FIN 200: Business Finance

Group 2 - Pelaelo

Lecturer Office Tel Email

Mr P.S. Pelaelo 245/212 355 5538 pelaelo@ub.ac.bw

bakwenabatsilel@ub.
Mr L. Bakwenabatsile 245/234 355 5679 ac.bw

Dr G.N Jatty 245/209 355 2142 jattygn@ub.ac.bw

 Lecture Timetable:

10:00 BLDG 240 ROOM

FIN 200/Lec/01 Tuesday,Thursday AM 12:00 PM 011 Jatty
Monday,Wednesday,Fr 12:00 BLDG 240 ROOM
FIN 200/Lec/02 iday PM 1:00 PM 011 Pelaelo
BLDG 240 ROOM Bakwenabatsil
FIN 200/Lec/03 Tuesday,Thursday 8:00 AM 10:00 AM 011 e
BLDG 248 ROOM
FIN 200/TUT/01 Monday 5:00 PM 6:00 PM 011 Tutor 1
BLDG 245 ROOM
FIN 200/TUT/02 Tuesday 2:00 PM 3:00 PM 135 Tutor 2
BLDG 248 ROOM
FIN 200/TUT/03 Wednesday 5:00 PM 6:00 PM 011 Tutor 3
BLDG 245 ROOM
FIN 200/TUT/04 Thursday 5:00 PM 6:00 PM 042 Tutor 4
 FINANCE

• Finance can be divided into three(3) broad categories being Public,

Corporate and Personal finance
1. Public Finance – deals with govt expenditure and income including
on public projects, National Budgets and the Tax systems
2. Corporate Finance – is the financial management of assets,
liabilities, revenues and expenditures for large companies with
shareholders
3. Personal Finance – addresses financial matters of you and me,
either as an individual or as a family commonly known as a household
4. These three broad areas forms an identifiable structure called the
Financial system
 Financial System
• The financial system consists of 5 components namely Financial
markets, Financial Institutions, Financial Instruments/securities,
Money and the Central bank
1. Financial Markets include Money Markets, Capital Markets and
Foreign exchange markets
2. Financial Institutions are Banks and Non-Banking Financial
Institutions supervised by Bank of Botswana (BoB) supervisory Unit
and NBFIRA respectively
3. Financial Securities are long term vs short term exchange
instruments used to raise funds in the financial markets. Common
examples are shares, bonds and foreign currency accounts
4. Money is the oil that lubricate the whole financial system so that it operates
smoothly and is controlled by the central bank (BoB) through monetary
policy
5. Central Bank – overarching authority over the financial system and is
responsible for overseeing the stability and soundness of this system largely
through controlling the supply of money which in turn affects demand and
thus the value of a country’s currency
 Overview of Financial Management

• Financial management
• It is primarily about financial decisions in Businesses. It can be defined as
the acquisition, application and disbursement of funds by the organisation.
• These funds are acquired and used in financial markets many a times the
whole process is facilitated by financial institutions such as brokerage and
investment banking houses as this involves large sums of money

• Corporate Financial management activities and decisions falls

under three broad areas of (i) financing, (ii) investment and (iii)
operations
1. Financing Activities – This means that a company first has to
raise funds. These funds have to be raised in the most cost
effective and efficient manner

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• Financing should be cost effective and/or convenient in terms of
matching repayment income with instalments.
• In other cases supplementary features of the financing process will
have the upper hand such as less stringent conditions of the funds
being raised
• To conduct a splendid financing process a lot goes into planning,
appraisal and risk assessment
• The scope of financial management is therefore quite broad. It
involves:
▪ Financial appraisal of business opportunities
▪ Assessment of the cost effective means of sourcing capital
▪ Securities evaluation
▪ Assessment of risk and returns
• Examples of Financing activities – issuing of shares, long term
(Bonds) or Short-term borrowing (commercial paper)
2. Investment Activities – refers to expenditure on capital assets
such as Property, Plant and Equipment (PPE), independent projects
and acquisition of other businesses.
• Investment of excess funds in market securities is also included in
this category
3. Operating Activities – deals with daily activities of the core
business of a company in order to produce and sell its products.
The main focus is in managing expenditure and generating revenue
• Examples are procurement of material, payment of salaries and
wages, payment of factory or warehouse rent, utilities etc
 Role of a financial manager

The goal of financial manager:

▪ Forecasting and planning for the firm’s future financial

requirements.
▪ Undertake investment and financing decisions. Assets must be
acquired, replaced, maintained or hired and funds must be
sourced to achieve these objectives.
▪ Dealing with financial markets in raising funds. A financial
manager needs to understand the workings of both the money
and capital markets.
▪ Risk management. Risk is an integral part of any business
venture, be it from natural disasters or security markets.
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 Primary objective in Finance

The objective of the firm :

➢Primary Goal: Maximize shareholder wealth i.e. stock price

➢Other Goals: Corporate Social Responsibility (CRS): a firm has a
responsibility for the welfare of its employees, customers and the
community at large.
➢This is an ethical objective that ensures a safe workplace, production of
safe products and a pollution free environment respectively.

Recent Business Trends:

➢Increased globalization of business
➢Improvements in Information Technology (IT)
➢Corporate Governance and Business Ethics 11
Flow of Funds…Fundamental Model

12
 The Financial Markets

Financial markets are trading places or platforms that create a conducive

environment for effective capital formation and capital transfer of funds from
Savings Surplus Units (SSUs) = Investors to Savings Deficit Units (SDUs) =
businesses.
Overall, the role of Financial Markets is to:
• bridge the gap between savings surplus units and savings deficit units
(facilitates an enabling environment)
• ensure effective capital formation (creation of appropriate securities)
• ensure effective capital transfer (regulation, legalities, processes and
procedures)

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 ▪ Types Financial Markets

• Physical vs Financial Markets

1.Physical Asset Markets
➢ trade in tangible products that can be seen, touched and physically valued, e.g. equipment,
computers, agricultural produce, oil, steel etc

2.Financial Asset Market

➢ trade in either claims on real assets (shares, bonds, mortgages) or derivative securities
(hedges on stock/economic movements)(GIY)

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 Money Markets vs Capital Markets

a) Money Markets
➢ Trade in short-term finance (normally up to 1 year) e.g. treasury bills
➢ Highly liquid and marketable securities
➢ Facilitate transactions between savers with temporarily idle funds and businesses temporarily
short of funds (working capital)

b) Capital Markets
➢ Trade in long-term finance, e.g. shares, bonds, debentures (GIY)
➢ Mechanism through which long-term finance is pooled and made available to corporations
➢ Higher in risk and return
 Mortgage Markets vs Consumer Credit Markets
a) Mortgage Markets
➢ Financial instruments linked to real estate (mortgages) are created by financial
institutions
➢ These instruments are then traded in the secondary markets

b)Consumer Credit Markets

➢ Personal Debt taken to purchase products for personal use and immediate
consumption.
➢ Examples are credit cards, personal loans, bank overdraft, auto loans

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 PRIMARY VS SECONDARY MARKETS

Primary Market
• The shares/stock are issued directly by the company to investors
• Achieved by either private placement or initial public offering (IPO)(GIY)
• The company receives the funds and issues share certificates (nowadays not physical)
• Funds used as start-up (IPO) or expansion capital(FPO)
• New capital is formed in the economy
• E.g. BTC listing

Secondary Market
• Trade in existing or already outstanding securities
• Transaction between security (share) holder and a third party investor
• Proceeds from the sale doesn’t accrue to the owner company
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 ORGANISED EXCHANGES VS OVER THE COUNTER
MARKETS(OTC)

Organised Stock Market

• Has physical location exchanges e.g NYSE, BSE, JSE
• Tangible entities where outstanding securities are resold (nowadays done electronically)
• Limited number of members (brokers) and governed by set rules and regulations
• Account for 62% of the volume of trade (by dollar volume)

• Over the Counter (OTC) Stock Market

• Intangible markets that trade in securities not traded in the organised exchanges
• Also referred to as Dealer Markets
• Has few dealers, compared to organised exchanges
• Dealers hold inventory of securities and create markets for them
• Uses an extensive computerised communication network, i.e. Nasdaq, Primary dealer
(banks) trading in Botswana
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 SPOT VS FUTURES MARKETS

• Spot market is where assets are bought or sold for on-the-spot

delivery (normally T+2 for currency, T+3 for bonds and stocks)
• Futures markets are whereby participants agree today to buy or
sell an asset at a specified future date.
• The deal is concluded today but the delivery is done at some future
date

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Methods of Capital Transfer
Direct vs Indirect Transfer
 Direct Transfer

BUSINESS Securities (Shares & Bonds) SAVERS

SAVINGS (INVESTORS)
DEFICIT SAVINGS
Capital (Pula)
UNITS (SDU) SURPLUS
UNITS(SSU)

Direct Transfer
• Businesses (SDUs) directly solicit and acquire funds from investors
• Limited capacity to raise finance
• Slow process
• Cuts the involvement and costs of the go-between such as an intermediary
• i.e. private equity firms like CEDA, Venture Capital, unlisted credit lending
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 Direct Transfer Through Investment Banks or brokers

Direct Transfer Through Investment Banks or

brokers
• The security ‘passes through’ an investment bank to investors
• Investment banks underwrite the issue, an assurance that the issued securities will be fully
subscribed
• Investment banks create conducive conditions for the successful floatation of securities
and transfer of funds between businesses and investors
• In Botswana this service is offered by companies like RMB 22
 Indirect Capital Transfer

Indirect Transfer Through Financial Intermediaries

• financial intermediaries directly trade with both savings surplus and deficit units
• in the process, Financial Intermediaries can create and float their own securities to savers to
create a pool of funds
• Thereafter amounts from this pool is invest in Business organisations or companies’ securities
that have productive projects
• Note, two separate security flotations could be necessary before a company finally gets its capita
• Financial Intermediaries enjoy economies of scale in terms of expertise in analysing
creditworthiness of potential borrowers and minimising the risk of its shareholders through a
diverse pool of investments.
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• Eg Unit trusts offered by companies like Stanlib and BIFM, Afinitas.
24
 Financial Institutions

1. Commercial Banks (ABSA, Stanbic, FNB, StanChart etc)

• custodians of the savers’ funds, administered through current, savings and fixed
deposit accounts
• offer a wide range of consumer credit products, e.g. credit/debit cards, short/long
term loans, investment packages/advice
• offer corporate financial products
• in recent decades has branched to investment finance, stock brokerage,
insurance,
2. Investment Banks (RMB only local company)
• Help corporations design securities with features currently attractive to investors
• They help companies sell their securities to investors
• also called underwriters since they guarantee that the companies will raise
needed capital
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3. Financial Services Corporations (BIHL, African Alliance etc)
• Large conglomerates that combine many different financial institutions within a
single corporation
• Services include investment banking, brokerage operations, insurance and
commercial banking
• E.g. BIHL (insurance, lending, asset management), African Alliance (broking, asset
management)
4. Savings and Loan Associations (BSB etc)
• Receive savings from individual (small) savers and in turn lend accumulated funds
to individuals and businesses through short and long term (mortgage) loans
• Advantage: they make professional services on investment and finance readily
available to small savers overlooked by commercial banks, e.g. BSB

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5. Mutual Savings Banks
• Localised financial institutions that have a depository functionary for individuals and small scale
operators
• The institution creates short and long-term securities for home ownership and other purposes e.g BBS

6. Credit Unions (BOPEU owned SACCOS)

• Have well-defined membership
• Operate at a much smaller scale
• Savings accumulated from periodic member contributions
• Pooled funds are lent within the membership at concessionary interest rates
• Credit unions are very common among labour organisations, e.g. Teachers’ Union

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7. Pension Funds (BPOPF,UBDPF)
• A pool of savings in the form of premiums is collected from members
• Employers may contribute to members’ funds
• Appointed fund managers oversee fund investment, creating suitable portfolios
• Rules and regulations govern how the funds ought to be invested
• Members are only entitled to the funds in case of occurrence of an event stipulated in the policy
document or after a defined time lapse, e.g. retirement, disability or death
• Member borrow short-term against their entitlements

8. Insurance Companies (Botswana Life, Metropolitan etc)

• A pool of savings in the form of premiums is collected from members
• Insurance can be life or Non-life Insurance
• Non-life include Home, disability, health, auto, Professional Indemnity etc
• Rules and regulations govern how the funds ought to be invested
• Members are only entitled to the funds in case of occurrence of an event stipulated in the policy
document or after a defined time lapse, e.g death, accident etc
• Member can borrow short-term against their entitlements 28
Mutual Funds (BIFM, IMARA, Unit Trusts etc)
• Create portfolios of securities from a pool of funds invested by savers
• Investors effectively invest in ‘slices’ of created portfolios, rather than individual shares or securities, i.e. Unit trusts
• Small investors enjoy the benefit of diversification, and thus reduced risk
• Small investors benefit from the economies of scale enjoyed by mutual funds companies

Exchange Traded Funds (ETFs)

• Similar to mutual funds and often operated by mutual funds companies
• EFTs buy a portfolio of stocks of a certain type (e.g. top 40 companies in JSE) and then sell their own shares to the
public
• ETFs are generally traded in the public market e.g betta beta and Gold ETF in BSE

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Hedge Funds
• Similar to mutual funds in that they accept money from savers and buy various securities
• Unlike mutual funds, hedge funds are largely unregulated as they target high net worth individuals and
institutions
• Used by individuals who want to hedge risks (or economic conditions)

Private Equity Companies (CEDA Venture Capital, CMA

Private Equity etc)
• Unlike hedge funds which purchase some of the stocks, private equity firms buy entire firms
• They buy and manage those entire firms
• Most of the money used to buy firms is borrowed

NOTE: With exception to hedge funds and private equity companies, financial institutions are regulated to
protect investors
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 Exercises

a. What are the key aspects involved in corporate financial management?

a. Discuss the responsibilities performed by the Finance Manager or Finance Director of a listed company.

a. Distinguish between: Direct capital transfer and Indirect capital transfer, with relevant hypothetical examples.

b. Distinguish between: i) Money and Capital markets; ii)Primary and Secondary markets; iii) organised and over the counter (OTC) stock
markets; and iv) spot and futures markets giving relevant hypothetical examples of each.

c. What would you consider to be a ‘conducive economic environment’ for a business to borrow debt? Use any three of the factors that
determine interest rate to explain your answer.

d. How does the interest rate of short-term securities differ from that of the long-term securities issued by the Central Bank?

e. A three-month BOB bond carries a nominal interest rate of 6.2%. A comparable (in Liquidity) three-month bond of a lowly rated
company’s carries a nominal interest rate of 7.6%. What is the default risk premium for the company

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 Interest Rates

Introduction
➢Cost of Capital: Interest Rate is a reflection of the cost of capital, and in
particular is the price of borrowed debt
➢Compensation: Interest rate is a compensation paid by the borrower of funds
to the lender
➢Rationing: Interest rate rations available capital funds, thereby allocating
funds prudently among alternative investment opportunities i.e. profitable
ventures attract most capital away from inefficient ones
➢Opportunity Cost: It represents the opportunity cost of capital

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 Determinants of Interest Rates

• Interest Rate levels in any given economy is influenced by 4 major

macro-economic factors that determine the supply and demand of
investment capital:
• Productions Opportunities – competition by way of variety of
investment opportunities available in an economy stimulates a sense of
eagerness and urgency, hence higher interest rates

• Time Preference for Consumption - propensity for high current

consumption starves savings, hence increases the price for lending.
▪ Capital formation would be difficult, supply low, therefore demand is
high, interest rate level would be high 33
• Risk – volatility of the returns, uncertainty about the outcome, instability of the
markets. Increased risk heightens required returns (interest rate)

• Rate of Inflation - the percentage amount by which prices in general,

increase over time. Inflation erodes the purchasing power of money and
hence an important factor to be incorporated when considering interest rates
(time value of money). The expected future rate of inflation determines interest
rate

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 •
Other Determinants of Interest Rates

• Foreign Trade Balance - Foreign trade deficit (net-importation) requires

finance and increased borrowing increases interest rates.
▪ Interest rate levels for securities held by foreign investors must remain
competitive with those investors’ comparative domestic rates, otherwise there
will be no economic incentive to hold (invest)

• Business cycles - The general trading conditions and business activity

influence the general levels of interest rates, i.e. recessions, depressions and
booms
▪ Also called Troughs and Peaks of a Business Cycles when Business Expand
and Contract

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 Monetary vs Fiscal Policies

• Monetary Policy -Deals with Monetary policy i.e the supply or amount of money in
the economy through the central Bank
• Central Bank Policy
• Economic activity, the rate of inflation, and hence interest rates, can be controlled using money
supply
– Increase in money supply increases expected inflation rate, thereby pushing interest rates up
– Reduction in money supply has the opposite effect
– Central bank also has direct control over interest rate
– Short term rates are most adversely impacted by Central Bank intervention. Long-term rates
may remain unchanged, or indicate slight change
– Read BoB 2022 Monetary Policy Statement (MPS) (GIY – Google It Yourself)

• Fiscal Policies - Deals with Govt expenditures through Treasury –Min Of Finance
• Budget Deficits or Surpluses
– Governments borrow to supplement budgets, thereby increasing the demand (competition) for
money
– Interest rates increase as a direct result of such expenditure
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– Debt security buy-backs reduce interest rates
 Nominal (Quoted) Market Interest Rate (k)

• The nominal market interest rate of a security (k) is the actual interest rate that is quoted on
the face of a security as charged by the lender and paid by the borrower

• ‘k’ will vary across situations, depending largely on the riskiness of both the security and
the borrower

• Determinants of nominal interest rate:

• k = k* + IP + DRP + LP + MRP Or

• k = krf + DRP + LP + MRP

• where: krf = k* + IP

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 Nominal vs Real risk-free Interest Rate

1. Real Risk-Free Rate of Interest (k*)

• The real compensation (return) an investor demands for foregoing the use of his/her money,
assuming a perfect world:
• The investor is guaranteed a stipulated return, hence risk-free
• Inflation-free economy

2. Nominal Risk-Free Rate (kRF)

• Inflation erodes the purchasing power of money
• Inflation lowers the real rate of return on an investment
• Inflation Premium (IP) is the (simple) average expected inflation rate over the lifespan of a
security, serves the purpose of protecting returns
• Inflation premium is not necessarily equal to current rate of interest
• kRF is normally equated to a short-term Bank of Botswana bond or T-bill

38
3. Default risk (DRP)
• The probability of a borrower being unable to service his/her debt obligations, i.e. paying principal and
interest at agreed intervals
• Default risk is largely influenced by the borrower’s history in debt servicing, hence rating agencies
become important. Debt securities of companies rated highly carry low DRP
• Central Bank debt securities carry the lowest (near zero) DRP while lowly rated companies carry the
highest DRP
• Effectively govt security is regarded as carrying no default risk

4. Liquidity Premium(LP)
• Securities with weak secondary market tie-up the funds of an investor
• The liquidity premium is levied depending on the marketability or liquidity of the security
• Liquidity is measured by the extent to which a security is easily marketable and saleable at reasonable
price on short notice in the secondary markets
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5. Maturity Premium(MRP)
• Investing in long-term securities carries a risk that is associated with unanticipated adverse
economic events that may occur with the passage of time i.e.
economic/political/environmental/social events that may occur with the passage of time
• To shield the investor’s returns on long-term securities from the possibility of being
disadvantaged from the prospects of some unanticipated occurrence happening with the
passage of time. This is also included in Central Bank long-term securities
• The maturity risk premium is charged for risking capital losses due to the passage of time as
a result of unexpected changes in interest rates,
• Generally, the longer to maturity for a security the higher will be the maturity risk premium

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 Structure of Interest Rates- RECAP
• K = Nominal or Quoted Interest rate – Reward for lending one’s funds
i. K = K* - Real risk-free rate - True/Pure Compensation
▪ Would be enough in a world without inflation and any other risk of loss
▪ Doesn’t exist in the real world
ii. K = K* + IP = Compensation for inflation → Krf - Nominal risk-free
▪ Bt absolutely no other risk exposure – No company can offer that. Only Govt
short-term bonds →T-Bills – come close to that
iii. k = krf + DRP includes the possibility of Default
▪ The possibility of default exists for all Businesses even the Blue-chip Firms
iv. k = krf + DRP + LP includes a measure of liquidity
▪ Marketability depends on the breadth and depth of the secondary market for
the concerned security
▪ It also depend on some features or conditions imposed on each security
• k = krf + DRP + LP + MRP – finally add Maturity risk premium which is a
collective name for all risks or potential calamities that can befall the
investment in the interim
▪ The longer the investment period the higher such risk even for govt bonds
▪ Could be economic/political/social/environmental and even technological
▪ Examples of Economic Calamities are Stock Market Crushes and Financial
Crisis
▪ Examples of Political risk are the ideological difference between Russia and
Ukraine that affected many markets and industries including Confectineries
and the Energy sector
▪ Examples of Social Unrest is the toppling of Sri Lanka Govt recently through
Protest. There are other examples of Social unrest in Bolivia Iraq, Sudan
even Canada where the transport routes where brought to a grinding halt
which affected many Business
• Environmental impact can be found from the move from Coal to cleaner
sources of energy. This affect coal based Business massively
• Technological impact could be a Trade/Credit Union whose members were
mostly concrete mixtures and Labourers being replaced by concrete mixers
and other Industrial machinery. Washing Machines and Dish washers being
replacing Maid Requirements etc
• Artificial Intelligence and Robotics are also affecting quite a number of
workplaces
 Exercise 1

• Gibbs, a UB graduate aged 21, has just been employed and is looking forward to moving out of
his parents’ house to establish himself. Mr Oldie, on the other hand has served the government
for 18 years and is starting to think of a retirement package. Based on the concept of time
preferences for consumption, explain why these two individuals would potentially demand
different interest rates (returns). Who would demand a higher interest rate (return) as a
motivation to invest?
• Answer:
• Gibbs will demand a higher interest rate than Oldie in the context of the time preference for
consumption because most of his income by necessity has to go towards current consumption
in covering his basic necessities which includes rent and other amnesties such as grocery.
• He therefore has to be incentivized by a higher margin to give up consumption
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
• His propensity for current consumption can be measured by his which
𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒
surely exceeds that of Oldie’s

44
II. Distinguish between ‘real’ and ‘nominal’ risk-free rates.
• Answer:
• The ‘nominal’ rate indicates that the rate includes inflation and ‘real’ indicates that the rate
is net of inflation
• Therefore Nominal Risk-free Rate(krf )is equal to Real Risk-free(k*)plus Inflation
Premium(IP)
• krf = k* + IP
• Real Risk-free is equals to k* . If given krf then:
• k* = krf - IP
III. There is a 5-year security to be offered next-year. You are informed that the current rate of
inflation is 3.5% and is to be as follows in the next 5 years: 5.0%, 5.6%, 4.9%, 7.0% and
7.2%. You are required to compute the Inflation Premium for the security.
• Answer:
• The inflation rates that are relevant are those of the period of investment. In this case the
investment occurs over the next 5 years we therefore take year 1, 2, 3, 4 and 5
• Note that we exclude the current year’s inflation of 3.5% as it has already
occurred
• The answer is therefore is the average of those 5 years which is
5+5.6+4.9+7+7.2 29.7
• IP = = = 5.9%
5 5
iv. Information drawn from the Central Statistics Office predicts inflation for the
next 6 years as follows; 4.4%, 5.3%, 3.5%, 4.0%, 3.7% and 4.8%. The
following data is available with regard to a company’s 6-year security:
Real Risk-free rate 3.75%
Default Risk Premium 1.25%
Liquidity Premium 2.20%
Maturity Risk Premium 1.45%
You are required to compute the Nominal Risk-Free and the Nominal Interest
Rates for the company’s security.
• Answer:
• Nominal Risk-free rate (krf ) = k* + IP
(4.4+5.3+3.5+4+3.7+4.8) 25.7
• Inflation Premium(IP) = =
6 6
• = 4.3%
• Nominal Risk-free rate (krf ) = k* + IP
• = 3.75 + 4.3
• = 8.05%
• K = krf + DRP + LP + MRP
• = 8.05 + 1.25 + 2.20 + 1.45
• = 12.95%
 Exercise 5

The following data has been compiled for a security with 4 years to
maturity:
Nominal Risk-free rate of return 7.5%
Default Risk Premium 1.75%
Liquidity Premium 2.25%
Maturity Risk Premium 2%
The current rate of inflation is 4.75%, and that expected for the next 5
years is 4.0%, 4.2%, 4.6%, 5.0% and 5.75%.

i) Calculate the security’s inflation premium.

ii) Calculate the security’s interest rate level.

iii) What is the difference in interest rates between a

short-term and long-term government security.

iv) What is the real risk-free rate of return in this

economy
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 (4.0+4.2+4.6+5.0) 17.8
i. IP = =
4 4
= 4.45%
i. K = krf + DRP + LP + MRP
• = 7.5 + 1.75 + 2.25 + 2
• = 13.5%
iii. The main difference for given that the two sets of security would be given by the same
entity therefore accounting for the same financial strength and same market depth would be
Maturity risk which relates to difference in investment horizon or investment period.
• We know that: krf = k* + IP
• then
• k* = krf - IP
• = 7.5 - 4.45
• = 3.05%
 Time Value of Money

• Money has time value

• This means that the same amount at different time periods commands
different weights in value
• One Pula received today has more value than the same one Pula to be
received in future
• This can be considered from a number of perspectives:
1. First the same amount received today can purchase more goods
today than in future.
• This means that if you postpone consumption today you have to be
compensated by an extra amount to enable you to buy the same
amount or basket of goods tomorrow
2. On the other hand today’s value is certain whilst the amount
expected in future has some degree of uncertainty
• Thus the saying ‘ a bird in hand is worth more than two in the
bush’.
• This makes today’s same amount more valuable
• From yet another dimension if you get your one pula earlier you can
invest it and earn more money rather than be given the one Pula at
the end of the period.
• This makes one Pula earned today potentially worth more than one
Pula in future
• This concept of the time value of money is used to price payments
from different time periods in financial management
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 Price of Money

• Money like any commodity has a price and this price is called
interest.
• Interest is the compensation for loss of value or purchasing power of
the future amount
• This interest should atleast be just enough to compensate for loss in
purchasing power
• There is therefore a need to compare Today’s values with Future
values
• Amounts of Pulas occurring at different time periods have different
values
• These amounts have to be translated into the same time value in
order to be compared
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• One can translate these amounts into either FUTURE VALUE or PRESENT
VALUE
• Risk- The present value is certain and has no risk whilst the future value is
uncertain and therefore carries a certain amount of risk
• In order to compare these two you use either present value(PV) or Future
value(FV) computations

53
 Future & Present Values

• Future value (FV) is how much your money today (Present Value)
will be worth in the future after growing it by a certain interest rate.
• The process of going to future values from the present is called
compounding.
• Present value (PV) is how much your future amount (FV) is worth
in today’s terms i.e assuming you were to use it now.
• The process of moving from future values (FV) back to present
values(PV) is called discounting.

54
• Today’s values can be compounded (grown) to future values.
• On the other hand Future Values that can be discounted (reduced) to
today’s values:
• Example
• Suppose P40 can be able to buy a bag of oranges today but a
person would need P46 to buy a bag of orange in a year’s time.
• Observations:
• It means that P40 is the PV
• P46 is the FV
46
• Interest Factor(1+i) = = 1.15
40
𝐹𝑉
• Interest factor of a single amount(1+i) =
𝑃𝑉
55
 𝐹𝑉
• If (1+i) =
𝑃𝑉
• FV = PV x (1+i)
• FV = 40 x 1.15
• = P46.00
• In the above example the sum of P40 is regarded as a lumpsum amount in
this transaction as only a single amount is spared
• This lumpsum amount is then allowed to grow over time
• Assuming constant growth of 15% the sum will grow as follows:

56
• Year 0 40
• Year 1 40(1.15) = P46
• Year 2 46(1.15) = P52.90
• Year 3 52.90(1.15) = P60.84
• ________________________________________
• Also recognized as follows:
• Year 0 = 40
• Year 1 = 40(1.15) = P46
• Year 2 = 40(1.15)(1.15) = P52.90
• = 40(1.15)2 = P52.90
• Year 3 = 40(1.15)(1.15)(1.15) = P60.84
57
• = 40(1.15)3 = P60.84
• PV = P40
• FVs = P46, P52.90, P60.84 etc
• Interest Factor(1+i ) = 1.15 = FVIF
• Therefore FVn = PV(FVIF)n
• FVn = PV(1+i )n

58
 Determining FVs & PVs

• There are four procedures that can be used to solve time value
problems.

–Time lines (step-by-step approach)

–Formula approach
–Financial calculators &
–Spread sheets
–Financial tables
–Statistical softwares e.g STATA, EVIEWS, SPSS ETC

59
• The future value could be for a lumpsum over a specific time period
• E.g In the previous exercise a lumpsum of P40 was allowed to grow
over a period of time
• In certain instances it will be a series of amounts being deposited over
a certain period of time
• Example, one could put P500 every month in a bank savings account
• A series of payments or deposits is referred to as a cashflow or
cashflow stream
• In this case each deposit will be earning interest

60
 Using Time Line
to determine FVs

• Lumpsum
• A time line help you to visualise what is happening in a particular problem.
See an illustration below.
0 1 2 3
Periods 6%

Cash PV = P200 FV = ?

• Using a time line is a step-by-step approach in which FV & PV can be

obtained depending on what information you have been given.
• In the time line illustration above we are given time(3 years), interest rate
(6%), PV(200) and we are required to calculate FV in period 3.
• To get the FV for period three you have to get the FV for period 1 and 2 first.
• Basically you multiply the initial amount at each period with (1+ i) to get the
FV for the next period until you get to the last FV. See the61
figure below.
 Future Value interest factor (1 + 𝑖)𝑛 −Recap
• In the previous Example the interest factor (1 + 𝑖)𝑛 was:
• Year 1 = (1.15) = (1+i)1
• Year 2 = (1.15)(1.15) = (1.15)2 = (1+i)2
• Year 3 = (1.15)(1.15)(1.15) = (1.15)3 = (1+i)3
• ________________________________________________________
• Future Value Interest Factors (FVIF) each year
• Year 1 = (1.15)1 = 1.15
• Year 2 = (1.15)2 = 1.323
• Year 3 = (1.15)3 = 1.521
• _____________________________________________________________________________________
• Using the financial tables at 15% Column and Rows n = 1, 2 and 3 you get the same values
of 1.150, 1.323 and 1.521

• This implies that Financial tables are worked out from the basic compounding Process
 Time Line Approach

• Continuing with our P200 lumpsum investment:

0 1 2 3
Periods 6%

(1+i)
Cash P212.00 P224.72 P238.20
P200.00

• To get FV for Period 1-3 you compute:

FV1 = P200(1+0.06) = P212.00
FV2 = P212(1+0.06) = P224.72
FV3 = P224.72(1+0.06) = P238.20
• Therefore the required FV3 = P238.20
63
• Yearly interest earned is as follows:
Year FVt Interest(i)

1 212.00 12.00
2 224.72 12.72
3 238.20 13.48
Total Interest 38.20
• Interest earned each period increases because the
beginning balance is higher each successive year.
• Total interest earned (P38.20) is reflected in the final
balance (P238.20).
64
 Formula Approach

• The formula for calculating FV is given as follows:

FVn=PV(1+i)n
• Where:
– FV= Future value
– PV=Present value
– i= interest rate
– n= Number of periods

• Calculate FV from the earlier example using the above formula given PV=200,
i=6% and n=3
65
 Solution

FV3 = PV(1+i)n
FV3 = 200(1+0.06) 3

Therefore: FV3 = 200(1.06)3 = P238.20

Note: the formula can be used with any calculator that has an exponential
function to help find any FV given any number of years “n”.

66
 Understanding Interest tables

– In the last example where we used the Formula FVn=PV(1+i)n

– The (1+i)n is called the FV interest factor (FVIF). The factor that
multiplies the PVn to get the FVn.
• The FVIF can be obtained from interest tables and used directly to
calculate the FV given the PV, i and n.
• From the interest table the FVIF is represented as FVIFi,n and is a
rounded off figure.
• From our example we look for FVIF6%,3

67
• FVIF(6%,3) = 1.191
• To get our FV we use the formula
• FV3 = PV0 x FVIF(6%,3)
• FV3 = 200 x 1.191
• = P238.20

68
 Using Financial Calculators

• Financial calculators can easily help calculate FVs

• You need to be familiar with the keys to strike in your calculator:
• The most commonly used calculator is the BA II plus Texas Instruments
Calculator with the following keys:
– N : representing number of periods
– I/YR: Interest rate per period
– PV = present value
– FV: Future value
– PMT: Payments

69
 Spread Sheets
• Refer to class exercise that we will do together in class.
• Basically you have to be familiar with the following notation to be used
in the excel function.
– PV = use this function for calculating Present Value
– FV = used for calculating Future Value
– RATE = used when determining the interest rate
– NPER = used when determining the number of periods
– PMT =used when determining constant periodic payments
• Example: to find FV used the function below in excel
• =FV(rate,nper,pmt,[pv])

70
• We now know that FVn = PV(1+i)n = Compounding
• From the Previous example the terms of the equation are:
• Present value; PVt=0 = 200
• Future value Interest Factor(FVIF6%,3)Use tables= ?
• (1+i)n = (1.06)3 = 1.191
• FVn = PV(1+i)n = 200 x (1.191)
• = P238.20

71
 Present Values

• To calculate PV you simply do the reverse of finding FV.

• Solve for PV from the previous equation: FVn=PV(1+i)n
• FV = PV(1+i)n
𝐹𝑉 𝑃𝑉(1+1)𝑛
• =
(1+1)𝑛 (1+1)𝑛
𝐹𝑉 𝑃𝑉(1+1)𝑛
• =
(1+1)𝑛 (1+1)𝑛
𝐹𝑉
Therefore = PV
(1+1)𝑛
𝐹𝑉
• Rewritten; PV =
(1+1)𝑛

72
 𝐹𝑉
• This is the PV formula: PV =
(1+1)𝑛
• Finding PV is called discounting
• All the four methods discussed earlier (step-by-step approach, formula,
Financial calculator and spread sheets can be used to solve PV problems.
• Example
• A security promises to pay P238.20 at the end of 3 years. How much is it
worth today . Use the formula approach to solve for the PV or fair price of this
security using a discount rate of 6%.

73
 Formula Approach

𝐹𝑉
• PV =
(1+1)𝑛
• Pv = ?
• FV =
• 238.20
• n =
• 3
• i =
• 6% or 0.06
𝐹𝑉
• ThereforePV =
(1+𝑖)𝑛
238.20
• =
(1.06)3 74
• = 199.997
• = P200

75
1. Step-by-step approach
• To get the PV for period zero(now) you have to get the PV
for period 2 and 1 first.
• Basically you divide the amount at the end of each period by
(1+ i) to get the PV for the previous period. See the figure
below.

(1+i)

76
 0 1 2 3
Periods 6%

(1+i)
Cash P200.00 P212.00 P224.72 P238.20

• For example to get PV for Period 2-0 you compute:

PV2= P238.20/(1+0.06) = P224.72
PV1= P1224.72/(1+0.06) = P212.00
PV0 = P212.00/(1+0.06) = P200.00
• Therefore the required PV0 = P200 and we have successfully
discounted FV3 to the present (PV0).

77
 Using Interest Table

• PVIF(6%,3) = ?
• 0.840

PV = FVxPVIF
PV = FV(1+i)-n
PV = 238.20 x 0.840
PV= P200

• Note that you don’t divide by the PVIF but rather you multiply by the factor.
Whenever you use the interest table you will always multiply by the interest
factor whether it’s a FV or PV interest factor.

78
 PVIF explained

𝐹𝑉
• PV =
(1+1)𝑛
1
• = FV x
(1+𝑖)𝑛
1
• = FV x
𝐹𝑉𝐼𝐹
1
• PVIF =
𝐹𝑉𝐼𝐹
• = FV x PVIF

79
 Finding the interest rate(i) and
and the period of investment (n)

• Once you know the formula for PV and Future value you can
always find missing items from the formula.
• E.g from our previous example assume in a FV calculation you
know both your FV, PV and (n) to be P238.20, P200 and 3 years
respectively, thus
FV3 = PV(1+i)3
238.20 = 200(1+i)3
• Calculate (i)

80
 Calculating “i” – the Interest rate

• FV3 = PV(1+i)3
• 238.20 = 200(1+i)3
• 238.20/200 = (1+i)3
• 1.191 = (1+i)3
• 3√(1.191) = 3√(1+i)3

• 1.06 = 1+i
• 1+i = 1.06
• 1+i - 1 = 1.06 -1
• i = 0.06
• Therefore i = 0.06 = 6%

81
 Calculating “n” – the period of investment

• Assume now that you are given everything but (n) in our previous example,
thus
• FV3 = PV(1+i)3
• 238.20 = 200(1+0.06)n
• Calculate (n), the number of years or Maturity of the Investment.

82
 Solution

• 238.20 = 200(1+0.06)n
• 238.20/200 = (1+0.06)n
• 1.191 = 1.06n
• Ln1.191 = (n)Ln1.06
• 0.1748 = (n)0.0583
0.1748
• = n
0.0583
• Therefore: n= 2.998 = 3 years

83
Annuities

84
 Introduction

• An Annuity is a series of equal instalments or payment amounts

made at agreed time intervals for a specified time period.
• Ordinary (deferred) annuity – whereby payments are made at the
end of each period, e.g. loans, mortgages, Salaries, Dividends,
Interest on debt etc
• Annuity due – where payments are made at the beginning of each
period, e.g. rentals, medical aid, Insurance etc.

85
 FV of an Ordinary Annuity

• Example 1
• Assume that instead of 1 lump sum payment of P200, you actually deposit
P200 at the end of each year for 3 years in your savings account. How much
money will you have in you account at the end of 3 years, if you earn 6%
interest per year.

86
 Solution

1. Formula approach
{(1+i)n −1}
• FVA n = PMT[ ]
i
{FVIFn −1}
• FVA n = PMT[ ]
i
{(1+0.06)3−1}
• FVOA 3 = 200x [ ]
0.06
{(1.191016)−1}
• FVOA 3 = 200x [ ]
0.06
{(1.191016)−1}
• FVOA 3 = 200x [ ]
0.06
(0.191016)
• FVOA 3 = 200x [ ]
0.06
• FVOA 3 = 200x 3.1836 = P636.72
87
 2. Using Financial tables
• FVOA = PMTxFVIFOA(6%,3)
• FVOA = PMT*FVIFOA(6%,3) Note sometimes we use * as the multiplication sign
• Find ** FVIFOA(6%,3) from the table
• FVIFOA(6%,3) = 3.1834
• Apply to FVOA = 200(3.1834)
• = P 636.68
• Note that we are able to directly get the FVIFA(6%,3) of 3.1834 from
the table which is a bit quicker.
 FV of an Annuity Due
• Example 2
• Assume the P200 in the previous example is deposited at the at the
beginning of each period(annuity due) for three years.

1. Formula Approach
• FVAdue = FVA(1+i)

• FVAD = FVOA x(1+i)

• FVAD = 636.68*(1.06) = P674.88

89
 2. Using Interest tables

• FVAdue = PMTxFVIFAdue(6%,3)

• FVAD = PMT*FVIFAD(6%,3)
• Find FVIFAdue(6%,3) = ?
• = 3.37462
• FVAD = 200(3.37462)
• = P674.92

• Note that FVAD > FVOA, thus 674.92 > 636.68.

• This is because each payment occur one period earlier in the case of an
annuity due, hence all of the payments earn interest for one additional period.

90
 PV of an Ordinary Annuity

• Example 1
• Assume that the series of P200 is actually deposit at the end of each
year for 3 years in your savings account. How much is your account
worth in today’s terms if it earns 6% interest per year.
1. Formula Approach
1

[ (1+i)n }
]
1−{
• PVA n = PMT
𝑖
1

[ (1+i)n }
]
1−{
• PVOA n = PMT
𝑖
1−(1+𝑖)−𝑛 }
• PVOA n = PMT[ ]
𝑖 91
 1−𝑃𝑉𝐼𝐹𝑖,𝑛 }
• PVOA n = PMT[ ]
𝑖
• Solution
1

[ (1+i)n }
]
1−{
• PVOA n = PMT
𝑖
1

200[ ]
(1+0.06)3 }
1−{
• PVA n =
0.06
• BODMAS – BRACKETS, ORDERS, DIVISION, MULIPLICATION,ADDITION AND SUBSTRACTION
1

[ (1.06)3 }
]
1−{
• PVA n = 200
0.06

[ 1.191016} ]
1
1−{
• PVA n = 200 92
0.06
• PVA n = [
200
1−0.8396
0.06
]
• PVOA n = 200[ ]0.1604
0.06

• PVOA n = 200[2.673]

• PVOA = P534.60

93
 2. Using Financial tables

• PVOA = PMT*PVIFOA(6%,3)
• Find the PVIFOA(6%,3 from the table = ??
• = 2.673
• PVOA = 200(2.673) = ?
• = P534.60

• PV of an Annuity Due(PVAD)
• PVAD = PVOA*(1+i)
• PVAD = 534.60* 1.06 = ?
• = P566.68
• Using Financial table: PVAD = PMT*PVIFAD(6%,3)
• Find PVIFAD(6%,3) = ?
• = 2.83339
• PVAD = 200*2.83339
94
• = P566.68
• Note that the PV of Annuity due > PV of Ordinary annuity. This is because
with Annuity due, each PMT is discounted back one less year.
 PERPETUITIES

• A perpetuity is actually an annuity but with an extended life into the

future
• They pay equal instalments forever, for eternity
• Preferred stock dividend is an example of a perpetuity.
• Other examples were the UK and US Govt Bond called Consols issued
in 1751 and 1877 Respectively
• Perpetuities can be valued using the following formula:
𝑃𝑀𝑇
• PV of a perpetuity =
𝑖

96
 Example

• Example: Assume a preference stock dividend of P2.50 per annum

indefinitely. What is the PV of the perpetual dividends assuming discount rate
of 10%?

• Solution
𝑃𝑀𝑇
• PV of a perpetuity =
𝑖
2.50
• PV = 0.10
• PV = P25

97
 Uneven Cash Flows

• So far our discussion has been based on constant (even) cash flows
(CF) in the form of annuity payments.
• However some situations may by nature require the use of non-
constant (uneven) cash flows.
• For e.g common stock dividend & CFs from capital projects are
usually uneven and increase over time.
• Uneven cash flows have two classes:

98
 1. Constant plus a lumpsum

• In stream 1 the Cashflow(CFs) stream consists of annuity PMT + Additional

final lump sum PMT ( e.g Bonds)

Periods 0 1 2 3
i=6%

Cash Flows P0.00 P200.00 P200.00 P200.00

P1000.00
P1200.00

• 2. Irregular Stream
• In this instance the payouts are uneven or irregular streams (e.g Stocks &
Capital Investments)
0 1 2 3
Periods i=6%

Cash Flows P0.00 P100.00 P300.00 P250.00

99
 Finding PV of Uneven Cash Flows
• Solutions
• Calculate the PV for Stream 1 above.
• PV = PMT(PVIFOA6%,3) + Principal(PVIF6%,3)
• PV = 200(2.673) + 1000(0.840)
• PV = 534.60 + 840 = P1,374.60
• You can also the USE FORMULA for (PVOA + PV)

• Calculate the PV for Stream 2 in the previous illustrations

𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇
• PVn = + +
(1+𝑖)𝑛−2 (1+𝑖)𝑛−1 (1+𝑖)𝑛−0

• PV0 = 100/(1+0.06)1 + 300/(1+0.06)2 + 250/(1+0.06)3

• PV0 = 94.34 + 267.00 + 209.90

• = P571.54 100
 FV of Uneven Cash Flows

• Calculate the FV for Stream 1 above.

• FV = PMT(FVIFOA(6%,3) ) + Principal
• FV = 200(3.1836) + 1000
• FV = 636.72 + 1000
• = P1,636.72
• You can also use a use formula to find (FVOA + Principal)

• Calculate the FV for Stream 2

• FVn= PMT(1+i)n-1 + PMT(1+i) n-2 +….PMT(1+i) n-n

• FV3 = 100(1+0.06)2 + 300(1+0.06)1 + 250(1+0.06)0

• FV3 = 112.36 +318.00 + 250

• = P680.36 101
 SEMI-ANNUAL AND OTHER COMPOUNDING PERIODS

• Different securities yield returns at different intervals in a year

• Bonds may compound semi-annually.
• Bank loans may be monthly compounded.
• Whilst dividends usually compound quarterly.
• In the event of multiple periodic payments/compounding in a year
the following two adjustments applies for any security or loan

102
 1. Annual interest rate(i)

• Annual interest must be converted to a periodic rate.

Stated annual rate
• Periodic rate(r) =
number of payments per year

• E.g 6% annual rate becomes:

6%
• = 3% semi-annual
2
6%
• = 1.5% Quarterly
4
6%
• = 0.5% Monthly
12

103
 Investment Period/
Maturity of the investment(n)
• The annual or number of years must be converted to the correct number of
periods.
• No. periods(n) = No. years X compounding periods per year
• Example: 3 years becomes :
• 3 x 2 = 6 periods; Semi-annually
• 3 x 4 = 12 periods; Quarterly
• 3 x 12 = 36 periods; Monthly

104
 Example
• P20 000 is deposited into a savings account paying 16% interest
for 5 years. Compute the FV of the investment assuming the
interest is compounded:
i. Annually
ii. Semi-annually
iii. Quarterly
iv. Daily (365 days in a year)

105
 Solution

i) Annually:
• FVn = PV(1 + i)n
= 20 000(1.16)5
= P 42,006.83
ii) Semi - Annually
• FVn = PV(1 + i)n
0.16
• Periodic Rate(i) = = 0.08
2
• No. Periods(n) = 5x2 = 10
• FVn = PV(1 + i)n
• FV = 20 000(1.08)10
= P43,178.50 106
3) Quarterly
• FVn = PV(1 + i)n
0.16
• Periodic Rate = = 0.04
4
• No. Periods (n) = 5 x 4 = 20
• FV = 20 000 (1.04)20
= P43,822.46

107
iv) Daily
• FVn = PV(1 + i)n
0.16
• Periodic Rate = = 0.0004
365
• No. Periods (n) = 5 x 365 = 1,825
• FV = 20 000(1.0004)1825
= 20 000 (2.2251)
= P44,503.02

108
• We conclude that
A. The more the compounding periods a year the greater the FV of
the investment at the end of the period, and
B. By extension, the higher the actual interest or return rate paid by
the investment
• This is basically a measure of effective annual rate

109
 Effective annual rate (EFF%)

• Different types of investments and loans use different compounding periods

(eg loans compound monthly; bonds compound semi-annually (pay Coupons
twice a year); while company shares usually pay dividends quarterly).

• Different compounding periods will yield different FVs & PVs for the same
loan or investment even though the annual percentage rate ( APR) also called
Nominal Interest rate (INOM) is the same

• Therefore to compare the effect of different compounding periods each year, a

common base called Effective Annual rate (EAR) or Equivalent Annual Rate
(EAR) has to be determined.

110
 EAR

• Given the Nominal Rate (iNOM) and the number of

compounding periods per year, we can find the effective
annual rate (EFF/EAR%).

Where:
• iNOM = nominal rate expressed as a decimal
•M = number of compounding periods per year
111
 Effective or Equivalent rate

• Periodic compounding or compounding more than once in a year has been

proven to provide a progressively higher return than annual compounding
Compounding Periodic Rate(r) FVn
Annually 0.16 P 42,006.83
Semi-Annually 0.08 P43,178.50
Quarterly 0.04 P43,822.46
Daily 0.0004 P44,503.02

• This means that the actual return in each instance is higher. This is referred to
as the Effective Annual Rate(EAR) or Equivalent Annual Rate(EAR)

112
 Example
• Assume you have two equally risky investment options,
Investment A pays 20% compounded semi-annually and
Investment B pays 20.6% compounded annually. Which
investment will you choose?

Solution
• First convert 20% semi-annual to an effective annual rate
(EFF%)

113
• Therefore we choose investment A since the 21% expected
interest in annual terms for Investment A is greater than 20.6%
expected for investment B.
Application of Time Value of Money
Concepts

Amortisation

115
 Amortised Loans

• Some loans are paid off in equal instalments over time

• Examples include Mortgages and automobile loans
• These kind of loans are called amortised loans
• The borrower often want to know the amount they will have to pay
for each loan and the interest they owe at any point in time.
• To determine these details you have to create what is called a
loan amortisation schedule.
• Lets take an example:

116
 Example
• Assume a homeowner borrows P100,000 as a mortgage
loan and the loan is to be repaid in five equal
instalments at the end of each of the next 5 years. The
loan has an annual interest rate of 6%.
• Required:
(a)Construct the loan amortisation schedule.
(b)What is the Total interest Paid on the loan?
(c)How much will be owed on the loan at the beginning
and end of 5th year?

117
 Solution

1. First, we need to calculate the PMT to be paid by the borrower each year.
PMTs should be such that the sum of their PVs is equals the original loan
amount.
i. To determine PMT:
• PVOA = PMTxPVIFOA(6%,5)
• PVIFOA(6%,5) = ???
• = 4.2124
• PVOA = PMTxPVIFOA(6%,5)
• 100 000 = PMT(4.2124)
100 000
• Solve for PMT: PMT = = ???
4.2124
• = P23,739.44
118
• Notice that this PMTs are equal and constant over time for 5 years.
• This represents an annuity; it is an ordinary annuity since PMTs are made at
end of each year.
• Remember when using interest tables:
• PVOA = PMT*PVIFOA(i,n)

2. Next construct the payment table as shown below:

 Loan Amortisation Schedule

Amount Borrowed BWP 100 000.00

Maturity 5 years
Rate 6%
PMT BWP -23 739.44
BEGINNIN PRINCIPAL ENDING
YEAR AMOUNT PAYMENT INTEREST REPAYMENT BALANCE

1 100 000.00 23 739.44 6 000.00 17 739.44 82 260.56

2 82 260.56 23 739.44 4 935.63 18 803.81 63 456.75
3 63 456.75 23 739.44 3 807.41 19 932.03 43 524.72
4 43 524.72 23 739.44 2 611.48 21 127.96 22 396.76
5 22 396.76 23 739.44 1 343.81 22 395.63 1.13

120
 The Amortisation Schedule

Amount Borrowed BWP 100 000.00

Maturity 5 years
Rate(i) 6%
PMT BWP -23 739.44

PRINCIPAL ENDING
YEAR BEGINNIN AMOUNT PAYMENT INTEREST REPAYMENT BALANCE
(1) (2) (3) (2) X (i) = (4) (3)-(4) = (5) (2)-(5) = 6

1 100 000.00 23 739.44 6 000.00 17 739.44 82 260.56

2 82 260.56 23 739.44 4 935.63 18 803.81 63 456.75

3 63 456.75 23 739.44 3 807.41 19 932.03 43 524.72

4 43 524.72 23 739.44 2 611.48 21 127.96 22 396.76

5 22 396.76 23 740.57 1 343.81 22 396.76 0.00

Total ----- 118 698.33 18,698.33 121 100 000 -----

 Solution Conti

(a) Payment Schedule is given above

(b) Total interest paid = P18,698.33
(c) Beginning of year 5, P22396.76 will be owed
• End of year 5, nothing (P0.00) owed, as the loan is fully amortised.

122
 TVM CONCLUSION
• WHAT IS FINANCE
• Finance involves making decisions about the best alternative option that will
either:
• Maximise the return/profitability of an organisation or
• Minimise it’s costs
• It is a study of decision making processes about money
• Such decisions are premised/based upon three basic principles, viz;

123
 Fundamental Principles of TVM
• 1. MORE VALUE IS PREFERABLE OVER LESS
• P100 now vs P70 now
• 2. THE SOONER CASH IS RECEIVED THE MORE VALUABLE IT IS
♦ Prefer to receive cash now than at end of year, because;
♦ You can buy more with it before prices of goods increase
♦ You can reinvest it and, earn interest for the rest of the year.
♦ Or the person/(organisation) that had promised you the money
may become bankrupt or cease to exist
• 3. LESS RISKY ASSETS ARE MORE VALUABLE THERE ARE
• Shares vs Bonds vs Money Market vs Cash (vs Loan to Risky
Colleague)
124
 Additional Principles of Finance

4. Higher returns are expected for taking on more risk

5. Financial Markets are fairly efficient in pricing Securities – EMH:
Weak, Semi-strong and strong form
6. Investing in different kinds of securities spread the risk through a
process known as diversification
• This simply means avoid putting your eggs in one basket
7. The primary objective in finance is always to maximise
shareholders wealth by maximising profit
• But Managers and Shareholders objectives may differ creating
an agency problem

125
 TVM CONCLUSION (CONT)

• TVM CONCEPT
• - when making decisions you have got to compare “like with like”
• - thus you must restate/translate all the cashflows that you are comparing to a
single reference point in time; either “t=0” (present value) or “t=n” (future
value)
• - to achieve this, we use the time value of money concepts

126
 TVM CONCLUSION (CONT)

• -this TVM Concept is used to move the value of money across time to
bring it to the comparator reference date, viz;
• 1. MOVING A LUMPSUM PAYMENT BACK (PV via discounting) OR
FORWARD (FV via compounding)
• 2.MOVING THE VALUE OF A SERIES OF EQUAL CASHFLOWS
RECEIVED OVER A SPECIFIED PERIOD, TO A REFERENCE DATE
• -DISCOUNTING (PV); COMPOUNDING (FV)
• - FOR ORDINARY ANNUITY VS ANNUITY DUE

• 3. FINDING THE VALUE OF AN UNENDING/PERPERTUAL,

CONSTANT-VALUE, SERIES OF PAYMENTS
• -PV of a PERPETUITY
• -WHERE “n=infinity”

127
 TVM CONCLUSION (CONT)

• 4. FINDING THE FUTURE/PRESENT VALUES OF AN UNEVEN STREAM

OF CASHFLOWS/PAYMENTS
• -Getting the Summation of the Present Values of Each one of the
Cashflows
• -(you might sometimes identify annuities within the series; which can
make your calculations/work a lot more easier)

128
 TVM CONCLUSION (CONT)

• 4 METHODS OF SOLVING TVM PROBLEMS

– 1. CASHFLOW TIMELINE METHOD
– 2. EQUATION (FORMULA) METHOD
– 3. INTEREST FACTOR TABLES
– 4. USING TECHNONOLGY – financial calculator and spreadsheet

129
 TVM CONCLUSION (CONT)

• -TVM is also used to quantify the true expected cost/return of a

loan/investment, at t=0, regardless of how many times interest is
compounded per year.
• - APR (simple/nominal rate) vs Effective Annual Rate
• - APR vs EAR
• -LOAN ARMORTISATION SCHEDULE
-a schedule of a series of equal loan repayments, broken down into the principal and
interest repayment components
-
(the longer the repayment period the more interest the borrower pays to the bank in
money terms)

130
The Basics of Capital Budgeting
• Capital budgeting refers to the process of evaluating major projects
and new investments aimed at the expansion and/or sustenance of
a business
• It basically refers to all expenditures on capital resources or
economic assets meant to produce other assets/profit or more
resources
• Examples
• A new plant/factory
• A new line of products such as an adult food line to a baby foodline;
TsaBana vs TsaBotlhe
• Men’s attire to Lady’s wear
• New investments such as a new subsidiary or division to a company
• Moving into a new sector or Industry such as an Aviation Company
adding the hospitality or Hotels Industry
• Even buying or hiring or maintain (old) machinery and equipment or
upgrading an entire software program
• A firm’s growth and its ability to remain competitive depend on a
constant flow of ideas for new products, new ways to make existing
products better, ways to produce output at a lower cost and even
venturing out into other sectors.
• Procedures must be established for evaluating the worth of such
projects.
 What is Capital Budgeting?
• The process of planning and evaluating expenditures on
assets whose cash flows are expected to extend beyond
one year
–Analysis of potential additions to fixed assets
–Long-term decisions which involve large expenditures
–Analysis of replacement of existing equipment or
processes
–Very important to the firm’s future
 Project Classifications
1. Replacement Decisions: whether to purchase capital assets to take
the place of existing assets to maintain or improve/upgrade existing
operations
2. Expansion Decisions: whether to purchase capital assets and add
them to existing assets to increase existing operations (grow the firm)
3. Independent Projects: Projects whose cash flows are not affected by
decisions made about other projects
• There is no competition between these projects
4. Mutually Exclusive Projects: A set of projects where the acceptance of
one project means the others cannot be accepted
• Here there is competition for only one place
 Normal and non-normal cash flow
streams
• The cash flow of projects under the capital budgeting process falls under two
categories:
• Conventional cash flow stream – Cost (negative CF) followed by a series of
positive cash inflows. One change of signs.

0 1 2 3
Project x
CFt -100 10 60 80
• Unconventional cash flow stream – Two or more changes of signs. Most
common: Cost (negative CF), then string of positive CFs, then cost to close
project. Nuclear power plant, strip mine, etc.

0 1 2 3
Project x
CFt -100 30 80 -10
 Steps in capital budgeting

1. Estimate the cash flows expected from the project.

2. Evaluate the riskiness of cash flows.
3. Determine the appropriate cost of capital
4. Compute the present value of the expected cash flows to
obtain an estimate of the asset’s value to the firm.
5. Compare the present value of the future expected cash
flows with the initial investment.
 Capital Budgeting Criteria

• We are going to consider 5 different methods of Capital Budgeting:

1. Regular Payback Period
2. Discounted Payback Period
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
5. Modified Internal Rate of Return (MIRR)
 Regular Payback Period

• The length of time it takes to recover the original cost of

an investment from its expected cash flows
• Payback period =
 Payback-Decision Rule
• The firm sets a maximum acceptable payback period (the
choice is purely arbitrary, e.g. 2 or 3 years etc.)
• Decision rule: Will Accept a project if its payback period
is within the maximum acceptable payback, and reject if
otherwise
 Calculating Regular payback
Example

0 1 2 3
Project L
CFt -100 10 60 80

0 1 2 3
Project S
CFt -100 70 50 20
 Project L
Cumulative
Year CFt CFt PaybackL
0 -100 -100
1 10 -90 2
2 60 -30 + 2.375 years
3 80 30 0.375
=
80
 Project S
Cumulative Payback
Year CFt CFt Paybacks PeriodS
0 -100 -100 1
1 70 -30 + 1.6 years
30
2 50 = 0.6
50
3 20
 Calculating Regular payback

0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

 Payback-Decision

• If the firm chooses 2 years as a maximum acceptable payback for

project L and S, then;
• Project S will be accepted because its payback(1.6 years) is less
than 2 years maximum acceptable payback ,and L rejected.
• If the company chooses 2.5 years:
• Both Projects will be accepted if they are independent projects
• Project S will be accepted if mutual exclusive
 Strengths and weaknesses of
payback
• Strengths
– Provides an indication of a project’s risk and liquidity.
• Weaknesses
– Ignores the time value of money.
– Ignores CFs occurring after the payback period.
– Requires an arbitrary cutoff point
– Biased against long-term projects, such as research and
development, and new projects
 Discounted payback period

• The length of time it takes for a project’s discounted (PV of)

cash flows to repay the cost of the investment
• Compute the present value of each cash flow and then
determine how long it takes to payback on a discounted basis
• Decision Rule – A project is acceptable if Discounted payback
period < Project’s useful life.
• This is when the present value of future cash flows of the
project exceed initial cost of project.
• Discount payback period calculation uses discounted cash flows
rather than raw or absolute values of CFs
 Calculating discounted payback

• Example
• Calculate the discounted Payback period for Project L and S assuming the
prevailing market rate for such projects is 10%.

0 1 2 3
Project L 10%

CFt -100 10 60 80

0 10% 1 2 3
Project S
CFt -100 70 50 20
 Project L
Cum
Year CFt PVIF10%,t PVt PVt PaybackL
0 -100 1.00 -100 -100
1 10 0.909 9.09 -90.91 2
2 60 0.826 49.56 -41.35 + 2.7years
41 .35
3 80 0.751 60.08 60 .08
= 0.68
 Example
.

0 10% 1 2 2.7 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL == 2 + 41.32 / 60.11 = 2.7 years

 Project S
Cum Payback
Year CFt PVIF10%,t PVt PVt Payback S PeriodS
0 -100 1.00 -100 -100 1
1 70 0.909 63.63 -36.37 + 1.9 years
2 50 0.826 41.30 36.37 0.88
41.30
3 20 0.751 15.02
 Discounted payback period

0 10% 1 1.88 2 3

CFt -100 70 50 20
PV of CFt -100 63.64 41.32 15.03
Cumulative -100 -36.36 4.96 19.09

Disc PaybackS == 1 + 36.36 / 41.32 = 1.88 years

 Advantages and Disadvantages of
Discounted Payback period
• Advantages
–Includes time value of money
–Biased towards liquidity
• Disadvantages
–Biased against long-term projects, such as R&D
and new products
 Net Present Value(NPV)

• The difference between the market value of a project and its

cost
• How much value is created from undertaking an investment?
– The first step is to estimate the expected future cash flows.
– The second step is to estimate the required return for projects of this
risk level.
– The third step is to find the present value of the Net cash flows and
subtract the initial investment.
• Best decision criteria-tells how much value each project
contribute to shareholders wealth
 NPV – Decision Rule

• If the NPV is positive, accept the project

• A positive NPV means that the project is expected to
add value to the firm and will therefore increase the
wealth of the owners.
• Since our goal is to increase owner’s wealth, NPV is a
direct measure of how well this project will meet our
goal
 NPV – Decision Rule

• If the NPV is positive, accept the project

• A positive NPV means that the project is expected to
add value to the firm and will therefore increase the
wealth of the owners.
• Since our goal is to increase owner’s wealth, NPV is a
direct measure of how well this project will meet our
goal
 Calculating Net Present Value
(NPV)
• Sum of the PVs of all cash inflows and outflows of a project:

NPV = CF0 + CF1 + CF2 +….+ CFN

1 2 n
(1 + k) (1 + k) (1 + k)
n
CFt
NPV =  t
t =0 ( 1 + k )
 Example

• What is NPV for project L?

0 1 2 3
Project L 10%

CFt -100 10 60 80
• Using the formula:
• NPV = PV of Net Cash inflows - Cost
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3
• NPVL= + + - CF0
(1+𝑖)1 (1+𝑖)2 (1+𝑖)3
10 60 80
• NPVL= + + - 100
(1.10)1 (1.10)2 (1.10)3
• NPVL= 9.09 + 49.59 + 60.11 - 100
• = P18.79
• Project L has a positive NPV of 18.79, therefore it is accepted if it is
independent of other projects.
• Using financial tables
• What is Project L’s NPV? i=10%
Year CFt PVIF10%,t PVt
0 -100 1.000 -100
1 10 0.909 9.09
2 60 0.826 49.56
3 80 0.751 60.08
NPVL 18.73
 Calculating Net Present Value
(NPV) for Project S

0 10% 1 2 3
Project S
CFt -100 70 50 20
• Using the formula:
• NPV = PV of Net Cash inflows - Cost
70 50 20
• NPVL= + + - 100
(1.10)1 (1.10)2 (1.10)3
• = P19.99
• Project S has a positive NPV of P19.99, therefore it is accepted if it is
independent of other projects.
 Using financial tables

Year CFt PVIF10%,t PVt

0 -100 1.000 -100

1 70 0.909 63.63
2 50 0.826 41.30
3 20 0.751 15.02
NPVs = 19.95
 NPV – Decision Rule

NPV= PV of inflows – Cost = Net gain/loss in wealth

• If projects are independent, accept all projects whose NPV >
0.
• If the projects are mutually exclusive, accept projects with the
highest positive NPV. The one that adds the most value.
• In this example, we would accept S if mutually exclusive
(NPVs > NPVL),
• And would accept both if independent as both have positive
NPV.
 4. Internal Rate of Return (IRR)

• This is the most important alternative to NPV

• It is often used in practice as is intuitively appealing
• This is because they provide percentage info that investors
easily relate to.
• Definition: IRR is the return or rate that makes the
project’s NPV = 0
• Decision Rule: Accept the project if the IRR is greater
than the required return i.e the cost of capital
 Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:
n
CFt
0= t
t =0 ( 1 + IRR )

Solving for IRR

•Trial and Error Method
•Linear interpolation method
• Use of financial calculator
 Trial and Error Method: IRR
• It is easy to calculate the IRR for a single investment period.
• Example 1
• What is the IRR for a project that costs P50 and is expected to produce P55 at
the end of the first assuming 12% market rate on such Projects
• Solution
𝐶𝐹1
• NPV = -CF0 + =0
(1+𝐼𝑅𝑅)1
𝐶𝐹1
• -CF0 + = 0
(1+𝐼𝑅𝑅)1
𝐶𝐹1
• = CF0
(1+𝐼𝑅𝑅)1
𝐶𝐹1
• CF0 =
(1+𝐼𝑅𝑅)1
55
• 50 =
(1+𝐼𝑅𝑅)1
• 50(1 + 𝐼𝑅𝑅)1 = 55
55
• (1 + 𝐼𝑅𝑅)1 =
50
• 1 + 𝐼𝑅𝑅 = 1.1
• IRR = 1.1 – 1
• IRR = 0.1
• IRR = 10%
• The cost of capital is 12% therefore reject the project as it produces an
internal return that is less than the cost of capital
 Example 2

• However if its more than one period it requires a different

approach.
• Suppose there is an investment opportunity with the following cash
flows;
–Project cost P100 and net cash flows of P10 year 1, P60 year 2
and P80 year 3 .
–What is the IRR of this investment opportunity?

– This is where all the funny begins. Please ensure you attend the next lesson!
 Trial and Error Method: IRR
NPV = 0
100 = 10 /(1 + IRR) + 60 /(1 + IRR) 2 + 80 /(1 + IRR) 3
10 60 80
• 100 = + +
(1+𝑖𝑟𝑟)1 (1+𝑖𝑟𝑟)2 (1+𝑖𝑟𝑟)3
• The only way to find the IRR is through trial and error.
• If we try a rate of 0 our NPV is P50
10 60 80
• NPV ? = + + - 100
(1+𝑖𝑟𝑟)1 (1+𝑖𝑟𝑟)2 (1+𝑖𝑟𝑟)3
10 60 80
• = + + - 100
(1+0)1 (1+0)2 (1+0)3
10 60 80
• = + + - 100
1 1 1
• = 50 169
 Trial and Error Method: IRR
• If we try a rate of 10% our NPV is P18.78
10 60 80
• NPV ? = + + - 100
(1+𝑖𝑟𝑟)1 (1+𝑖𝑟𝑟)2 (1+𝑖𝑟𝑟)3
10 60 80
• NPV = + + - 100 = ??
(1.10)1 (1.10)2 (1.10)3
• NPV = 9.09 + 49.59 + 60.10 - 100 = ??
• NPV = 18.78
• We can try a number of rates and then have a table as shown below:

NPVL
50.00 33.05 18.78 6.67 0.26 (1.75) (12.64)
Disc Rate 0% 5% 10% 15% 18% 19% 25%
170
 Trial and Error Method: IRR

• From the calculations the discount rate is between 18%

and 19%.
• The IRR could be found by plotting the curve of the NPV
and discount rate on a graph using the points on the
table.
• The y-axis will be the NPV and x-axis discount rate.
• The IRR will be at the point where curve crosses the x-
axis where the NPV is equal to zero.
• In this case the IRR is 18.13%
171
 Trial and Error Method: IRR

NPV Profile
60.00

50.00

40.00

30.00
NPV

20.00

10.00

-
0% 5% 10% 15% 18% 19% 25%
(10.00)

(20.00) Discount Rate

 Linear Interpolation Method: IRR
• The steps in linear interpolation are:
• Calculate two NPVs for the project at two different
discount rates resulting in positive and negative NPVs.
• NPVs should be closer to zero.

• Formula
NL
IRR = L + x ( H − L)
NL − NH

173
 Linear Interpolation Method: IRR

Where:
L = Lower discount rate
H = Higher discount rate
NL = NPV at lower discount rate
NH= NPV at higher discount rate

174
 Linear Interpolation Method: IRR

Answer for the previous example using linear interpolation formula

0.26
• 𝐼𝑅𝑅 = 18 + 𝑥 19 − 18
0.26− −1.75
0.26
• 𝐼𝑅𝑅 = 18 + 𝑥 19 − 18
0.26+1.75
0.26
• 𝐼𝑅𝑅 = 18 + 𝑥 19 − 18
2.01
• 𝐼𝑅𝑅 = 18 + 0.129𝑥 19 − 18
• 𝐼𝑅𝑅 = 18 + 0.129𝑥 1
• 𝐼𝑅𝑅 = 18 + 0.129𝑥
• 𝐼𝑅𝑅 = 18.129
• 𝑰𝑹𝑹 = 𝟏𝟖. 𝟏𝟑%
175
 Linear Interpolation Method: IRR

• Calculate the IRR for project S using the

linear interpolation method.

0 1 2 3
Project S
CFt -100 70 50 20
• If we try a rate of Zero% the NPV = 40
• If we try a rate of 10% our NPV:
NPV = 70 /(1.1) + 50 /(1.1) + 20 /(1.1) − 100 = P19.99
2 3

• We can try a number of rates and then have a table as shown

below.

NPV 40.00 19.99 11.83 4.63 0.71 (0.54) (1.76)

Disc Rate 0% 10% 15% 20% 23% 24% 25%

177
 Linear Interpolation Method: IRR

• Project S: IRR

0.71
• 𝐼𝑅𝑅 = 23 + 𝑥 24 − 23
0.71− −0.54

•
𝐼𝑅𝑅 = 23.56

178
 IRR Acceptance Criteria

• If IRR > Weighted Average Cost of Capital (WACC), the

project’s rate of return is greater than its costs.
• This means that there is some return left over to boost
stockholders’ return.
• If IRR > k, accept project & If IRR < k, reject project.
• IRRL = 18.13% and IRRS=23.56%
• If projects are independent, accept both projects, as both
IRR > k = 10%.
• If projects are mutually exclusive, accept S, because IRRs
> IRRL.
179
 NPV Profiles

• Project NPVs at various different costs of capital.

k NPVL NPVS
0% $50 $40
5% 33 29
10% 19 20
15% 7 12
20% (4) 5

180
 Graph of NPV profiles

NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

10 .. S IRRS = 23.6%
L . .
0 . Discount Rate (%)
5 10 15 20 23.6
-10
181
 NPV Method vs IRR - Recap

0 1 2 3
Project L 10%

CFt -100 10 60 80

0 10% 1 2 3
Project S
CFt -100 70 50 20
 NPV Profiles

• Project NPVs at various different costs of capital.

k NPVL NPVS
0% $50 $40
5% 33 29
10% 19 20
15% 7 12
20% (4) 5

183
 Graph of NPV profiles

NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

10 .. S IRRS = 23.6%
L . .
0 . Discount Rate (%)
5 10 15 20 23.6
-10
184
 Comparing the NPV and IRR methods

• If projects are independent, the two methods always lead to the same
accept/reject decisions.
• If projects are mutually exclusive …
–If k > crossover point, the two methods lead to the
same decision and there is no conflict.
–If k < crossover point, the two methods lead to
different accept/reject decisions.

185
 Reasons why NPV profiles cross

• Size (scale) differences – the smaller project frees up

funds at t = 0 for investment. The higher the
opportunity cost, the more valuable these funds, so
high k favors small projects.
• Timing differences – the project with faster payback
provides more CF in early years for reinvestment. If k
is high, early CFs are especially good, NPVS > NPVL.

186
 Reinvestment rate assumptions

• NPV method assumes CFs are reinvested at k, the

opportunity cost of capital.
• IRR method assumes CFs are reinvested at IRR.
• Assuming CFs are reinvested at the opportunity cost
of capital is more realistic, so NPV method is the
best. NPV method should be used to choose
between mutually exclusive projects.
• A hybrid of the IRR that assumes cost of capital
reinvestment is needed to improve the IRR method.

187
• Since managers prefer the IRR to the NPV method, is
there a better IRR measure?
• Yes, MIRR is the discount rate that causes the PV of a
project’s terminal value (TV) to equal the PV of costs.
• TV is found by compounding inflows at Weighted Average
Cost of Capital (WACC) i.e. sum of FV of inflows.
• MIRR assumes cash flows are reinvested at the WACC.

188
 Calculating MIRR

• PV cash outflows = = TV inflows

(1 + MIRR)n

1. TV inflows =

t =n
COFt
2. PV outflows =

t = 0 (1 + k )
t

189
 Example

0 10% 1 2 3

-100.0 10.0 60.0 80.0

190
 Calculating MIRR

0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%

191
 Calculating MIRR

0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.6

192
 Calculating MIRR

0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% =(𝟏. 𝟏𝟎)𝟐 12.1

193
 Calculating MIRR

0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% =(𝟏. 𝟏𝟎)𝟐 12.1

FV of Cash Inflows 158.1

194
 Calculating MIRR

0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% =(𝟏. 𝟏𝟎)𝟐 12.1
MIRR = ??
-100.0 158.1

195
 Calculating MIRR for Project L

0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% =(𝟏. 𝟏𝟎)𝟐 12.1
MIRR =
-100.0 158.1
Formula↓

$100 $158.1
=
(1 + MIRR)3
PV outflows TV inflows

196
 0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% = 12.1
MIRR =
-100.0 158.1
Formula?

$100 $158.1
=
(1 + MIRR)3
PV outflows TV inflows
 𝑇𝑉 𝑜𝑓 𝐶𝐼𝐹
• PV of COF =
(1+𝑀𝐼𝑅𝑅)𝑛
158.1
• 100 =
(1+𝑀𝐼𝑅𝑅)3
158.1
• (1+𝑀𝐼𝑅𝑅)3 =
100

• (1+𝑀𝐼𝑅𝑅)3 = 1.581
• 1+ MIRR =
3
1.581
• 1+ MIRR = 1.1649
• MIRR = 1.1649 -1
• MIRR = 0.1649 0r 16.5%
 MIRR for Project L

0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% 12.1
MIRR = 16.5%
-100.0 158.1
$158.1 TV inflows
$100 =
(1 + MIRR)3
PV outflows
MIRR = 16.5%

199
 Why use MIRR versus IRR?

• MIRR correctly assumes reinvestment at opportunity cost =

WACC.
• MIRR also avoids the problem of multiple IRRs.
• Managers like rate of return comparisons, and MIRR is
better for this than IRR.

200
Security Valuation
Bonds
 What is a Bond?

• A long-term contract where a borrower agrees to make payments of interest

and principal on specific dates to the bondholder (investor).
• It is a certificate created by a borrower in order to raise funds from investors
who then become bondholders
• Note that Bondholders are the Creditors is this setup whereas the Company
or Entity that floated or created/Issued the bond is a debtor
• A bond is a debt financial instrument
 Issuers of Bonds

• Bonds are normally issued by:

• Either 1. Federal/State Govt, 2. Local Govt 3. Corporations or 4.
Foreign Entities
1. State Govt Bonds (Through Bank of Bots)- are called Treasury Bonds
– Parastatals, State Owned Enterprises(SOE) and other Govt Agencies
also issue Bonds
2. Large companies- are called Corporate bonds
3. Local government- such as District and Other Administrative structures’
bonds – are called municipal bonds
4. Foreign governments issue what is collectively called foreign bonds
 Types of Bonds

• Income Bond
–A bond that pays interest to the holder only if the firm earns
sufficient income to cover the interest payment
• Putable Bond
–Bond that can be redeemed at the bondholder’s option if the
firm takes a particular action
 Types of Bonds

• Indexed (Purchasing Power) Bond

–A bond that has interest payments attached to an inflation
index to protect the holder from inflation
–Usually anchored on the Consumer Price Index(CPI)
• Floating-rate bonds
–Coupon rate of the bond “floats’ with a specific market
interest rate such as prime rate rather than with the inflation
rate
–Also known as variable rate bonds as opposed to fixed-rate
bond
 Example-Bonds

• If Gaborone City Council needs P25 000 000 to construct a new dam,
it might issue 25 000 bond notes at P1 000 each, paying an annual
interest of 10% over a 15-year period.
• Gaborone City Council, the bond issuer, becomes obliged to pay the
bond holders periodic interest plus principal at maturity.

206
 Key Features of a Bond Contract

1. Par Value – The principal/face value is the amount that is written on

the face of the bond that the issuer borrows and promises to repay on
maturity date, i.e. P1 000.
2. Maturity – Duration or lifespan of the bond e.g. 15 years in this case.
It declines over time after initial issue.
3. Maturity Date – The day the issuer has to repay the principal
4. Coupon Rate – the interest rate stated on the face of the bond, i.e.
10%.
5. Coupon Payment – the Pula amount of interest to be paid.
• i.e. P1 000 x 10% = P100
6. Indenture – The legal binding and formal agreement
between the issuer of a bond and the bondholders
–Traditionally, these documents had indented/perforated
sides
7. Trustee - An official who ensures that the bondholders’
interests are protected, and the terms of the indenture are
complied with.
8. Restrictive Covenants – provisions or commitments in a
debt contract that certain activities will be undertaken by
the borrower
 Features of a Bond Contract

Call Provision
• A provision in a bond’s contract that gives the issuer the
right to redeem the bonds under specified terms prior to the
normal maturity date
Convertible Feature
• Permits the bondholder to convert the bond into shares of
common stock at a fixed price.
• Once converted, the Investor is not allowed to convert the
stocks back to bonds, later on
Sinking Funds Provision
• Any arrangement that facilitates an orderly retirement of
bonds e.g. retire a portion of bond issue each year
 New vs Outstanding Bonds

• A bond that has just been issued is known as a “New Issue” and
normally sells at par value.

• Outstanding/Existing Bonds are those that have been in the market for
a while and are known as "Seasoned issues” . Their price might be
different from the par value.
 Bond Valuation

• The price or value of a bond is given as the sum of the present values
of all its future expected cash flows.

n
INT M
Bond Value =  +
t =1 ( 1 + k d ) t
( 1 + k d ) n

𝐼𝑁𝑇1 𝐼𝑁𝑇1 𝐼𝑁𝑇1 𝐼𝑁𝑇1 𝑀

• = + + + ……+ +
(1+𝑘𝑑 )1 (1+𝑘𝑑 )2 (1+𝑘𝑑 )3 (1+𝑘𝑑 )𝑛 (1+𝑘𝑑 )𝑛

• Bond Value = INT(PVIFA kd, n) + M(PVIF kd , n)

213
• Where Kd or rdis the appropriate or prevailing Market interest
rate of a bond.
• The bond market rate is determined by prevailing market or
economic conditions and would fluctuate over time depending on
the forces of demand and supply
• n- The number of years to bond maturity.
• n declines each year after the bond has been issued.
• INT- The annual Pula value of interest payable on a bond as given
by (Coupon Rate x Par Value).
• M - The par or face value of the bond, being the principal payable
at maturity.
 Example

• Suppose the Gaborone City Council bond has a par value of P1 000,
a coupon rate of 10%, maturity period of 15 years and the prevailing
market interest rate is 10%.
• Calculate the bond’s value.

215
 Example 1
• Vb = INT(PVIFAkd,n) + M(PVIFkd,n)
• n = 15 kd = 10%
• Therefore PVIFA10%,15 = ???
• 7.6060
• PVIF10%,15 = ???
• 0.2394
• INT = Par Value x Coupon Rate
• = 1000 x 0.10
• = 100
• Vb = INT(PVIFAkd,n) + M(PVIFkd,n)
• Vb = 100(PVIFA10%, 15yrs) + 1 000(PVIF10%, 15yrs)
= 100(7.6060) + 1 000(0.2394)
= 760.60 + 239.40
= P1,000 216
 Example 2

• Five years after the issue, suppose the market interest rates for the same bond falls
to 6%.
• Calculate the value of the bond.
• Answer
 Kd = 6%, n = 10 years
Vb = INT(PVIFA kd, n) + M(PVIF kd,n)
Vb =?
INT(PVIFA 6%,10yrs) + M(PVIF 6%,10yrs)
=100(7.3601) + 1,000(0.5584)
= 736.01 + 558.40
= P1,294.41

217
 Example 3

• Calculate the value of the bond 5 years after initial issue assuming the market interest
rate actually raises to 12%.
• Solution
Kd = 12%, n= 10 years

Vb = INT(PVIFA 12%,10yrs) + M(PVIF 12%, 10yrs)

Vb = 100(5.6502) + 1,000(0.3220)
= 565.02 + 322
= 887.02

218
 Conclusion
At first issue, the Coupon rate would normally be set at Kd so that the
bond can sell at its par value.
Thereafter, fluctuations in market interest rates affects bond value.
A fall in Kd below the coupon rate results in the bond selling at a
premium (i.e. a price higher than par value).
Such Bonds are referred to as Premium Bonds
An increase Kd above the coupon rate results in the bond selling at a
discount (price below par)
Such bonds are referred to as Discount Bonds
 Semi-annual bonds

• Vast majority of bonds pay interest semi-annually

• To evaluate semi-annual bonds;
1. Divide the annual coupon interest payment, INT, by 2 to
determine the dollars of interest paid each six months.
2. Multiply the years to maturity, n, by 2 to find the number of semi-
annual periods
3. Divide nominal(quoted) interest, kd, by 2 to determine the periodic
semi-annual interest rate
 Semi-annual bonds

• The value of semi-annual bonds:

• Vb = INT/2 (PVIFAkd/2, nx2) + M(PVIFkd/2, nx2)

• Example
• Annual Coupon Rate = 12%, payable semi-annually
• M = P1 000,
• Nominal Rate (kd) = 14%,
• N = 15 years
• Vb = ?
221
 Semi-annual bonds
𝐼𝑁𝑇
• Vb = (PVIFA 𝐾𝑑 ,nx2) + M(PVIF𝐾𝑑 ,nx2)
2
2 2

• Vb = INT/2 (PVIFAkd/2, nx2) + M(PVIFkd/2, nx2)

• INT = 12%/2 x1000 = ??
• = 0.06x 100 = P60
• M = 15x2 = 30 periods
• kd = 14%/2 = 7%

• Vb = 60(PVIFA7%,30 ) + M(PVIF7%,30)
= 60(12.4090) + 1,000(0.1314)
= 744.54 + 131.4
= 875.94

222
 Security Valuation
Preferred & Common
Stock
 What is a Preferred Stock?
• A hybrid security
– similar to bonds with fixed dividend amounts to
investors;
– Also similar to bonds in that it has no voting rights
– but like bonds it has priority in terms of payment over
common stock
– similar to common stock as missed preferred dividend
payments will not force a company into bankruptcy
– Also similar to common stock in that it has no fixed
maturity date
 Features of a Preferred Stock
• Par Value
– The nominal or face value of a stock
• Cumulative Earnings
– Any preferred dividends not paid in
previous periods must be paid before
common stock dividends can be distributed
• Maturity
– Generally has no specific maturity date
• Priority to Assets and Earnings
– Dividends must be paid on preferred stock
before they can be paid on common stock
• Control of the Firm (Voting Rights)
– Almost all preferred stocks are non-voting stock
• Convertibility
– Some Preferred stock that can be converted to
common stock at the option of the investor
• Redeemable
– The company has a right to buy back the stock at
any point in time
• Other Provisions
– Call provision - Gives the issuing
corporation the right to redeem/buyback the
preferred stock at any point in time
– Sinking fund - Calls for the repurchase and
retirement of a given percentage of the stock
each year
– Participating- Participates with the common
stock in sharing the firm’s earnings over and
above their fixed periodic payments
 Preferred Stock Valuation
• Preference shares entitle the holder to a
fixed-amount of dividend normally
determined as a percentage of the stock’s
par value / face value.
• Ordinarily, preference stock dividend is
payable on condition of adequate profit
availability.
 Valuation Model

• Assuming a regular, fixed and perpetual declaration of

preference stock dividends, the value of preference
stock will thus be calculated as follows:
𝐷𝑝𝑠
• Vps =
kps
• Where:
• Dps = Fixed preference stock dividend
• Kps = Required rate of return
 Example

 BIFM limited Company has an outstanding preference

stock paying an annual dividend of 90t per share. Given
the required rate of return of 13%, compute the
preference stock value:
 Calculating the market Price of Pref Shs
 Vps = ?
𝐷𝑝𝑠
 Vps =
kps
0.90
 =
0.13
 = P6.92
 Exercise 1

• What will be the rate of return on a preferred stock

with a P100 par value, a stated dividend of 8 percent of
par value, and a current market price of
• (a) P60,
• (b) P80,
• (c) P100, and
• (d) P150?
 Solutions
• Calculating the Expected Rate of return of Pref Shs
• Par Value(Vpv) = P100:
• Dividends = 8% of par
• 𝐷𝑝𝑠 = 100 x 0.08 = P8.00
a) Vps = P60
𝐷𝑝𝑠
• Vps =
kps
8
• 60 =
kps
8
• kps = 60
• = 0.133 or 13.3%
b) Vps = 80
𝐷𝑝𝑠
• kps =
𝑉𝑝𝑠
8
• =
80
• = 0.10 or 10%
c) Vps = 100
𝐷𝑝𝑠
• kps = 𝑉𝑝𝑠
8
• =
100
• = 0.08 or 8%
d) Vps = 150
𝐷𝑝𝑠
• kps = 𝑉𝑝𝑠
8
• =
150
• = 0.05 or 5%
 Exercise 2

• XYZ Corporation issued preferred stock with a stated dividend of

9 percent of par. Preferred stock of this type currently yields 8
percent, and the par value is P100. Assume dividends are paid
annually.
a) What is the Market value of XYZ’s preferred stock?
b) Suppose interest rate levels rise to the point where the
preferred stock now yields 12 percent. What would be the value
of XYZ’s preferred stock?
 Solutions

𝐷𝑝𝑠
a) Vps =
kps
9
• Vps =
0.08
• Vps = P112.50

𝐷𝑝𝑠
b) Vps =
kps
9
• Vps =
0.12
• Vps = P75.00
 Common Stock/Equity
Facts about common stock
• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Management’s goal: Maximize the stock price

238
 Features of Common Stock

• Par Value
– Legally, represents a stockholder’s minimum financial
obligation in the event the corporation is liquidated
• Dividends
– The firm has no legal obligation to pay common stock
dividends.
– Dividends can only be paid when there is enough Profit.
It cannot be paid from the sale of a company’s assets
• Maturity
– Generally has no specific maturity date
• Priority to Assets and Earnings
– Dividends can be paid only after interest on debt and
preferred dividends are paid
• Control of the Firm (Voting Rights)
– Common stockholders have the right to elect the firm’s
directors and to vote on directors’ proposals, mergers,
and changes in the firm’s charter.
• Preemptive Right
– Gives stockholders the right to purchase any additional
shares of stock sold by the firm on a pro rata basis (in
proportion to their current holding) before the shares can
be offered to new investors.
Intrinsic Value and Stock Price

242