash
flows $2,833.40
$3,374.62
× 1.063

Perpetuities Examples?
Perpetuities (also called consols)

– A perpetuity is a stream of equal cash flows that occur at
regular intervals and last forever
– Here is the timeline for a perpetuity:
– the first cash flow does not occur immediately; it arrives at the
end of the first period
FINA 5120 – Perpetuities

Example of consol

Perpetuities
• Using the formula for present value, the present value
of a perpetuity with payment C and interest rate r is
given by:
C C C
PV=    ......
(1  r) (1  r) (1  r)
2 3
• Notice that all the cash flows are the same

• Also, the first cash flow starts at time 1 (not 0)

Perpetuities/Consols
• Present Value of a Perpetuity
• This formula only works when r is positive!

Illustration
Problem:
• You just won the lottery, and you want to endow a professorship at your
alma mater.
• You are willing to donate $4 million of your winnings for this purpose.
• If the university earns 5% per year on its investments, and the professor
will be receiving her first payment in one year, how much will the
endowment pay her each year?

Solution : Endowing a Perpetuity
• The timeline of the cash flows you want to provide is:
• This is a standard perpetuity. The amount she can withdraw each year
while keeping the principal intact is the cash flow C when solving the
equation:

Solution : Endowing a Perpetuity (cont’d)
• From the formula for a perpetuity,

Annuities Examples?
• Annuities (also called fixed payment loans)

– An annuity is a stream of N equal cash flows C paid at
regular intervals
– The difference between an annuity and a perpetuity is that an

annuity ends after some fixed number of payments (N)
FINA 5120 – Annuities

Annuities
Present Value of An Annuity
• Note that, just as with the perpetuity, we assume the
first payment takes place one period from today (time
1)
C C C C
PV=    ......
(1  r) (1  r) (1  r)
2 3
(1  r) N

Annuities
Future Value of an Annuity

Illustration (1)
Problem:
• Your parents have made you an offer you can’t refuse.
• They’re planning to give you part of your inheritance early (!).
• They’ve given you a choice.
– Option a: They’ll pay you $10,000 per year for each of the next seven years
(beginning today, last payment at the end of the 7th year)
– Option b: they’ll give you their BMW Convertible, which you can sell for
$61,000 (guaranteed) today.
• If you can earn 7% annually on your investments, which should you
choose?

Solution : Present Value of an Annuity
• Option (a) provides $10,000 paid over time. To evaluate it correctly, we
must convert it to a present value. Here is the timeline:
• The $10,000 at date 0 is already stated in present value terms, but we

need to compute the present value of the remaining payments.
• Fortunately, this case looks like a 7-year annuity of $10,000 per year, so
we can use the annuity formula.

Solution : Present Value of an Annuity (cont’d)
Execute:
• PV = 53,892.89

Execute (cont’d):
• Thus, the total present value of the cash flows is $10,000 + 53,892.89 =
$63,892.89 which is more than the value of the car. In timeline form:
0 1 2 3 4 5 6 7
10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000
53,892.89
63,892.89

Execute (cont’d):
• Financial calculators or Excel can handle annuities easily—just enter
the cash flow in the annuity as the PMT:
Given: 7 7 10000 0
Solve for: -53,892.89
Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.07,7,10000,0)

Illustration (2)
Problem:
• Adam is 25 years old, and he has decided it is time to plan seriously for
his retirement.
• He will save $10,000 in a retirement account at the end of each year
until he is 45.
• At that time, he will stop paying into the account, though he does not
plan to retire until he is 65.
• If the account earns 10% per year, how much will Adam have saved
at age 65?

Solution : Retirement Savings Plan Annuity
• As always, we begin with a timeline. In this case, it is helpful to keep
track of both the dates and Adam’s age:

Execute:
X 1/0.10
Using Financial calculators or Excel:
Given: 20 10.0 0 -10,000

Solve for: $572,750
Excel Formula: =FV(RATE,NPER, PMT, PV) = FV(0.10,20,-10000,0)

Execute:
Using Financial calculators or Excel:
Given: 20 10.0 -$572,750 0
Solve for: $3,853,175
Excel Formula: =FV(RATE,NPER, PMT, PV) = FV(0.10,20,0,-572750)

Growing Cash Flows
• A growing perpetuity is a stream of cash flows that
occur at regular intervals and grow at a constant rate
forever
• For example, a growing perpetuity with a first payment
of $100 that grows at a rate of 3% has the following
timeline:
FINA 5120 – Growing Cash Flows

Growing Cash Flows
Present Value of a Growing Perpetuity
r = interest rate
g = growth rate
This formula ONLY works when r>g

Illustration
Problem:
• In a previous example, you planned to donate $4 million to your alma
mater to fund an endowed professorship.
• Given an interest rate of 5% per year, the professor would be able to
collect $200,000 per year from your generosity.
• The inflation rate is expected to be 2% per year.
• With the same amount of donation, how much can the professor be
paid in the first year in order to allow her annual salary to increase by
2% each year and keep the principal intact?

Solution: Endowing a Growing Perpetuity (cont’d)
Plan:
• The salary needs to increase 2% per year forever. From the timeline,
we recognize the form of a growing perpetuity and can value it that
way.

Solution: Endowing a Growing Perpetuity (cont’d)
Evaluate:
• She can only withdraw $120,000 in her first year.
• In the second year, her payment will be $120,000 X 1.02 = $122,400

and the payments will continue to increase each year.
PV is the donation of $4
million, r is the interest rate of
5% and g is the growth rate
(inflation) of 2%

Growing Cash Flows
Present Value of a Growing Annuity
• A growing annuity is a stream of N cash flows C , paid
at regular intervals and growing at a rate of g
• It is like a growing perpetuity that eventually comes to
an end

Growing Cash Flows
• Present Value of a Growing Annuity:
N
1  1 g  
PV= C  1    
r - g   1 r  
FINA 5120– Growing Cash Flows

Illustration
Problem:
• In the previous example, Adam considered saving $10,000 per year for
his retirement. Adam is 25 years old, will save $10,000 in a retirement
account at the end of each year until he is 45 then save nothing until
retirement at 65
• Although $10,000 is the most he can save in the first year, he expects
his salary to increase each year so that he will be able to increase his
savings by 4% per year.
• With this plan, if he earns 10% per year on his savings, how much will
Adam have saved at age 65?

Solution: Retirement Savings with a Growing
Annuity (cont’d)
His new savings plan is represented by the following timeline:
19
This example involves a 20-year growing annuity with a growth rate of 4% and
an initial cash flow of $10,000.

Annuity (cont’d)
The present value of Adam’s growing annuity is given by:
20
1   1.04  
PV= $10,000  1    
0.10 - 0.04   1.10  
 $10,000  11.2384
 $112,384 today
N
1  1 g   C is the annual payment of $10,000;
PV= C  1    
r is the interest rate of 10% and g
r - g   1 r   the growth rate of 4% with N being
20 years

Annuity (cont’d)
• Adam’s proposed savings plan is equivalent to having $112,384 in the
bank today.
• To determine the amount he will have at age 65, we need to move this
amount forward 40 years (in other words calculate the future value in
40 years of the previously calculated amount) :
FV= $112,384  1.10 40
 $5,086, 416 in 40 years

Solving for Variables Other Than Present Value or
Future Value
Solving for Cash Flows
P
C
1 1 
 1 
r N
(1 r) 
FINA 5120 – Solving for Variables other than PV and FV

Illustration
Problem:
• Suppose you accept your parents’ offer of a BMW convertible, but that’s
not the kind of car you want.
• Instead, you sell the car for $61,000 and use that money for a down
payment on an Aston Martin V8 Vantage Roadster. You got a real
bargain at $110,000!
• The bank offers you a 5-year loan with equal monthly payments and
an interest rate of 4% per year.
• What will be the payment on the loan?

Solution : Computing a Loan Payment
Plan:
• The loan amount is $110,000 – $61,000 = $49,000
• Note, we need to use the monthly interest rate.

• Since the quoted rate (4%) is an APR , we can just divide the annual
rate by 12:
r = .04/12 = .0033333 (0.33333%)
FINA 5120– Solving for Variables other than PV and FV

Solution : Computing a Loan Payment (cont’d)
• We use to P
solve for C
C
1 1 
 1 N
r (1 r) 
• P is the loan amount ($49,000-); r is the monthly interest
rate 0.3333..% and N is the number of monthly periods
(5*12=60)
• We find a monthly payment of $902.41

Solution: Computing a Loan Payment (cont’d)
Execute (cont’d):
• Using a financial calculator or Excel:
Given: 60 4/12 49,000 0

Solve for: -902.41
Excel Formula: =PMT(RATE,NPER, PV, FV) =
PMT(4%/12,60,49000,0)

Solving for the rate - calculating the Internal Rate
of Return
• Imagine that you run a toy manufacturing company and
that you are considering purchasing a new machine.
– Machine costs $4 million and can produce 50,000 toys per
year.
– You sell the toys for $10, generating $500,000 in revenue per
year.
– Assume the machine is the only input, you have certainty
about the revenue, the machine requires no maintenance and
has a 10 year lifespan.

Internal Rate of Return: Example
• If you borrow $4 million, is the revenue enough to make the
payments?
• We need to calculate the internal rate of return of this
investment:
– It is the interest rate that equates the present value from
the cash flow of an investment with its cost.
• Balance the cost of the machine against the revenue.
– $4 million today versus $500,000 a year for ten years.
• At the internal rate of return, the cost of the machine is
equal to the present value of all the yearly revenues.
– Solve for r - the internal rate of return

Internal Rate of Return: Example
• Solving for r,
• 4,000,000 = ++…+
• r = 4.28%
• As long your borrowing cost is less than 4.28%, then you
should buy the machine.
• Knowing the cash flows (and dates), this IRR
calculation is a way to identify the break even funding
cost.

llustration
• Problem:
• Let’s return to the BMW example. Your parents have made you an offer
you can’t refuse. They’re planning to give you part of your inheritance
early. They’ve given you a choice.
– Option a: They’ll pay you $10,000 per year for 7 years, starting
today and with the last payment at the end of year 7
– Option b: they’ll give you their BMW Convertible, which you can sell
for $61,000 (guaranteed) today
• What rate of return would make you indifferent between the car
and the $10,000 per year payout?

Solution : Computing the Internal Rate of Return
• Option (a) provides $10,000 paid over time. To evaluate it correctly, we
must convert it to a present value. Here is the timeline:
• The $10,000 at date 0 is already stated in present value terms, but we

need to compute the present value of the remaining payments.
• Fortunately, this case looks like a 7-year annuity of $10,000 per year, so
we can use the annuity formula.

Solution : Computing the Internal Rate of Return
Execute:
Given: 7 -51,000 10,000 0

Solve for: 8.6071
Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(7,10000, ‑51000,0)
The rate equating the two options is 8.61%.

Solving for the Number of Periods
• In addition to solving for cash flows or the interest rate,
we can solve for the amount of time it will take a sum of
money to grow to a known value
• In this case, the interest rate, present value, and future
value are all known
• We need to compute how long it will take for the
present value to grow to the future value

Illustration
Problem:
• Ellen is Adam’s older sister.
• Suppose Ellen decides she will continue working until she has as much
at retirement as her brother, Adam, will have when he retires
($3,850,000).
• She has saved $1,645,000 at age 65 and earns 10% on her
investments.
• She will continue to contribute $10,000 each year to her retirement
account until she has the same amount of retirement money as her
brother.
• Until what age will she need to work to tie the competition with her
brother?

Solution: Solving for the Number of Periods in a
Savings Plan
• The timeline for this problem is

Solution: Solving for the Number of Periods in a
Savings Plan
• Execute:
• The PV is $1,645,000, the annual payments (PMT) are
$10,000, the FV is $3,850,000 and the rate r is 10% so we
solve for N
Given: 10 -1,645,000 -10,000 3,850,000

Solve for: 8.57
Excel Formula: =NPER(RATE,PMT, PV, FV) =
NPER(0.10,‑10000,‑1645000,3850000)
• N= 8.57 , 65+8.57 ~74


In Practice: Your Credit Card
• Check out your credit card statement
• What does it show at the end of the statement?
• Why do you think the financial regulators are forcing the
credit card issuers to include this information?

Your Turn!
• Erika opened a savings account today and
she immediately put $30,000 into it. She
plans to make 10 additional contributions
of $4,000 a year. The first contribution
occurs one year from today, the final
contribution will occur ten years from
today. The savings account pays a 6%
annual interest rate. If she makes no other
deposits or withdrawals, how much will she
have in the account 15 years from today?
A) 59,440
B) 142,452
C) 106,448
D) 134,339
E) 150,999
Answer B
FINA 5120 – Chapter 4
Solution:
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-30,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 0 0 0 0 FV
• First method: Compute the FV of each cash flow one by one

FV  30,000  (1.06)15  4,000  (1.06)14  4,000  (1.06)13  ...  4,000  (1.06)5
• Second method: Annuity formula
1
 1.06  1  (1.06) 5
 10 10 
FV   30,000  (1.06)  4,000 
 0.06 
• Both methods will have the same result. She will have approximately
$142,452 in the account 15 years from today.

Your Turn!
• Investment X and Investment Y are both
growing perpetuities with initial cash flow of
$100. Both investments have the same interest
rate (r) and cash flows. The present value of
Investment X is $5,000, while the present value
of Investment Y is $4,000. Which of the
following is true?
A) Investment X has a higher growth rate than
Investment Y.
B) Investment X has a lower growth rate than
Investment Y.
C) The answer cannot be determined without
knowing the interest rate for both investments.
D) With the same initial cash flow and the same
interest rate, Investment X and Investment Y
should have the same present value.
Answer A
Solution:
Investment X
$100 $100  g $100  g 2 $100  g 3
Investment Y
$100 $100  g $100  g 2 $100  g 3

• With the same initial cash flow, the same interest rate,
PX(X) > PV (Y),
C/(r-gx) > C/(r-gy).
(r-gy)>(r-gx)
gx>gy

Your Turn!
• Your parents are planning to retire in
Phoenix, AZ in 25 years. Currently, the
typical house that pleases your parents
costs $200,000, but they expect
inflation to increase the price of the
house at a rate of 4% over the next 25
years. In order to buy a house upon
retirement, what must they save each
year in equal annual end-of-year
deposits if they can earn 10% annually?
A) $10,842.56
B) $7,650.94
C) $5,421.28
D) $2,715.52
Answer C

Solution
• The future value of the house = $200,000 x 1.0425 = $533,167.27
• The required annual deposit:
0 1 2 3 4 25
0 C C C C $533,167.27
FV ( Annuity )  C 
1
r
 
1  r N  1
FV(Annuity) = $533,167.27; r = 10%; N = 25

$533,167.27  C 
1
10%

 1  10%   1
25

• By solving the equation, the required annual end-of-year deposit is
$5,421.28.
Solution
Using financial calculator or Excel
• The future value of the house = $533,167.27
Given: 25 4 200,000 0
Solve for: -533,167.27
Excel Formula: =FV(RATE,NPER, PMT, PV) = FV(0.04,25,0,200000)
• The required annual end-of-year deposits = $5,421.28
Given: 25 10 0 533,167.27
Solve for: -5,421.28
Excel Formula: =PMT(RATE,NPER, PV, FV) = PMT(0.10,25,0,533167.27)

Your Turn!
• Assume that you are 30 years old today, and
that you are planning on retirement at age 65.
Your current salary is $40,000 and you expect
your salary to increase at a rate of 5% per year
as long as you work. To save for your retirement,
you plan on making annual contributions to a
retirement account. Your first contribution will be
made on your 31st birthday and will be 8% of
this year's salary. Likewise, you expect to
deposit 8% of your salary each year until you
reach age 65. Assume that the rate of interest is
10%.
The future value (FV) at retirement (age 65) of
your savings is closest to ________.
A) $722,766
B) $1,445,531
C) $1,011,872
D) $1,590,084 Answer B

Solution
• The first deposit = $40,000 x 8% = $3,200
Age: 30 31 32 33 34 … 65
0 1 2 3 4 35
0 -$3,200 -$3,200x1.05 -$3,200x1.052 -$3,200x1.053 FV
1   1  g  
N
PV(Saving at age 65)  C   1  

r - g   1  r  
C = $3,200; r = 10%; g = 5%; N = 35
1   1  5% 35 
FV  $3,200   1      1  10% 35
10% - 5%   1  10%  
• By solving the equation, The future value (FV) at retirement (age 65) of
your savings is closest to $1,445,531.

ADDENDUM
Key Formulas Takeaway (single cash flow)
Where:
FV = future value of a cash flow C at period n
PV = present value of a cash flow C
C = cash flow (or payment PMT)
n = period
r = interest rate (or interest i)
FINA 2303 – Chapter 3 – Time Value of Money

Present Value of a Stream of Cash Flows
FINA 5120 – Key Formulas

Present Value of Annuity (Fixed Payments
Loans)
C C C C
PV=    ......
(1  r) (1  r) (1  r)
2 3
(1  r) N
Present Value of Perpetuity (Consol)
This formula only works when r is positive!

Key Formulas Takeaway (cont’d)
(Eq. 4.6)

Key Formulas Takeaway (cont’d)
Present Value of Growing Perpetuity
r = interest rate
g = growth rate
This simplified formula Eq. 4.7 ONLY works when r>g
Present Value of Growing Annuity
N
1  1 g  
PV= C  1    
r - g   1 r  
of Cash Flows
• Financial calculators and spreadsheets (Excel) have the
formulas pre-programmed to quicken the process
• There are five variables used in DCF calculations:
– N (number of periods)
– PV (present value)
– PMT (periodic payment/cash flows)
– FV (future value)
– I/Y (interest rate)
The trick is to identify the variables! One of the challenges we commonly face is
terminology. We will be using different terms throughout the course,
particularly for “interest rate” so it can get a bit confusing!

of Cash Flows
Example 1:
• Suppose you plan to invest $20,000 in an account paying
8% interest.
• How much will you have in the account in 15 years?
• We want to determine the future value of that investment.
• To compute the solution, we enter the four variables we
know and solve for the one we want to determine, FV.
Name the
four variables
in this
example

of Cash Flows
Example 1:
• For the HP-12C or the TI-BAII Plus calculators:
– Enter 15 and press the N key. (15 years is the number of periods)
– Enter 8 and press the I/Y key (i for the HP) (8% interest rate per
annum)
– Enter -20,000 and press the PV key. (note the negative sign as the
20,000 present value is an investment – negative cash flow)
– Enter 0 and press the PMT key.(there are no periodic payments in
this case)
– Press the FV key (for the TI, press “CPT” and then “FV”).

of Cash Flows
Given: 15 8 -20,000 0
Solve for: 63,443
Excel Formula: = FV(0.08,15,0,-20000)
Notice that we entered PV (the amount we’re putting in to the bank) as a negative
number and FV is shown as a positive number (the amount we take out of the
bank).
It is important to enter the signs correctly to indicate the direction the funds are
flowing.
Timelines with cash flows are
useful to avoid confusion

FINA 5120 - Fall (1) 2022 - Session 2 - IR TVM and DCF - No Arb - 19aug22

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FINA 5120 – Learning Objectives

• Quantifying Costs and Benefits

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – Cost-Benefit Analysis

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – The Valuation Principle

• Law of One Price

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – Law of One Price

Copyright ©2017 Pearson Education, Inc. All rights reserved.

FINA 5120 – Arbitrage

Copyright ©2017 Pearson Education, Inc. All rights reserved.

FINA 5120 – Arbitrage

Copyright ©2017 Pearson Education, Inc. All rights reserved.

FINA 5120 – Arbitrage

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – IR Quotes and Adjustments

Jan June Dec

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – IR Quotes and Adjustments

Copyright ©2017 Pearson Education, Inc. All rights reserved.

FINA 5120 – IR Quotes and Adjustments

• E.g. Is earning 5% every six months return the same

• EAR: Adjusting the Discount Rate to Different

Equivalent n-Period Discount Rate  (1  r ) n  1

Copyright ©2017 Pearson Education, Inc. All rights reserved.

FINA 5120 – IR Quotes and Adjustments

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – IR Quotes and Adjustments

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – IR Quotes and Adjustments

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120 – IR Quotes and Adjustments

Copyright ©2015 Pearson Education, Inc. All rights reserved.

FINA 5120– IR Quotes and Adjustments

Equivalent n-Period Discount Rate = (1 + r)n – 1

FINA 5120 – IR conversion Key Formulas

FINA 5120 – PRS Questions

Bank 1: EAR = 7.95 %

• What rate is used to calculate your payment if you

FINA 5120 – APR v. EAR

FINA 5120 – Time Value of Money

FINA 5120 – Time Value of Money

• The concept of discounted value is based on the notion (assumption)

FINA 5120 – Time Value of Money

– Representing Various Time Periods

• The rate at which we can exchange money today for

FINA 5120 – Time Value of Money

• The risk-free rate is also referred to as the discount

Warning! The biggest difficulty we will face is one of

FINA 5120 – Time Value of Money

FINA 5120 – Time Value of Money

FINA 5120 – Time Value of Money

FINA 5120 – Time Value of Money

• This is just the future value calculation inverted.

FINA 5120 – Time Value of Money

 We can generalize the process as we did for future value.

FINA 5120 – Time Value of Money

Difference Difference Difference

FINA 5120 – Time Value of Money

Please note the convexity of the curve!

PV (10 years) = $55.84