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Chapter 3

Chapter 3. Principles of Corporate Finance, 8/e (Special Indian Edition). How to Calculate Present Values. Topics Covered. Valuing Long-Lived Assets PV Shortcuts – Perpetuities and Annuities Compound Interest & Present Values Nominal and Real Rates of Interest (inflation).

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Chapter 3

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  1. Chapter 3 Principles of Corporate Finance, 8/e (Special Indian Edition) How to Calculate Present Values

  2. Topics Covered • Valuing Long-Lived Assets • PV Shortcuts – Perpetuities and Annuities • Compound Interest & Present Values • Nominal and Real Rates of Interest (inflation)

  3. Present Values Discount Factor = DF = PV of Rs.1 • Discount Factors can be used to compute the present value of any cash flow.

  4. Present Values • Discount Factors can be used to compute the present value of any cash flow.

  5. Present Values • Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time

  6. Present Values Example You just bought a new computer for Rs.3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

  7. Present Values • PVs can be added together to evaluate multiple cash flows.

  8. Present Values • PVs can be added together to evaluate multiple cash flows.

  9. Present Values Rs.200 Rs.100 Present Value Year 0 100/1.07 200/1.0772 Total = Rs.93.46 = Rs.172.42 = Rs.265.88 Year 0 1 2

  10. Present Values • Given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r1 = 20% and r2 = 7%.

  11. Present Values Example Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

  12. Present Values Example - continued Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

  13. Present Values Example - continued Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value. +Rs.320,000 -Rs.100,000 -Rs.170,000 = -Rs.170,000 = Rs.95,238 = Rs.290,249 = Rs.25,011 Present Value Year 0 -170,000 -100,000/1.05 320,000/1.052 Total = NPV Year 0 1 2

  14. Short Cuts • Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tolls allow us to cut through the calculations quickly.

  15. Short Cuts Perpetuity - Financial concept in which a cash flow is theoretically received forever.

  16. Short Cuts Perpetuity - Financial concept in which a cash flow is theoretically received forever.

  17. Short Cuts Annuity - An asset that pays a fixed sum each year for a specified number of years. Asset Year of Payment 1 2…..t t + 1 Present Value Perpetuity (first payment in year 1) Perpetuity (first payment in year t + 1) Annuity from year 1 to year t

  18. Short Cuts Annuity - An asset that pays a fixed sum each year for a specified number of years.

  19. Annuity Short Cut Example You agree to lease a car for 4 years at Rs.3000 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

  20. Annuity Short Cut Example - continued You agree to lease a car for 4 years at Rs.3000 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

  21. Compound Interest i ii iii iv v Periods Interest Value Annually per per APR after compounded year period(i x ii) one year interest rate 1 6% 6% 1.06 6.000% 2 3 6 1.032 = 1.0609 6.090 4 1.5 6 1.0154 = 1.06136 6.136 12 .5 6 1.00512 = 1.06168 6.168 52 .1154 6 1.00115452 = 1.06180 6.180 365 .0164 6 1.000164365 = 1.06183 6.183

  22. Compound Interest

  23. Compound Interest

  24. Compound Interest Example Suppose you are offered an automobile loan at an APR of 6% per year. What does that mean, and what is the true rate of interest, given monthly payments?

  25. Compound Interest Example - continued Suppose you are offered an automobile loan at an APR of 6% per year. What does that mean, and what is the true rate of interest, given monthly payments? Assume Rs.10,000 loan amount.

  26. Inflation Inflation - Rate at which prices as a whole are increasing. Nominal Interest Rate - Rate at which money invested grows. Real Interest Rate - Rate at which the purchasing power of an investment increases.

  27. approximation formula Inflation

  28. Inflation Example If the interest rate on one year govt. bonds is 5.9% and the inflation rate is 3.3%, what is the real interest rate? Savings Bond

  29. Inflation Rates in India (1948 - 2006) 0.3 0.25 0.2 0.15 0.1 0.05 0 -0.05 1952- 1957- 1962- 1967- 1972- 1977- 1982- 1987- 1992- 1997- 2002- 53 58 63 68 73 78 83 88 93 98 03 -0.1 -0.15 -0.2 Inflation

  30. Web Resources Web Links Click to access web sites Internet connection required www.bankrate.com www.money.cnn.com www.quicken.com www.smartmoney.com

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