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Basic Financial

Concepts
Time Value of Money
Investment Decision Making
Risk and Return

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Corporate Finance
Peoplehave been running business for
thousands of years.
Corporate Finance is few decades old.

Principles of Corporate Finance are


commonsense and have changed very
little over time.
It tried to provide some structures, mainly
on detailing.

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Corporate Finance
Maximizing Value
Investment Decisions
Financing Decisions
Dividend Decisions

Tools
Time Value
Risk & Return

Applications
Leasing
Short Term Financial Management
Mergers and Acquisitions
Derivatives
International Finance
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Time Value of Money

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The Interest Rate
Which would you prefer -- Rs. 10,000
today or Rs. 10,000 in 5 years?

Obviously, Rs. 10,000 today.

You already recognize that there is TIME


VALUE TO MONEY!!

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Why TIME?

Why is TIME such an important


element in your decision?

TIME allows you the opportunity to


postpone consumption and earn
INTEREST.

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Types of Interest
Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).

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Simple Interest Example
Assume that you deposit Rs. 1,000 in
an account earning 7% simple interest
for 2 years. What is the accumulated
interest at the end of the 2nd year?

SI = P0(i)(n)
= Rs. 1,000(.07)(2)
= Rs. 140
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Simple Interest (FV)
What is the Future Value (FV) of the
deposit?
FV = P0 + SI
= Rs. 1,000 + Rs. 140
= Rs. 1,140
FutureValue is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
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Simple Interest (PV)
What is the Present Value (PV) of the
previous problem?
The Present Value is simply the
Rs. 1,000 you originally deposited.
That is the value today!
PresentValue is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
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rate.
Future Value
Single Deposit (Graphic)
Assume that you deposit Rs. 1,000
at a compound interest rate of 7%
for 2 years.
0 1 2
7%
Rs. 1,000
FV2
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Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = Rs. 1,000 (1.07)
= Rs. 1,070
Compound Interest
You earned Rs. 70 interest on your Rs.
1,000 deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
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Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = Rs. 1,000 (1.07)
= Rs. 1,070
FV2 = FV1 (1+i)1
= P0 (1+i)(1+i) = Rs. 1,000(1.07)(1.07)
= P0 (1+i)2 = Rs. 1,000(1.07)2
= Rs. 1,144.90
You earned an EXTRA Rs. 4.90 in Year 2 with
compound over simple interest.
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General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:


FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- Exhibit 1
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Using Future Value Tables
FVIFi,n is found on Exhibit 1

FV2 = Rs. 1,000 (FVIF7%,2)


= Rs. 1,000 (1.145)
= Rs. 1,145 [Due to Rounding]
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
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Example
You want to know how large your deposit
of Rs. 10,000 today will become at a
compound annual interest rate of 10% for 5
years.
0 1 2 3 4 5
10%
Rs. 10,000
FV5
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Solution
Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = Rs. 10,000 (1+ 0.10)5
= Rs. 16,105.10
Calculation based on Table:
FV5 = Rs. 10,000 (FVIF10%, 5)
= Rs. 10,000 (1.611)
= Rs. 16,110 [Due to Rounding]

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Present Value
Single Deposit (Graphic)
Assume that you need Rs. 1,000 in 2 years.
Lets examine the process to determine how
much you need to deposit today at a discount
rate of 7% compounded annually.

0 1 2
7%
Rs. 1,000
PV0 PV1
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Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2 = Rs. 1,000 / (1.07)2
= FV2 / (1+i)2 = Rs. 873.44

0 1 2
7%
Rs. 1,000
PV0
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General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.

General Present Value Formula:


PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- Exhibit 2
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Valuation Using Table
PVIFi,n is found on Exhibit 2

Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
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Using Present Value Tables
PV2 = Rs. 1,000 (PVIF7%,2)
= Rs. 1,000 (.873)
= Rs. 873 [Due to Rounding]
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
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5 .747 .713 .681
Example
You want to know how large of a deposit to
make so that the money will grow to Rs. 10,000
in 5 years at a discount rate of 10%.

0 1 2 3 4 5
10%
Rs. 10,000
PV0
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Solution
Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = Rs. 10,000 / (1+ 0.10)5
= Rs. 6,209.21
Calculation based on Table I:
PV0 = Rs. 10,000 (PVIF10%, 5)
= Rs. 10,000 (.621)
= Rs. 6,210.00 [Due to Rounding]
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Types of Annuities
AnAnnuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
Ordinary Annuity: Payments or receipts
occur at the end of each period.
AnnuityDue: Payments or receipts
occur at the beginning of each period.

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Examples of Annuities

Student Loan Payments


Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings

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Parts of an Annuity
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

Rs. 100 Rs. 100 Rs. 100

Today Equal Cash Flows


Each 1 Period Apart
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Parts of an Annuity
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

Rs. 100 Rs. 100 Rs. 100

Today Equal Cash Flows


Each 1 Period Apart
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Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R
R = Periodic
Cash Flow

FVAn
FVAn = R(1+i)n-1 + R(1+i)n-2 +
... + R(1+i)1 + R(1+i)0
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Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
Rs. 1,000 Rs. 1,000 Rs. 1,000

Rs. 1,070
Rs. 1,145
FVA3 = Rs. 1,000(1.07)2 +
Rs. 1,000(1.07)1 + Rs. 1,000(1.07)0 Rs. 3,215 = FVA3
= Rs. 1,145 + Rs. 1,070 + Rs. 1,000
= Rs. 3,215

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Valuation Using Exhibit 3
FVAn = R (FVIFAi%,n)
FVA3 = Rs. 1,000 (FVIFA7%,3)
= Rs. 1,000 (3.215) = Rs. 3,215

Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
REVISE TABLE
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
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Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
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Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%

$1,000 $1,000 $1,000


$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
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= $2,624.32
Valuation Using Table 4
PVAn = R (PVIFAi%,n)
PVA3 = $1,000 (PVIFA7%,3)
= $1,000 (2.624) = $2,624
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
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Amortizing a Loan Example
Sunil is borrowing Rs. 10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment
PV0 = R (PVIFA i%,n)
Rs. 10,000 = R (PVIFA 12%,5)
Rs. 10,000 = R (3.605)
R = Rs. 10,000 / 3.605 = Rs. 2,774
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Amortizing a Loan Example
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000

[Last Payment Slightly Higher Due to Rounding]


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Exercises
1. You just turned 35 and have been saving for an around-the-
world vacation. You want to take the trip to celebrate your
40th birthday. You have set aside, as of today, $15,000 for
such a trip. You expect the trip will cost $25,000. The financial
instruments you have invested the $15,000 in have been
earning, on average, about 8%. (You may ignore income
taxes)
Will you have enough money in that vacation account on your
40th birthday to take the trip? What will be the surplus, or
shortfall, in that account when you turn 40?
If you had to, you could further fund the trip by making,
starting today, five annual $500 contributions to the account.
If you adhere to such a plan, how much will be in the account
on your 40th birthday?
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2. Your company has been offered a contract for the development and
delivery of a solar powered military troop transport vehicle. The request
for proposal provides all the necessary technical specifications and it also
stipulates that two working, economically feasible prototypes must be
delivered in four years, at which time you will receive your only customer
paymenta single final payment of $50 million. Assume a reinvestment
interest rate of 18% for all the monies received over the next four years.
(You may ignore income taxes.)

a. What lump-sum dollar amount would you be willing to accept today


instead of the $50 million in four years?
b. Alternatively, what four yearly receipts, starting a year from now, might
you be willing to accept?

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3. The aged but centrally located golf course you manage does
not have an in-ground automated water sprinkling system.
Instead, to properly water the course, sprinklers and hoses must
be repeatedly set, moved, and put away by some of the grounds
crewa tedious and laborious task. If over the next 12 years you
project annual savings of about $40,000 from having an
automated system, what is the maximum price you would be
willing to pay today for an installed, automated golf course
sprinkler system? (Assume an interest rate of 6%, and you may
ignore income taxes.)
a. Redo your calculation using a 10-year time period and $48,000
in annual savings.
b. Redo your initial calculation one more time using $50,000 in
annual savings for the first six years and $30,000 in annual
savings for the next six years.
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4. The cafeteria you operate has a regular clientele for all three
meals, seven days a week. You want to expand your product line
beyond what you are currently able to offer. To do so requires the
purchase of some additional specialty equipment costing $45,000,
but you project a resultant increase in sales (after deducting the
cost of sales) of about $8,000 per year for each of the next eight
years with this new equipment. Assuming a required rate of return
(i.e., a hurdle rate) of 8%, should you pursue this opportunity?
Why or why not? Do the analysis under two conditions:
a. You are part of an income-tax-exempt enterprise
b. The enterprise you are part of is subject to a 40% corporate
income tax rate and the straight-line, depreciable life of the
equipment you are contemplating purchasing is five years.

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5. You are contemplating the purchase of a one-half interest in a corporate
airplane to facilitate the expansion of your business into two new
geographic areas. The acquisition would eliminate about $220,000 in
estimated annual expenditures for commercial flights, mileage
reimbursements, rental cars, and hotels for each of the next 10 years. The
total purchase price for the share is $6 million, plus associated annual
operating costs of $100,000. Assume the plane can be fully depreciated,
on a straight-line basis, for tax purposes over 10 years. The companys
weighted average cost of capital (WACC) is 8%, and its corporate tax rate
is 40%. Does this endeavor present a positive or negative net present
value (NPV)? If positive, how much value is being created for the company
through the purchase of this asset? If negative, what additional annual
cash flows are needed for the NPV to equal zero? To what phenomena
might those additional positive cash flows be ascribable?

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6. The final tally is in: This years operating costs were
down $100,000, a decrease directly attributable to the
$520,000 investment in the automated materials handling
system put in place at the beginning of the year. If this level
of annual savings continues for five more years, resulting
in six total years of annual savings, what compounded
annual rate of return will that represent? If these annual
savings continue for nine more years, what compounded
annual rate of return will that represent? (You may ignore
income taxes.)

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Name:
Roll no: 123

X = Unit place digit of your roll no


Y = Tenth place digit of your roll no
You plan to buy a property when your age would be: 30 + X
Your present age: 20 + Y
Cost of the property at present: Rs (40 +X) lakhs
The property cost is expected to increase @ 8% per year
Your current savings: Rs (20 + Y) lakhs
Earning from your investments: 10% per year

How much you must save per year (at the end of the year) so that you can buy the property.

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