Simple Interest.

Valuation of Money Market Instruments

Example 1
You invest in a 181-day sterling CD with a face value of 1,000,000 and a coupon of 11%. What are
the total maturity proceeds?

Example 2
You purchase some sterling Eurocommercial paper as follows:
Purchase value date: 2 July 20X6
Maturity value date: 2 September 20X6
Yield: 8.2%
Amount: 2,000,000.00
What do you pay for the paper?

Example 3
An investor seeks a yield of 9.5% on a sterling 1 million 60-day bankers acceptance. What is the
discount rate and the amount of this discount?

Example 4
If the discount rate were in fact 9.5%, what would the yield and the amount paid for the bankers
acceptance be?

Example 5
The rate quoted for a 91-day US treasury bill is 6.5%.
a. What is the amount paid for US$1,000,000.00 of this T-bill?
b. What is the equivalent true yield on a 365-day basis?

The Applications of the Concept of Present Value in Financial Management

The basic formula for present value used in corporate finance is as follows:

FCF1 FCF2 FCF3 FCFn

PV ............
1 r 1 r 1 r
2 3
1 r n

PV present value of a series of cash flows

FCF the value of the future cash flow
r yearly interest rate (required rate of return, yield)
n the number of periods in the series of cash flows

Value of Bonds

h Cj N
PV
t j 1 YTM
tj
1 YTM th
PV present value of the bond,
YTM yield to maturity required rate of return,
tj consecutive payment of coupon expressed in years
C coupon payments,
N face value of the bond
 f
C N
m

fi - annual coupon in percent

m number of coupon payments in a year

m
i
YTM EAR 1 1
m
i - the annual interest rate

Example 6
The face value of a bond amounts to PLN 1,000. The redemption term expires in 5 years. The coupon
rate is 15% and the interest is payable annually at the end of each year. Price the bond taking into
account that YTM on investments in such instruments is 12%.

Example 7
Calculate the present value of a 10-year bond having the following parameters: face value: PLN 500;
coupon rate (p.a.): 4%; coupon payable quarterly; YTM: 10%.

Example 8
The company ABC has been trying to sell the real estate it currently holds on the balance sheet. There
is a willing buyer, who agrees to buy the asset under condition of dividing the payment into 5 equal
yearly installments. The first installment should be paid in one year and equal 10 mln PLN. What is
the total value of the real estate, if the cost of capital for the investor equals 10%.

The value of perpetuity is calculated as follows:

FCF
PV
r

This formula serves to value instruments or assets, which will yield to its owners constant stream of
cash flows in regular intervals over an indefinite time period. It is impossible to calculate the future
value of a perpetuity as it approaches infinity.

When calculating the present value of a stream of cash flows growing at a steady rate g, we rely on
the below formula:

FCF 1 g
PV
rg

where: FCF the free cash flow in the first period of calculation of the steadily growing perpetuity,
g the rate of growth of the free cash flows.

Example 9
Please value an office building with the following parameters:

m2 10 000
 Monthly rent EURO / m 15
Monthly inflow 150 000
Monthly maintenance costs 45 000
Income
tax rate 19%
Income 105 000
Yearly cash flow for the owner 1 260 000
Planned rate of growth of cash flows 2%
Expected rate of return on invested
capital 15%

Example 10
Please evaluate an investment in private residential real estate (apartment):

(m 2) 55
Monthly rent 2 100
Lump-sum tax rate 8,50%
Location Warsaw
Monthly income 1 922
Average number of months of occupancy per
11
year
Provision for renovation 120
Expected rate of return 7,00%
Planned rate of growth of rent 1%

The current market price of the apartment if 7 200 z / m2. Taking into account the above information,
evaluate the rate of return achieved by the investor when deciding to buy an apartment.

Example 11
An entrepreneur in currently in the process of negotiation with a VC company regarding potential
purchase of his company. Financial analysis of the company shows that currently the firm generates
the FCF at the level of 350 thousand PLN. The market analysis shows that in the forthcoming 4 years
the FCF is expected to grow at the rate of 10% per year. The following 4 years should result in gradual
stabilization of FCF. The long-term projections are highly uncertain. To reduce the risk, the valuator
adopted an assumption of gradual decay of the FCF at the pace of 1% per year in the residual period.
Please estimate the value of the company, taking into account that the rate of return required by the
VC company is equal to 20%.

Example 12
The following data is available regarding the financial prospects of the company WAB Sp. z.o.o.:
FCFE in the forthcoming years equal: 100, 500, 300. After 3 years the cash flows will be growing at
a steady pace of 4% per year. The rate of return required by the stockholders equals 11%. Taking into
account the presented information please estimate the value of the companys stock and the share of
residual value in the total value assuming that the projection period equals a) 3 years; b) 8 years.

CAPITAL BUDGETING
Simple Methods of Project Evaluation Concept of Break Even Point
Concept of Break Even Analysis

Break even analysis is based on several quite material simplifications:

 Output volume is equal to sales volume (this assumption is used in a situation when we want to base
our CVP analysis on total costs; this shortcoming is eliminated using variable costs);
Range of products sold is constant and unit prices of sale and variable unit costs remain constant,
too;
Only those products that fall within the significant output range are subject to analysis;
Fixed costs remain constant in significant output range;
Total costs and revenue are lineary functions of sales volume.

Example 13
An entrepreneur is considering the economic viability of opening a retail outlet in the local shopping
centre where brand clothes are sold. According to his projections, he would have to rent premises
with the area of ca. 110 square metres and employ three members of staff. The rent is ca. PLN 113
per meter. The cost of employing one employee will be ca. PLN 3,000 per month. Other shop-related
expenses (telephones, security, etc.) are estimated at ca. PLN 2,000 per month. The entrepreneur
expects to apply a 30% mark-up on merchandise purchased from suppliers. The expected
investment outlays and purchases of merchandise are to amount PLN 150,000. The shop is
expected to be open 280 h a month, on the average. Please calculate:
a) Turnover at which the owner will break even in each month;
b) Monthly turnover at which the investment will pay off within 15 months;
c) Based on experience, the average bill paid by customers in shops of that type is ca. PLN 50. How
many customers would have to make purchases during one average hour of shop operation to make
the assumption of recovering investment within 15 months real?

Calculation of Fixed Costs Break Even 10,000 in Profit

Costs of Equity Funds and External Funds

Estimation of equity costs based on CAPM model

The formula to calculate the value of the rate of return required by the diversified stockholders, in
accordance with CAPM model:

where: re expected return on equity, rf return on zero-risk assets (e.g.: Treasury bills ), rm return
on market portfolio (this parameter may be estimated based on the observation of the stock exchange
index), b - measurement of the response of the rate of return on a particular share to changes on the
securities market.
Assumptions of CAPM model
- Investment RISK in respect of shares, measured by sensitivity of the value of a particular share to
changes in the stock exchange index. Observations of historical share prices and indexes serve this
purpose.
- the MODEL assumes that the higher the risk, the higher the rate of return expected for investors.
- Sensitivity of the share value to changing values of the stock exchange index is measured by the so-
called beta.
- beta VALUES ====> beta <1 => a share that is less sensitive to changes in the index, a lower risk
as compared to investment in the market portfolio; beta >1 => a share that is more sensitive to changes
in the index, a higher risk as compared to investment in the market portfolio.

Shortcomings of CAPM model for estimating equity costs

- the model does not take into consideration the specific risk
- if calculated on the basis of historical data, the model may not reflect the current risk
- possibility of manipulation
- considerable problem with determining the market risk premium
- the Stock Exchange concentration does not allow for assuming that indexes change accordingly to
events of general economic nature
- structure of listed companies does not reflect the GNP, therefore indexes may change as a result of
events,
which affect industries represented to a formidable extent on the stock exchange.

Example 14
Alfa and Beta companies obtain the identical result from operations (EBIT) - 1000 mu. Alfa company
is financed with own funds, only, while Beta companys liabilities disclose , in addition to own funds,
a credit in the amount of 1000 mu with the interest rate applicable on the credit in the amount of 20%
annually (this is bullet interest, paid at the end of a year). Both companies pay a 40% income tax.
Please, calculate the real cost of financing with external funds taking into consideration the tax shield
effect.

Example 15
Please, calculate the cost of a two-year credit of the following parameters: the value of 1million zlotys,
the (annual) interest rate 10%, installments and interest paid twice a year, assuming that:
a) a company does not pay the income tax, fees and charges on the credit,
b) the company pays the income tax at the rate of 19% but it does not pay fees and charges on the
credit,
c) the credit has the following additional parameters: 500 thousand instantly, 500 thousand after 30
days.
On contracting the credit, the enterprise pays a 1.5% bank fee (calculated on the credit amount). The
credit is to be repaid at equal principal installments and variable interest installment. The company,
being the borrower, pays the income tax at the rate of 19%.

Estimation of weighted average cost of capital for the purpose of enterprise valuation
The weighted average cost of capital (WACC) is calculated according to the following formula:

where: r cost of particular elements of capital, u share of particular elements of capital in their
total value.

Example 16
The cost of the share capital of a certain company amounts is calculated based on CAPM (risk free
rate 5%, market premium 7%, beta 1,3), the nominal cost of a long-term credit amounts to 12%,the
 nominal cost of capital raised from the issue of bonds amounts to 11%. Interest on the bonds is paid
twice a year, the credit is repaid four times a year. We also know that the market value of the share
capital equals 1000 mu, the nominal value of shares amounts to 700, the nominal value of the long-
term credit: 500, the nominal value of the issued bonds: 300. On the basis of the available data and
the information that the tax rate amounts to 19%, please, estimate the value of WACC.

Value Creation Process

Estimation of value for shareholders which allows to check whether the enterprise is following the
strategy of maximizing value for shareholders (VBM) implies discounting of projected free cash
flows, that is, converting future cash flows to current value, accounting for the rate of return expected
by the owners. The concept of this conversion is presented in the chart below:
In the case of valuation of stocks / shares of the company, this formula looks as follows:

Estimation of share value

Opis do rysunku:
FCF1 FCF2 FCF3 FCF4 FCF5 FCFn FCF

Balance sheet of the enterprises in market values

present

share Aktywa
value trwae =
Aktywa obrotowe = current assets
Kapitay wasne = Equity
bringing future cash flows to present value, or discounting,
Dug oprocentowany = Interest-bearing debt

where
r - the annual interest rate
m - the number of compounding during a year
PV Present Value (single amount)
FCF Free Cash Flow at the beginning of perpetuity
g the constant grow rate
Example 17
EF company wishes to assess the value of its AS Devision. This division holds debt with market
value of $10 000 000 and no preffered stock outstanding. Its WACC is 10%. The AS Devisions
estimated free cash flow for firm (FCFF) each year 2013 through 2016 is given in the following table.
FCF in year 2016 is equal to net profit (depreciation equals investment). Beyond 2016 to infinity,
the firm expects its free cash flow to grow at 3% annually.
year FCFF
2013 700 000
2014 1 200 000
2015 1 100 000
2016 1 200 000

a) Use the FCF valuation model to estimate the value of entire AS Devision.
b) Use your finding in part a along with the data provided above to find this divisions common
stock value.
c) If a AS Division is a public company having 500 000 shares outstanding, use your finding in
part b to calculate its value per share.

Calculation What is being Calculation method

Discount rate
model calculated
n
FCFFt CVFCFFt
V NOA
t 1 (1 WACC )t (1 WACC ) n
FCFF WACC - Company value where: V company value including
(Discounted Weighted including debt (funds debt, CVFCFF continuation value
Free Cash average cost available to owners and calculated from the standpoint of all
Flow to Firm) of capital creditors) parties providing financing, NOA
value of non-operating assets

EVA n EVAt RV t
Company value V CI NOA
(Discounted t 1 (1 WACC )
t
1 WACC t
including debt (funds
Economic WACC
available to owners and where: V - company value including
Value Added)
creditors) debt, CI invested capital level

FCFF - owners + other financing parts (banks, bondholder, leasing companies)

Revenue on sales
- Operational costs (net of depreciation)
- Depreciation
= Operating profit (EBIT)
- Income tax*
= Net Operating Profit After Taxes (NOPAT)

+ Depreciation
- Capital expenditure
- Working capital investment
+ Continuing or (residual value)

= FCFF

Example 18
The management board of the ABC company is thinking of implementing a new strategy which
entails making certain investment expenses. However, the forecast says that investment would
translate into an increase of revenues. Valuation for the company without including the strategy
has shown that the value of equity (MV) of the ABC company amounts to PLN 25.3 million.
without strategy
thousand
E (equity) 5 300 PLN
thousand
D at beginning of period 200 PLN
V (value of indebted
company) 5 500 thousand PLN
The accounting balance sheet of ABC company is presented below:

Assets OB.
Fixed assets 5 200
Current assets 900
Inventories 300
Accounts receivable 300
Cash 300
Total assets 6 100

Liabilities and equity OB.

Stockholder's equity 5 700
Common Stock 5 000
Capital surplus / Accum. Retain earning 500
Net Incom 200
Liabilities 400
Long-term debt 200
Accounts payable 200
Total liabilities and stockholder's equity 6 100

Forecast of economic values assuming the strategy is implemented

in thousand
Year 1 Year 2 Year 3 Year 4
Sales revenues 21 125 28 920 33 100 33 209
Operating costs, less depreciation 17 893 24 033 28 231 28 321
Depreciation 389 1 270 1 142 1 600

Investments into fixed assets 1 706 1 997 2 437 1 600

Working capital investment 1 112 505 111 3

The market value of non-operating assets (fixed assets and securities which are not needed for FCF
creation) is 300 thousand. The average expected rate of return by all capital providers (WACC)
amounts to 13%. Starting value of interest-bearing debt is 2 00 thousand zloty. The market data
suggests that after 4 years, the free cash flows should reach a stable level. On the basis of the planned
results please determine if the strategy would increase company value for its owners. Estimate value
of one share taking into consideration that ABC issued 1 million shares.
Tax rate = 19%