ADM 2350A

FORMULA SHEET
CHAPTER 4: TIME VALUE OF MONEY
LUMP SUM RELATIONS:
There are 4 variables in the lump sum relations, present value PV0, future value FVN, number of
periods N, and interest rate r. If you know 3 of the values, you can find the 4 th value using the
appropriate equation below;

PV0

FVN

1 r

FVN PV0 1 r

FVN

PV0

1 N

FVN

PV0

ln

ln 1 r

Note that all 4 of these equations are really the same equation rearranged to solve for the relevant
variable.
Sometimes the terminology present value interest factor PVIFr,N and future value interest factor
FVIFr,N are used in the PV0 and FVN equations:

PVIFr , N

1 r

FVIFr , N 1 r

ANNUITY RELATIONSHIPS:
An ordinary or regular annuity is a level periodic payment PMT at the END of EVERY
period for a specified number of periods N. Loan payments for mortgages and cars are examples
of ordinary annuities.
There are 4 variables in the calculation of the present value PV0 of an ordinary annuity.
These are the present value PV0, payment PMT, interest rate r, and number of periods N. The
following equations can be used for solving for the PV0, payment PMT, and number of periods
N:
1
1 1 r N

PV0 PMT

PMT

PV0
1

1 1 r N

PMT

PMT rPV0
ln 1 r

ln

Note that all 3 of these equations are really the same equation rearranged to solve for the relevant
variable. Unfortunately, solving for the interest rate r is a trial and error process unless you
have a scientific calculator with a solver function that does the trial and error process for you.
There are 4 variables in the calculation of the future value FVN of an ordinary annuity.
These are the future value FVN, payment PMT, interest rate r, and number of periods N. The
following equations can be used for solving for the FVN, payment PMT, and number of periods
N:
1 r 1

FVN PMT

PMT

FVN
1 r N 1

rFVN PMT
PMT

ln 1 r

ln

Note that all 3 of these equations are really the same equation rearranged to solve for the relevant
variable. Unfortunately, solving for the interest rate r is a trial and error process unless you
have a scientific calculator with a solver function that does the trial and error process for you.
Sometimes the terminology present value interest factor of an annuity PVIFAr,N and future
value interest factor of an annuity FVIFAr,N are used in the PV0, FVN, and 2 PMT equations:

PVIFAr , N

1
1 1 r N

1 r N 1

FVIFAr , N

An annuity due is a level periodic payment PMT at the BEGINNING of EVERY period for a
specified number of periods N. Leases for cars or apartments are examples of annuities due.
Sometimes the terminology present value interest factor of an annuity DUE PVIFADr,N and
future value interest factor of an annuity DUE FVIFADr,N are used in the PV0, FVN, and 2
PMT equations that we will show on the next page:

PVIFADr , N

1
1

1 r

PVIFAr , N 1 r
1 r

FVIFADr , N

1 r N 1
FVIFAr , N 1 r
1 r
r

There are 4 variables in the calculation of the present value PV0 of an annuity due. These
are the present value PV0, payment PMT, interest rate r, and number of periods N. The following
equations can be used for solving for the PV0, payment PMT, and number of periods N:

1 r PMT
1 r PMT rPV0
ln 1 r

PV0 PMT PVIFADr , N

PMT

ln

PV0
PVIFADr , N

Note that all 3 of these equations are really the same equation rearranged to solve for the relevant
variable. Unfortunately, solving for the interest rate r is a trial and error process unless you
have a scientific calculator with a solver function that does the trial and error process for you.
There are 4 variables in the calculation of the future value FVN of an annuity due. These are
the future value FVN, payment PMT, interest rate r, and number of periods N. The following
equations can be used for solving for the FVN, payment PMT, and number of periods N:

FVN PMT FVIFADr , N

PMT

rFVN 1 r PMT
1 r PMT

ln

FVN
FVIFADr , N

ln 1 r

Note that all 3 of these equations are really the same equation rearranged to solve for the relevant
variable. Unfortunately, solving for the interest rate r is a trial and error process unless you
have a scientific calculator with a solver function that does the trial and error process for you.
The formula for the present value of a growth annuity PVIFGAr,g,n is as follows:

1 g
N
1 r

PVIFGAr , g , N

for 1 g but g r and 1 N

rg

N
PVIFGAr , g , N
1 r

for g r and 1 N

The present value of the growth annuity can be used to find the PV of a series of payments
indexed for inflation or the PV of a finite stream of dividends growing at a constant rate.
The perpetuity factor PVIFAr, is as follows:
PVIFAr ,

1
r

Perpetual bonds, such as a British consols, and preferred shares are examples of perpetuities.

The growth perpetuity factor is as follows:

1
PVIFGAr , g ,

r g

for 1 g r

The Gordon Dividend Valuation Model in Chapter 8 incorporates the growth perpetuity factor as
do the various CCA tax shield formulas in Chapter 11.
Interest rates in North America are quoted as a nominal annual rate INOM with specified frequency
of compounding denoted by M. The effective annual rate EAR is calculated as follows:

I
EAR 1 NOM
M

Often the frequency of payments Q does NOT match the specified frequency of compounding
M. In this situation the effective periodic rate EPR for a payment period is given by the
following equation:

I
EPR 1 NOM
M

Only when the payment frequency Q equals the specified compounding frequency M does
EPR for a payment period equal INOM/M.
A typical example of M Q is for mortgages, where by the Bank Act M = 2 and payments are
made monthly (Q = 12), semimonthly (Q = 24), biweekly (Q = 26), or weekly (Q = 52). Car
loans have M = 12 and payments may NOT be monthly. Semimonthly (Q = 24), biweekly (Q =
26), and weekly (Q = 52) car payments are increasingly being negotiated.

CHAPTER 6: BONDS, BOND VALUATION, AND INTEREST RATES

The value VB of a bond that makes an annual interest payment INT with a maturity value M with
N years to maturity and a yield to maturity YTM = rd is given by the following formula:

INT PVIFAr ,N M PVIFr ,N

d

1,000 *($80 PVIFA6%,10 1000 PVIFA6%,10 )

Bonds in Canada typically pay interest semi-annually even though the coupon interest rate
I is quoted as a nominal annual rate. The above valuation formula must be modified. The
interest payment INT is replaced by the semi-annual interest payment INT/2, the yield to
maturity rd is replaced the effective semi-annual rate rd/2, and the number of years N is replaced
by the number of semi-annual periods 2N as shown in the following equation:
5

INT

VB

2

1
1 rd

rd
2

2N

M
1 rd

2N

INT

PVIFArd /2,2 N M PVIFrd /2,2 N

2

An approximation formula for the YTM = rd is given by the following formula:

M Vb

2Vb M

INT

YTM

Since it is an approximation formula, it may be used for annual or semi-annual pay bonds using
annual values.
Remember that nominal or quoted bond yield to maturity rd includes the risk-free rate rRF,
the default risk premium DRP, the liquidity risk premium LP, and the maturity risk
premium MRP.
rd rRF DRP LP MRP

Note the Treasury-bill rate rT-bill is often suggested in theory to be the risk-free rate rRF, which
is a real rate r* plus an inflation premium IP. In practice, however, the Canada long-bond rate
is often used as the risk-free rate in cost of equity calculations using the SML (discussed in Chs.
7 & 9) even though the long-bond rate includes a maturity risk premium
rT bill rRF r * IP

CHAPTER 7: RISK, RETURN, AND THE CAPITAL ASSET PRICING MODEL

According to the Security Market Line (SML) of the Capital Asset Pricing Model (CAPM), the
required rate of return ri on stock i is equal to the risk-free rate rRF plus the product of the
market risk premium (rM rRF) times the beta bi of stock i.
ri rRF rM rRF bi
Although the Treasury-bill rate is suggested in theory as the risk-free rate, in practice the Canada
long-bond rate is used in the SML when estimating an equity cost of capital.

When forming a portfolio of assets the portfolio beta bp is simply the weighted average of the
individual asset betas bi, where the weights wi represent the fractions of investment in the
individual assets.
n

i 1

i 1

bp wi bi with wi 1
The beta bi of a stock is often estimated by regressing the stock risk premium (ri rRF) against
the market risk premium (rM rRF). The resulting estimate of beta bi is the covariance of the
stock risk premium with the market risk premium COVi,M divided by the variance of the
market risk premium M2.

bi

COViM
M2

Just as the portfolio beta is a weighted average of individual betas, the portfolio return rp is a
weighted average of individual stock returns ri.
n

i 1

i 1

rp wi ri with wi 1

CHAPTER 8: STOCKS, VALUATION, AND STOCK MARKET EQUILIBRIUM

For preferred or preference shares that never mature and pay a constant dividend, the preferred
1
.
rps
stock price Pps is the product of the preferred dividend Dps and perpetuity factor

D
Pps ps
rps
The Gordon Constant Growth Dividend Valuation Model incorporates the perpetuity growth
P0
factor developed in Chapter 4. This model estimates the stock price for common equity
as
1
rs g
the product of the first dividend D1 times the growth perpetuity factor

D1
P0
rs g

Rearranging this formula to get an estimate of the cost of common equity

rs

rs

yields

D1
g
P0

This equation is often referred to as the Gordon Dividend Valuation Model in Yield Form.
An estimate of the dividend growth rate g is the product of the retention rate b times the
return on common equity ROE.
g b ROE

Sometimes a stock grows initially at a pace that is erratic or is non-sustainable before settling
down to a sustainable growth rate. In this case, the stock price can be estimated as follows:
N

P0
t 1

Dt

1 rs

PN

1 rs

D
where PN N 1
rs g

The first N dividends may contain embedded annuities or growth annuities where the PVIFA or
PVIFGA factors developed in Chapter 4 can be applied.

CHAPTER 9: THE COST OF CAPITAL

The weighted average cost of capital is calculated as follows:
WACC wd rd 1 T w ps rps wCE rs where wd w ps wCE 1
There are 3 methods commonly used for estimating the common equity cost of capital. These are
the Gordon Dividend Valuation Model in Yield Form, the required rate of return from the SML
of the CAPM, and the bond yield plus risk premium method. A weighted average of the 3
methods is usually employed to get a best estimate of the cost of common equity. Sometimes
only 2 of the methods are employed when data is unavailable for one of the methods.
When there are flotation costs, only the Gordon Dividend Model in Yield Form can be employed.
In this case, any overestimate (underestimate) of the Gordon yield compared to the best estimate
without flotation costs is subtracted (added) to the Gordon yield with flotation costs to arrive at a
best estimate for the cost of common equity with flotation costs. For example, if the Gordon
estimate without flotation costs underestimates the best estimate without flotation costs by 25
basis points or 0.25%, then these 25 basis points or 0.25% must be added to the Gordon estimate
with flotation costs to get the best estimate of common equity with flotation costs.
The Gordon estimate with flotation costs is as follows:

re

D1
g
P0 1 F

Note that the subscript is now e on the return variable to indicate that this an estimate of the
cost of external equity capital. F is the flotation cost expressed as a percentage of the current
price. Note that if F is given as 25%, you must use its decimal equivalent 0.25 in the formula.
The cost of preferred shares is given as follows:

rps

D ps
Pps

Flotation costs could incur with preferred shares.

rps

D ps

Pps 1 F

The flotation percentage for preferred shares F typically has a much lower value than the
flotation percentage associated with the issuing of new common equity.
There can be flotation costs associated with issuing new debt. However, the flotation percentage
for debt is typically so low that the impact of the debt flotation percentage is usually negligible
on the WACC.

CHAPTER 10: CAPITAL BUDGETING BASICS: EVALUATING CASH FLOWS

The Net Present Value NPV of a project is simply the present value of all the cash flows:
NPV CF0

CF1

1 r

CF2

1 r

CFN

1 r

t 0

CFt

1 r

The Internal Rate of Return IRR is the discount rate that makes the NPV of project be ZERO.
NPV CF0

CF1

1 IRR

CF2

1 IRR

CFN

1 IRR

t 0

CFt

1 IRR

The Profitability Index PI is the ratio of the PV of future cash inflows to initial investment INV.
N

PI

CFt

1 r
t 1

CF0

where CF0 INV

10

The Payback Period PB is the expected number of years required to recover the initial
investment.

PB Number of years prior to full re cov ery

Unre cov ered cos t at start of year

Cash flow during full re cov ery year

CF1 CF2 CFN CF

If the cash inflows
after the initial investment INV are an annuity,
then PB can be calculated as follows:

INV
CF

PB

The Discounted Payback Period DPB is similar to PB but the cash flows are discounted.
The Equivalent Annual Annuity EAA is the NPV of project divided by the PVIFA at the project
cost of capital rate r for the life of the project N.
EAA

NPV
PVIFAr , N

The EAA is useful for comparing mutually exclusive repeatable projects that have non-identical
lives.

CHAPTER 11: CASH FLOW ESTIMATION AND CAPITAL BUDGETING

The 5 steps of the CCA Formula Approach are as follows:
STEP 1: Calculate the PV of the After-Tax Net Revenues.

Rt Ot 1 T
t
t 1
1 r
N

PV

If the after-tax net revenues are an annuity, this calculation simplifies.

PV R O 1 T PVIFAr , N
STEP 2: Calculate the PV of all CCA Tax Shield Effects.
TdC
PV
r d

1 0.5
1 TdS N
r

1 r
1 r r d

STEP 3: Calculate the PV of the Salvage Value SN.

11

PV

SN

1 r

STEP 4: Calculate PV of Net Operating Working Capital NOWC effects for Years 1 through N.
N

PV
t 1

NOWCt

1 r

STEP 5: Subtract the Initial Investment INV.

- INV= - C NOWC0 Opportunity Cost
When using the Cash Flow Analysis Approach, remember to include the correction term for
Year N denoted PVN to account for CCA tax shields in Years N + 1 through infinity when UCC N
SN.
Td UCCN S N

rd

PVN

12