Six Fundamental Principles of Finance

 P1: There Is No Such Thing As A Free Lunch.

 P2: Other Things Equal, Individuals:
• Prefer more money to less (non-satiation)
• Prefer money now to later (impatience)
• Prefer to avoid risk (risk aversion)
 P3: All Agents Act To Further Their Self-Interest
 P4: Financial Market Prices Shift To Equalize Supply and Demand
 P5: Financial Markets Are Highly Adaptive and Competitive
 P6: Risk-Sharing and Frictions Are Central to Financial Innovation
Lecture 1:
1. Deterministic Valuation I
 Review of TVOM
 DCF Valuation
 Long-Term Financial Planning
 Determinants of Interest Rates
2. Review of time value of money
 Simple interest
 Eg: a firm borrows $1,000 for a year at 10% simple interest per year. How much must the firm
repay after one year?
 FV = future value = 1,000(1+r) = 1,000 (1.1) =1,100
 What if the loan is for 3 years, at compound interest of 10% for year?
 If compounding is annual:
o FV = 1,000 (1+r)3 = 1,000 (1.1)3 = 1,331
 In general, FV = PV (1+r)t = PV x FVIF (r, t)
 FVIF(r,t) = future value interest factor = (1+r)t
 On exam, if you write FV = 1,331, this is not enough. It is not acceptable
 You must write at least
o FV = 1,000 FVIF (10%, 3) or
o FV = 1,000 (1 + 0.1)3 = 1,331 or you can TVM notations (n=3, i/y=10, pmt=0,
pv= -1,000, CPT>> FV =1,331)
 If FV = PV (1 + r)t, then
 PVIF = present value interest factor = 1 / (1+r)t

 To find r in PVIF or FVIF

 We know that FV = PV (1+r)t
 To solve for t, take the log:
 Eg, PV = 25,000; FV = 50,000; r= 12%, t =?
FV = PV (1+r)t
t
50,000 = 25,000 (1+.12)
50,000/25,000 = 1.12t
2 = 1.12t
 Log 2 = Log 1.12t
 t log 1.12 = log 2
 t = log2/log 1.12 = 6.1163
 ‘log’ or ‘ln’ button on financial calculator
 Annuities
o Draw time line
o Eg cash flow of $1,000 at the end of the year for 4 years
o What is the FV? PV?
0 1 2 3 4
o |------|-------|--------|--------|
1,000 1,000 1,000 1,000
o r = 10%, t = 4, c = cash flow = 1,000

 Show the above steps in the exam, OR

 FV = 1,000 FVIFA (10%, 4) = 4,641
 PV = 1,000 PVIFA (10%, 4) = 3,169.87
 3 special cases:
 (i) Annuities due: C occurs at beginning of period
0 1 2 3 4
|----------|---------|---------|--------|
1,000 1,000 1,000 1,000
 FV or PV of annuity due = PV or FV (Annuity) x (1+r)
 (ii) Perpetuities or consols:
0 1 2 3
|----------|---------|---------|------ forever
1,000 1,000 1,000
PV perpetuity = C/r
o Used for stock valuation
o PV CCATS for declining balance (future lectures)
 (iii) Growing perpetuities; growing annuities

3. Effective annual rates, or EAR

 Let stated or quoted rate be denoted as ‘r’ (typically given as an annual rate)

 m = number of compounding periods per year

 E.g. monthly compounding, r = 12%

 EAR = 1.0112 – 1 = 0.126825 = 12.6825%

FV = 1000xe(0.10*3) = 1,349.86 (Refer to the annual compounding example with FV=1,331 for r=10%)
For an APR = 12%, EAR = er – 1 = 0.1275 or 12.75% contrast this with 12.68255% for monthly
compounding)
4. Interest rates contd.
 Types of Loans
1) Pure discount loans: loan on which the interest and financing charges are deducted from the face
amount when the loan is closed. The borrower only receives the principal after the financing charges and
interest are taken out but must repay the full amount of the loan
o Given principal
o No coupons
o Eg Repayment = $1,000; r =10%
o Loan amount = 1,000 = 1,000 = 909.09
1+ r 1.1
2) Interest-only loans:
o Rare in Canada
o Loan in which, for a set term, the borrower pays only the interest on the principal balance, with
the principal balance unchanged. At the end of the interest-only term the borrower may pay the
principal, or convert the loan to a principal and interest payment (or amortized loan), etc. (eg
Bonds)
3) Amortized loan – eg car loan, mortgage
(i) equal repayment amounts
(ii) like an annuity
5. Interest rates
 Finding ‘r’ in an annuity
o PV = 3,200; C= 1,200; t = 3; r = ?
o C x PVIFA (r, 3) = PV
o 1,200 PVIFA (r, 3) = 3,200
o PVIFA (r, 3) = 3,200/1,200 = 2.67 (correct to 2dp)
Use interpolation (trial and error) to find ‘r’:
o Try r = 6%

o (hint: can also use annuity tables at back of textbook; financial calculator; PVIFA calculator on
line)
 o We were lucky: ‘r’ is indeed 6% in this case
o Suppose C= 300; t = 12; PV = 3,200
o 300 PVIFA (r, 12) = 3,200
o PVIFA (r, 12) = 3,200 = 10.67
300
 Interpolation steps:
1) Try any ‘r’, say r = 2%

If PVIFA (2%, 12) < PVIFA (r, 12), it must be that r <2%
2) Try an r < 2%, say r = 1%
PVIFA (1%, 12) = 11.2551
3) If you find a PVIFA less than 10.67 and another PVIFA greater than 10.67, STOP finding PVIFA’s.
4) Interpolate to find r

 Interpolate:
 r – 1% = 0.86
 r = 1 + 0.86 = 1.86%
 However, in excel you can use Goal-Seek, Solver to find an unknown for a non-linear, complicated
formula.
 Nominal rates: interest rates or rates of return that have not been adjusted for inflation
 Real rates: interest rates or rates of return that have been adjusted for inflation
 Notation:
o Nominal rate = upper case ‘R’
o Real rate = lower case ‘r’
o Expected inflation = πe
o Textbook Fisher Equation
o (1+R) = (1 +r) (1+ πe)
o In class: R ≈ r + πe
6. Definition of ODA
 The DAC (development assistance Committee) of Organization of Economic Cooperation and
Development (OECD) defines ODA as “those flows to countries and territories on the DAC List of
ODA Recipients and to multilateral institutions which are:
 i. provided by official agencies, including state and local governments, or by their executive
agencies; and
 ii. each transaction of which:
 a) is administered with the promotion of the economic development and welfare of developing
countries as its main objective; and
 b) is concessional in character and conveys a grant element of at least 25 per cent (calculated at a
rate of discount of 10 per cent).”
 Official development assistance (ODA) is a term coined by the Development Assistance Committee
(DAC) of the Organisation for Economic Co-operation and Development (OECD), an
intergovernmental organisation, to measure aid. To qualify as official development assistance
(ODA), development loans must have a grant element (the difference between the loan’s nominal
value (face value) and the sum of the discounted future debt-service payments to be made by the
borrower (present value), expressed as a percentage of the loan’s face value) of at least 25 percent,
calculated using a stated annual interest rate of 10 percent.
7. ODA
To qualify as official development assistance (ODA), export credit must have a grant element of at least
25%, calculated using a stated annual interest rate of 10%. Suppose that the Export Development
Corporation (the agency of the Canadian government that provides export credit) considers the
following loan: $100 million, to be amortized over 6 years by 12 semi-annual payments, after a grace
period of 4 years during which only interest would be paid semi-annually. The stated annual interest rate
is 6%.
Determine whether or not this loan would be qualified as ODA. What is the maximum interest rate the
Corporation could charge for this loan to qualify as ODA?

 Find the payments (C) at subsidized interest rate of 6%

r =6% / 2 = 3% semi-annually
In year 4 C × PVIFA (3%, 12) = $ 100m
C = 100m / PVIFA (3%, 12) = 100m /9.954 = $ 10.0462m
 Find PV of all the payments at market rate 10% annually (5% semi-annually)
o PV of the “C” flows
In year 4, PV of “C” flows= C × PVIFA(5%, 12)
= 10.0462 × 8.8623 = $ 89.0426m
In year 0, PV of “C” flows= 89.0426 / 1.058
= $ 60.2675m
o PV of the “3m” flows
In year 0, PV of “3m” flows = 3m × PVIFA (5%, 8)
= $ 19.3896m
o PV of payments = PV of “C” flows + PV of “3m” flows
= 60.2675m + 19.3896m
= $ 79.6571m
 o The grant element = (100m – 79.6571m) / 100m
= 20.3429% < 25%
Since the grant element is lower than 25%, this loan would not be qualified as ODA.
 Find the maximum interest rate:
o Use the method of linear interpolation
o Since an interest rate of 6% disqualifies the loan as ODA, we should try an interest rate lower
than 6%, say 5%.
Try r = 5% annually (2.5% semi-annually)
Find the payments (C) at subsidized interest rate of 5%
r = 5% / 2 =2.5% semi-annually
C × PVIFA (2.5%, 12) = $ 100m
C = 100m / PVIFA (2.5%, 12) = $ 9.7487m
Find PV of all the payments at market rate 10% annually (5% semi-annually)
PV of the “C” flows
In year 4 PV’ of “C” flows = C × PVIFA (5%, 12)
= 9.7487 × 8.8623
= $ 86.4052m
In year 0, PV of “C” flows = 86.4052 / 1.058
= $ 58.4824m
PV of the “2.5m” flows
In year 0, PV of “2.5m” flows = 2.5m × PVIFA (5%, 8)
= $ 16.158m
PV of payments = PV of “C” flows + PV of “2.5m” flows
= 58.4824m + 16.158m = $ 74.6404m
The grant element = (100m – 74.6404m) / 100m
= 25.3596% > 25%


Chapter 4 L-T Financial Planning and Corporate Growth
 Financial Plan
o Systematically thinking about the future and anticipating possible problems before they arrive
o Logical and organized procedure for exploring the unknow
o “Planning is the process that at best helps the firm avoid stumbling into the future backwards.”
– GMC’s board.
o What it does?
• Establishes guidelines for change and growth in a firm
• Focuses normally on the “big picture” – major elements of a firm’s financial and investment
policies
1. Financial Planning: Basic elements
 To develop an explicit financial plan, management must establish certain elements of financial
policies
o Investment in new assets – determined by capital budgeting decisions
o Degree of financial leverage – determined by capital structure decisions
o Cash paid to shareholders – dividend policy decisions
o Liquidity requirements – determined by net working capital decisions
4.1 Dimensions of Financial Planning
 Planning Horizon - divide decisions into short-run decisions (usually next 12 months) and long-run
decisions (usually 2 – 5 years)
 Aggregation - combine capital budgeting decisions into one big project
 Assumptions and Scenarios
o Make realistic assumptions about important variables
o Run several scenarios where you vary the assumptions by reasonable amounts
o Determine at least a worst case, normal case and best case scenario
2. Role of Financial Planning
 Examining interactions – helps management see the interactions between decisions (linkages
investment vs. financing)
 Exploring options – gives management a systematic framework for exploring its opportunities
(drop a product line or introduce new one, expand a profitable project)
 Avoiding surprises – helps management identify possible outcomes and plan accordingly
 Ensuring Feasibility and Internal Consistency – helps management determine if goals can be
accomplished and if the various stated (and unstated) goals of the firm are consistent with one
another
4.2 Financial Planning Model Ingredients
 Sales Forecast – many cash flows depend directly on the level of sales (often estimated using a
growth rate in sales)
 Pro Forma Statements – setting up the financial plan in the form of projected financial statements
allows for consistency and ease of interpretation
 Asset Requirements – how much additional fixed assets will be required to meet sales projections
3. Ingredients Continued
 Financial Requirements – how much financing will we need to pay for the required assets
 Plug Variable – management decision about what type of financing will be used (makes the balance
sheet balance)
 Economic Assumptions – explicit assumptions about the coming economic environment (most
important ones are level of Interest Rate and the firm’s Tax Rate)
Example 1 – Historical Financial Statements

Pro Forma Income Statement

Pro Forma Balance Sheet

4.3 Percent of Sales Approach
 Some items tend to vary directly with sales, while others do not
 Income Statement
o Costs may vary directly with sales
o If this is the case, then the profit margin is constant
o Dividends are a management decision and generally do not vary directly with sales – this
affects the retained earnings that go on the balance sheet
 Balance Sheet
o Initially assume that all assets, including fixed, vary directly with sales
o Accounts payable will also normally vary directly with sales
o Notes payable, long-term debt and equity generally do not vary with sales because they depend
on management decisions about capital structure
o The change in the retained earnings portion of equity will come from the dividend decision
Example 2 – Percentage of Sales Method
Example 3 – External Financing Needed
 The firm needs to come up with an additional $200 in debt or equity to make the balance sheet
balance
o TA – TL&OE = 10,450 – 10,250 = 200
 Choose plug variable
o Borrow more short-term (Notes Payable)
o Borrow more long-term (LT Debt)
o Sell more common shares (C Shares)
o Decrease dividend payout, which increases Additions To Retained Earnings
Example 4 – Operating at Less than Full Capacity
 Suppose that the company is currently operating at 80% capacity.
o Full Capacity sales = 5000 / .8 = 6,250
o Estimated sales = $5,500, so would still only be operating at 88%
o Therefore, no additional fixed assets would be required.
o Pro forma Total Assets = 6,050 + 4,000 = 10,050
o Total Liabilities and Owners’ Equity = 10,250
 Right side (TL & OE) is greater than the left side (Total Assets) by $200
 Choose plug variable
o Repay some short-term debt (decrease Notes Payable)
o Repay some long-term debt (decrease LT Debt)
o Buy back shares (decrease C Shares)
o Pay more in dividends (reduce Additions To RE)
4.4 Growth and External Financing
 At low growth levels, internal financing (retained earnings) may exceed the required investment in
assets
 As the growth rate increases, the internal financing will not be enough and the firm will have to go
to the capital markets for money
 Examining the relationship between growth and external financing required is a useful tool in long-
range planning
4. The Internal Growth Rate
 The internal growth rate tells us how much the firm can grow assets using retained earnings as the
only source of financing.
 Assuming ROA = NI/total assets = 10%, and R= retention rate = addition to retained earnings/net
income = 67%

 The firm can grow at a rate of 7.18% before any external financing is required
5. The Sustainable Growth Rate

 Assuming ROE = return on equity = NI/equity = 25% and retention rate = R = addition to retained
earnings/net income = 67%

 The firm can increase its sales and assets at a rate of 20.12% per year without selling any additional
equity and without changing its debt ratio or payout ratio
 If and when a higher growth rate is desired or predicted, then something has to give.
6. Determinants of Growth
 Profit margin – operating efficiency, when increases the firm has more internally generated funds to
finance growth.
 Total asset turnover – asset use efficiency, increases the sales generated for each dollar in assets.
 Financial policy – financial leverage, choice of optimal debt/equity ratio
 Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm
4.5. Some Caveats
 It is important to remember that we are working with accounting numbers relying on accounting
relationships not financial relationships
 We need to ask ourselves some important questions as we go through the planning process
o How does our plan affect the timing, size and risk of our cash flows?
o Does the plan point out inconsistencies in our goals?
o If we follow this plan, will we maximize owners’ wealth?
 Closing note: this is an iterative process: create, examine, modify over and over to contain different
goals and satisfy many constraints
TVM Examples

Solution to 55
a) Using formula, PVA = $950{[1 – (1/1.095)8 ] / 0.095} = $5,161.76
Using TVM: PVA=CPT from [n=8, I/Y=9.5, PMT=-950, FV=0]
=$5,161.76
Using CFW: CF0=0, C01=950, F01=8, NPV=[for I=9.5]= $5,161.76
b) Annuity Due:
PVAD = PVA *(1+r) = $5,161.76*1.095=$5,652.13
There are also a lot of methods to calculate this…….

Solution to 79
a) Assuming 52 weeks in a year, APR = 52(8%) = 416%
EAR = (1 + 0.08)52 – 1 = 53.7060 or 5,370.60%
b) In a discount loan w/ 8% rate, you receive $92 for $100 loan
Actual rate per week, r = 8/92 = 8.70%
APR = 8.700 * 52 = 452.40%
EAR = (1+0.087)^52 – 1= 75.5484 or 7,554.84%
c) Consider $63.95 is the PV of that $25 payments at the end of 4 weeks
N=4, I/Y = r, PV=-63.95, PMT=25, FV=0 CPT>>r=20.63%
APR = 20.63%*52 = 1,072.76%
EAR = (1+0.2063)^52 – 1=17,204.89 or 1,720,488.62%