CORPORATE FINANCE

I.- INVESTMENT DECISIONS

TOPIC 1.- Present values

2º ADEB
Curs0 2022-23
Profesor: Andrés Mesa Toro
Texto de referencia.1 Principles of Corporate Finance,
Brealey, Myers y Allen . McGraw Hill (2020, 13 Ed.)*
CORPORATE FINANCE

• This course: how corporations make

financial decisions.
• Firms invest in assets:
• Fix assets
Income
• Working capital

• How corporations pay for assets

• Cash, short term investments
• Debt
• Selling shares to shareholders.
CORPORATE FINANCE
1-­‐1 INTRODUCTION TO CORPORATE FINANCE
Objective: Maximize value

Financing Shareholders
Investment
decisions retribution
decisions

Invest in projects
Find the optimal Decide whether to
that maximize the
capital structure of remunerate
value of the firm.
the firm: Debt vs shareholders or
Equity. Long vs reinvest benefits in
Projects with
short term debt. the firm.
expected return
Bonds vs bank
higher than the cost
loans.
of capital of the firm.

2-4
1-­‐2 INTRODUCTION.-­‐ FLOW OF CASH BETWEEN
FINANCIAL MARKETS AND THE FIRMS OPERATIONS.
Financial manager rol

(2) (1)

Firm's Financial Financial

operations manager (4a) markets

(3) (4b)

(1)Cash raised from investors

(2) Cash invested in firm
(3)Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
1-­‐3 INTRODUCTION.-­‐ INVESTMENT DECISIONS

Stockholders want three things

• To maximize current wealth
• To transform wealth into most desirable time
pattern of consumption
• To manage risk characteristics of chosen
consumption plan

• The financial manager must help the shareholder

to maximize its current wealth.

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1-­‐3 INTRODUCTION.-­‐ INVESTMENT DECISIONS

2-7
1-­‐3 INTRODUCTION.-­‐ INVESTMENT DECISIONS

The investment trade-off

Hurdle rate/cost of capital

Minimum acceptable rate of return on investment
Opportunity cost of capital
Investing in a project eliminates other opportunities to
use invested cash
2-­‐1 INTRODUCTION TO PRESENT VALUE
•One dollar today have highest value
than a dollar tomorrow.
•One dollar secure have higher value
than a dollar in a risky investment.
•Future value
Amount to which an investment will grow after earning
interest.

• Present value
Value today of a future cash flow.

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2-­‐1 INTRODUCTION TO PRESENT VALUE
• Future value (VF) of $100 =

FV  $100  (1
r)
• Example: FV
t

What is the future value of $100 if interest is

compounded annually at a rate of 7% for two
years?
VF  $100 (1.07)  (1.07) 
$114.49 VF  $100 (1 .07) 2 
$114.49 2-10
FIGURE 2.1 FUTURE VALUES
WITH COMPOUNDING

2-11
2-­‐1 INTRODUCTION TO PRESENT VALUE

Present value = PV
PV  discount factor C1

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2-­‐1 INTRODUCTION TO PRESENT VALUE
Discount factor = DF = PV of $1

1
DF 
1  r  t

Discount factors can be used to compute the present

value of any cash flow.
• r.- Discount rate. Rate of return that shareholders
would obtain if they invest by their own in projects
with similar risk.

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2-­‐1 INTRODUCTION TO PRESENT VALUE
The PV formula has many applications. Given any
variables in the equation, you can solve for the
remaining variable. Also, you can reverse the prior
example.

PV  DF2  C2
1
PV   $114.49  $100
1  .07 2
FIGURE 2.2 PRESENT VALUES
WITH COMPOUNDING

2-15
2-­‐1 INTRODUCTION TO PRESENT VALUE
Step 1: Forecast cash flows.
Cost of building = C0 = 700,000
Sale price in Year 1 = C1 = 800,000

Step 2: Estimate opportunity cost of capital.

If equally risky investments in the capital market
offer a return of 7%, then
Cost of capital = r = 7%
2-­‐1 INTRODUCTION TO PRESENT VALUE
2-­‐1 INTRODUCTION TO PRESENT VALUE
Step 3: Discount future cash flows.

C1 800,000
PV    747,664
1  r  1  .07
Step 4: Go ahead if PV of payoff exceeds
investment.

NPV  747,664  700,000

 47,664
2-­‐1 INTRODUCTION TO PRESENT VALUE
Suppose in the example above.

Once you have bought the land and paid for

the construction (which cost you 700,000).
You decide to sell the project. How much
should you sell it for?
2-­‐1 INTRODUCTION TO PRESENT VALUE

NET PRESENT VALUE (NPV)

NPV  PV  required investment

C1
NPV  C0 
1 r
2-­‐1 INTRODUCTION TO PRESENT VALUE
• Risk and present value
• Higher risk projects require higher rates of
return.
• Higher rates of return cause lower present
values

PV of C1  $800,000 at
7%
1
$8 00,00 0
PV   .07  $747,664
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2-­‐1 INTRODUCTION TO PRESENT VALUE

NPV = PV  required
investment NPV = $747,664 
$700,000
 $47,664

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2-­‐1 INTRODUCTION TO PRESENT VALUE
• NPV rule:
• Accept investments that have positive net
present value.

Example
Use the original example. Should we accept the project
given a 10% expected return?

800,000
NPV  700,000   $27,273
1.10
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2-­‐1 INTRODUCTION TO PRESENT VALUE
If r=7%
C $800,00
PV (1r
1  0 
 ) (1.07) $747,664
NPV  -700,000 + 747,664 =
47,664
2-­‐1 INTRODUCTION TO PRESENT VALUE

If r=12%

C $800,00
PV (1r
1  0  $714,286
 ) (1.12)

NPV -700,000 + 714,286 = 14,286

2-­‐1 INTRODUCTION TO PRESENT VALUE
Rate of Return Rule
Accept investments that offer rates of return in
excess of their opportunity cost of capital.

Example
In the project listed below, the foregone investment opportunity is 12%. Should we do
the project?

profit 800,000  700,000

Return    .143 or 14.3%
investment 700,000
2-­‐1 INTRODUCTION TO PRESENT VALUE

For multiple periods we have the discounted cash flow

(DCF) formula.

C1 C2 Ct
PV    ... 
1  r 
1
1  r  2
1  r  T

T
Ct
NPV  C0  
t 1 1  r  t
FIGURE 2.5 NET PRESENT VALUES

2-28
2-­‐2 HOW TO VALUE PERPETUITIES

Perpetuity: Financial concept in which a cash flow

is theoretically received forever.

cash flow
Return 
present value
C
r 
PV
2-­‐2 HOW TO VALUE PERPETUITIES

PV of cash flow cash flow

 discount
VP0  C
rate
1

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2-­‐2 HOW TO VALUE PERPETUITIES
Example
What is the present value of $1 billion every year, for
all eternity, if you estimate the perpetual discount rate
to be 10%?

$1 bil
PV   $10 billion
0.10

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2-­‐2 HOW TO VALUE PERPETUITIES

Example continued
What if the investment does not start making money
for 3 years?

$1 bil  1 
PV   3
 $7.51 billion
0.10  1.10 

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2-­‐3 HOW TO VALUE ANNUITIES

Annuity: An asset that pays a fixed sum each

year for a specified number of years.
2-­‐3 HOW TO VALUE ANNUITIES

Annuity: An asset that pays a fixed sum each

year for a specified number of years.

1 1 
PV of annuity  C    t 
 r r 1  r  
2-­‐3 HOW TO VALUE ANNUITIES

PV Annuity Factor (PVAF): The present value

of $1 a year for each of t years.

1 1 
PVAF    t 
 r r 1  r  
2-­‐3 HOW TO VALUE ANNUITIES
Suppose that Tiburon Autos offers an “easy payment” scheme on a
new Toyota of $5,000 a year, paid at the end of each of the next five
years, with no cash down. What is the car really costing to you?

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2-­‐3 HOW TO VALUE ANNUITIES
• Example: The national lottery would pay a
prize of $365 millions to be paid in 30 years.
The lottery Will pay 12.167 millions at the end
of each year. What would be the PV of this
prize if we use a discount rate of 6%?
2-­‐3 HOW TO VALUE ANNUITIES

Annuity due: Level stream of cash flows starting

immediately.
How does it differ from an ordinary annuity?

PVAnnuity due  PVAnnuity  1  r 

2-­‐3 HOW TO VALUE ANNUITIES
Paying off a Bank Loan:

Bank loans are paid off in equal installments. Suppose

that you take out a four-year loan of $1,000.
The bank requires you to repay the loan evenly over
the four years.
It must therefore set the four annual payments so
that they have a present value of $1,000.
2-­‐3 HOW TO VALUE ANNUITIES
Beginning-of-Year Year-End Interest on Total Year-End Amortization of End-of-Year
Year Balance Balance Payment Loan Balance
1 $1,000.00 $100.00 $315.47 $215.47 $784.53

2 784.53 78.45 315.47 237.02 547.51

3 547.51 54.75 315.47 260.72 286.79

4 286.79 28.68 315.47 286.79 0

2-­‐3 HOW TO VALUE ANNUITIES

• Future value of an annuity:

 1  r t  1
FV of annuity  C   
 r 
2-­‐3 HOW TO VALUE ANNUITIES
• Suppose you invest $20,000 annually
at the end of each year at 8% interest.
After 5 years, how much would your
investment be worth?
 1  .085  1
FV  20,000   
 .08 
 $117,332
2-­‐4 GROWING PEPETUITIES
Present value of growing perpetuity

C1
PV0 
r g
g = the annual growth rate of the cash flow

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2-­‐4 GROWING PEPETUITIES
Example
What is the present value of $1 billion paid at the
end of every year in perpetuity, assuming a rate of
return of 10% and a constant growth rate of 4%?

1
PV0 
.10  .04
 $16.667 billion

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2-­‐5 GROWING ANNUITIES

• Growing annuitie
• To have a membresy of Golf club you need to pay a fee
of $5,000 during 3 years (at the end of each year) the
fee Will increase at a rate of 6% annualy. You have the
alternative option of making a single $12,750 payment
today. What would you do?

PV= 5.000 x 1/(0.1-0.06)x 1- (1+0.06)^3/(1+0.1)^3

=13,147
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SHORTCUTS FORMULAS
2-6 INTEREST RATES
Effective Annual Interest Rate*:
Interest rate that is annualized using
compound interest.

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2-6 INTEREST RATES
Annual Percentage Rate (APR)*:
APR  MR  12
Effective Annual Interest Rate (EAR):

EAR

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2-6 INTEREST RATES
Example:
Given a monthly rate of 1%, what is the effective
annual rate (EAR)? What is the annual percentage
rate (APR)?

EAR  (1  .01)12  1  r
EAR  (1  .01)12  1  .1268 or 12.68%

APR  .01  12  .12 or 12.00%

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2-6 INTEREST RATES
If you invest $100 in a bond where the interest rate is 10%
compunded semiannually.

100*(1+0,05) = 105; 105*(1+0.05) = 110.25.

The effective anual rate is 10.25%
= 0.1025 = 10.25%
2-6 INTEREST RATES
A mortgage of 200,000 euros for 30 years. With montly
payments were the montly interest rate is 1%

AF = = 97.218

PV = C*AF C= PV/AF
C = 200.000/97.218 = 2572 EUROS.
2-6 INTEREST RATES
If you invest $1 at a rate r per year compounded m
times a year your investment at the end of the year
will be worth: [1 + (r/m)]^m
2-6 INTEREST RATES
Interest rate can be compounded annually (m = 1),
semiannually (m = 2), monthly (m = 12), weekly
(m = 52), daily (m = 365),...

If m 1 then [1 + (r/m)]^m

Hence, $1 invested at a continuously compounded

rate r will grow to = (2.718)^r by the end of the first
year.

By the end of t years it will grow to

2-6 INTEREST RATES
Example: Investment of $1 at a continuously
compounded rate of 11% for one year.

• End-year value

• Same as investing at 11.6% a year annually

compounded.

• 2 years:
2-6 INTEREST RATES
Evenly-spread cash flows.

• Recall PV of a perpetuity that pays $C/year:

PV = C/r

• If payment is an even stream throughout the

year, same formula but substitute the
continuously compounded rate.
2-6 INTEREST RATES
If annually compounded rate is 18.5%, PV of $100 is
100/0.185 = $540.54

If is continuous compounding
(What is the value of r continuous compounding equivalent
to 18,5% EAR?)

1 euro in one year= 1.185

= 17%

PV = 100/0.17 = 588.24
2-6 INTEREST RATES
Example annuity:
vaccination program during 20 years. 1000 million
annually.
10% continuously compounded

= 9.53%
PV = C ; VP = C
PV = 1000= 8932 million