FM101 – Week 2 – Time Value of Money

(1) Time value of money & Opportunity cost of capital

- Time Value of Money = A pound today is worth more than a pound in the future
 Reasons:
 One could put the money in the bank and receive interest
 Inflation
 Uncertainty of receiving money in the future (risk)
- When considering an investment opportunity we need to
 Identify all incremental cash flows associated with the investment decision
 Identify the appropriate interest rate to use when converting future cash flows into
today's cash (收息)
 The appropriate rate is the best available return offered in the market on an
investment of comparable maturity and risk （息口最高幾多）
 This rate provides a benchmark against which the cash flows of the investment
should be evaluated, hence opportunity cost of capital
 This is a competitive market rate at which investors can borrow and lend
(2) Present value (PV)
- What would you be willing to pay today to get £100 in one year. The interest rate is 10% per
year.

- The present value is today’s cash value of future cash flows discounted at the opportunity cost of
capital

- The present value is the cash cost today of “doing it yourself” - it is the amount you need to
invest at the current interest rate to replicate the future cash flow

- Present value – general formula - where r = interest

- Discount factor – present value of a $1 future payment

- Discounted cash flow (DCF) valuation - calculating the present value of a future cash flow to
determine its value today
 We have seen that £1 today is worth more than £1 in the future - investors demand a
reward to postpone consumption
  Investors are also risk averse - they demand a reward for accepting risk, hence a safe £1
is worth more than a risky £1
 The market rate for risky cash flows will be higher than the market rate for risk-free cash

(3) Net Present value (NPV) Decision Rule

- As long as we convert all costs and benefits to the same period of time, we can compare them to
make a decision

NPV =PV(Benefits)−PV(Costs)
- Accepts projects with positive NPV - equivalent to receive their NPV in cash today, i.e.
increase investors’ wealth by NPV
- Reject projects with negative NPV - equivalent to reducing investors’ wealth by NPV
- Decision rule is independent from investors’ preference over the timing of cash flows – why?
- Note that one fast way to change NPV into money is to borrow
 The loan, with interest, will be repaid using the firm's net future cash flow (in X
year) .
 So essentially you can borrow X (if X combined with interest in Y period of time
would be returned by future cash flows)
 However, consider the future cash flow actually available, i.e., if there are any
payments due throughout the year

(4) Arbitrage and Law of One Price

- Competitive markets: assets can be bought and sold at the same price  there are sufficient
buyers and sellers so that it is possible to trade at the current market price
- Law of One Price – if equivalent investment opportunities trade simultaneously in different
competitive markets, then they must at the same price  otherwise there is an arbitrage
opportunity (套利機會)
 Arbitage is the simultaneous purchase and sale of the same or similar asset in different
markets in order to profit from tiny differences in the asset’s listed price
 Arbitage opportunity arises when it is possible to make a profit (NPV >0) without taking any
risk or making any investment
 When there is arbitrage opportunity in financial markets, investors will race to take
advantage, once they place their trades the prices will respond and increase and the
opportunity will quickly disappear
 Therefore, trading financial assets (securities) is a zero-NPV transaction
- Markets without arbitrage opportunities are called efficient/normal markets
- Side note – for loans taking advantage of a lower interest rate  there is exchange rate risks 
its called carry trade  therefore engaging in such transactions could incur a loss if the value of
the currency traded drops
(5) Valuing financial assets & arbitrage opportunities
- Principle to value financial assets: trading financial assets (securities) is a zero-NPV
transaction. Trading securities neither creates nor destroys value

Price(security) = PV(All cash flows paid by security)

- Valuing government bond

(6) Determining the return of the bond

- Usually, market interest rates are derived from the current price of risk-free government bonds
trading in financial markets
- Step 1 – Figure out the current price of the bond

- Step 2 – Rearranging and figuring out the return percentage: (Net cash inflow in the year -old)/
old
(7) Firm investment and financing decisions
- We have seen that positive-NPV decisions increase the value of the firm and the wealth of its
investors
- These positive-NPV opportunities arise in real investment projects the firm undertakes, such as
developing new products, opening new stores or creating more efficient production methods -
relates to the asset side of the balance sheet
- Financial transaction do not create value but instead serve to adjust the timing of the cash flows
- relates to the liability side of the balance sheet
- Therefore, we can separate the investment decision from the financing decision

FM101 – Week 3 – Time Value of Money

(1) Future value & Compounding
- Future Value: the amount an investment is worth after 1/more periods
- Compounding: the process of accumulating and reinvesting interest on an investment over time
to earn more interest
- Interest on interest: interest earned on the reinvestment of previous interest payments (利疊利)
 = Compound interest: interest earned on the internet reinvested from prior periods (formula
– 利疊利好和味)
 Future Value calculation (lump sum)
 Investing for t periods:

 where Vt = value at time t, r = interest rate

 Simple interest: interest earned only on principal amount invested (simple maths)

「利疊利，好和味」
- But note that if the question – you save money at the end of each year  那一年唔會 compound
 Also that if they ask ‘how much will you have five years from now? – 最後一年都係未
cmpound!!!

(2) Present value & Discounting

- Present value (PV): current value of future cash flows discounted at the appropriate discount
rate
Net Present Value Decision Rule

- Discounting: calculating the present value of some future amount (reverse of compounding)
- Discounted cash flow (DCF) valuation: calculating PV of a future cash flow to determine its
value today
- PV calculation (lump sum)

 Investing for t periods:

 Discount or PV factor – is the present value of a ‘$1 future payment’

- Example: You would like to make a deposit for a flat. You have $50,000 or so, but the deposit is
$68,500. If you can earn 9%, how much do you have to invest today to have enough for the
deposit in 2 years? Do you have enough?
 PV = $68, 500/(1 + 0. 09)^2 = $57655.08
 Still about $7,655 short, even if you're willing to wait 2 years
- The greater the rate and time (r and t), the smaller the PV

(3) Tying it together

NB: realised vs expected return

- When we consider future cash flows, we use expected returns (required returns)
- When considering past (historical) cash flows we calculated realised returns
NB: calculations of r could be different for the same investment
- The returns calculated in (c) and d are the expected returns that investors require to be willing to
buy the security.
- This can change due to the risk in the firm (e.g. worsening of company’s financial position)
and/or changes in wide economic interest rates. The return calculated in e are realised returns
which reflects the changes in expected returns
(4) Annuity formula (continuous cash flow) – 年金
- Stream of ‘n’ cash flows paid at regular intervals – (年金投資)
- Present value of an annuity with discount rate ‘r’ is given by:


 Where the stream of cash flows is constant we can use the same formula – 年金


 C = amount of money promised to pay each year
 R = interests
 Pv0 = how much you have to put in each year
  First clash flow occurs at the end of the first period & PV valuation period is one
period before the first cash flow
 Discount rate is constant
- For questions calculating the bond’s present value
 However, note that in the last year of an annuity question – you have to add back
present value by considering the face value of the bond as well  hence for some
questions you would have to add back
 E.g., Consider a UK Government bond with a face value (principal) of £1,000. The
bond matures in 5 years and pays annual coupons of 3%. If the discount rate is 10%
at what price is this bond trading?
 The annual cash flows are £30 from years 1 to 5. In addition, in year 5 you will
get the face value of £1,000


 Hence the bond is trading at a discount, i.e., the price is lower than the face value
(5) Growing Annuity formula (when annuity grows) – 增長型年金
- Stream of ‘n’ cash flows paid at regular intervals – (年金投資)
General formula
- Present value of an annuity with discount rate ‘r’ is given by:

- Consider the fact that the money will not have grown in the final year  hence to the power of
n=1
- PV period is always one period before the cash flow  as
 Or if you see it as a loan given instead of annuity: C is the annuity you get from your
debtors, Pv0 is money you need to lend them now
Overall formula if growth of annuity is constant

- Where C is the annuity paid

- Pv0 is money required to be invested now
- G is the growth rate
 Or if you see it as a loan given instead of annuity: C is the annuity you get from your
debtors, Pv0 is money you need to lend them now
(6) Perpetuity formula – 永續年金
- Stream of ‘n’ cash flows paid at regular intervals – (年金投資)
General formula if it is an annuity without growth

- where C1 = return each year ; R = discount rate (interest rate)

General formula if it is an annuity with growth

where C1 = cash flow in the first period; R = discount rate (interest rate), g =

annuity growth rate

- Note the PV should be taken 1 period before the cash flow!!!  therefore if delayed start
we take PV as a year before the start!

- e.g., (1) Consol: in the past UK gov issued some bonds (consols) that promised a fixed interest
forever
 What is the PV of a 4% consol with a face value of £1,000, if the discount rate is 0.75%?
 You first calc the amount of annuity paid to you (1000 x 0.04)
- e.g, the growth perpetuity formula but with a delayed start!!! – A preference share that
promises to pay a growing dividend every 6 months
 first dividend which will be paid at the end of the 1st two years (delayed start) – is 2 dollars
and will grow at constant rate g = 2%
 If the discount rate is 4 per semester, what is price of this preference share? (assuming
they grow indefinitely
 Step 1: Recognizing the growth perpetuality formula  what do you have to invest when
perpetuality start!
 PV0 = C/ (r-g)  PV3 = 2/(0.04-0.02) = 100
 Step 2: Discounting back to the present (since this price is at semester 4) –S ince the
first dividend is paid at the end of the second year (after 4 semesters), we need to
discount the perpetuity price back to 3 semesters (because we are discounting from 4
semesters to 1 semester before the first dividend is paid).PV0 = PV4/ (1+r)^t
(where t in this case = 3)


  Formula combined =
(7) ROI – Return of Investment

- R = (annual) internal rate of return (IRR)  Rate that sets the NPV of an investment
opportunity equal to zero
- E.g., Apple annual return
 You bought one share of Apple stock (AAPL) in January 2019 and sold it 5 years later.
What was the annual return on your investment?
 The price of one share on 3/1/2019 was $39.94. Five years later, on 3/1/2024 it was
$193.89.

 Annual return on investment was 37%

Week 2 & 3 class questions

Week 2

1. You have an investment opportunity in Japan. It requires an investment of £0.98

mn today and will produce a cash flow of ¥107 mn in one year with no risk.
Suppose the risk-free interest rate in the U.K. is 3.9%, the risk-free interest rate
in Japan is 2.3%, and the current competitive exchange rate is ¥110 per £1.
What is the NPV of this investment? Is it a good opportunity?
2. You run a construction firm. You have just won a contract to construct a
government office building. It will take one year to construct it, requiring an
investment of £9.77 mn today and £5 mn in one year. The government will pay
you £21.50 mn upon the building’s completion. Suppose the cash flows and
their times of payment are certain, and the risk-free interest rate is 7%.

 (a) What is the NPV of this opportunity?

 (b) How can your firm turn this NPV into cash today?
 Borrowing money so that the principal and interest would be covered by
future cash flow
  Note however for the calculation of turning NPV into cash  consider
the future cash flow actually available  you first have to deduct
the amount you have to deduct the amount due to pay in the future
upon completion first
 What if the firm requies an investment of an extra 0.1 million
pounds 6 months from now – will this affect the calculation?  it
further reduces the amount of money you could take out
 (c) What is the Return on this project? Relate to your answer to part (a)

3. Over the last two decades risk-free interest rates in Japan have been
considerably lower than in the United States. As a result, many Japanese
investors were tempted to borrow in Japan and invest the proceeds in the
United States. If these investments are in short term US Government debt
(Treasury Bills, or treasuries), which is risk-free, does this represent an arbitrage
opportunity?

- (c) Note if they ask you to calculate the cash flow:

  Step 1: you think about how many cash remains after putting in money to the
investment now!
 i.e., 100-22-7-57= 14  and then 14 as a present value  converts to future value of
cash flow  14 x 1.098 = 15.372
 Step 2: then you add on all the future cash flows:  15.372 + 52 +76 = 143.372
 Step 3: And you calc back the present cash flow  143.372/ 1.098 = 130.576
- (d), (e ) and (c) all calc the value of assets today  therefore actions further down the line
would not affect present value!!
 Point is firm cannot increase its value by what investors can do by themselves (separation
principle)
Week 3

1. Oasis Pods has been working on a new sustainable business that uses plastic
waste to create standard office pods that can be placed in free spaces in a
building. The new office pod technology has now been cleared for manufacture
and development. Oasis Pods anticipates the first annual cash flow from the
office pods to be £2 mn, received 2 years from today. Subsequent annual cash
flows will grow at 10% in perpetuity. What is the present value of the new
technology if the discount rate is 16%?

Note how for the PV0 calculation you would assume deduct that off 1 period  as we count PV
based on 1 semester before the first cash flow
2. You have a loan outstanding. It requires making six annual payments at the end
of the next six years of £9,000 each. Your bank has offered to restructure
the loan so that instead of making the six payments as originally
agreed, you will make only one final payment at the end of the loan in
six years. If the interest rate on the loan is 9.85%, what final payment will the
bank require you to make so that it is indifferent between the two forms of
payment?

Note how money has timen value so after calculating the PV of the annuity  you would have to
find the future value at the end of the loan of year 6.

3. You are thinking of purchasing a house. The house costs £350,000. You have
£50,000 in cash that you can use as a down payment on the house, but you need
to borrow the rest of the purchase price. The bank is offering a 30-year mortgage
that requires annual payments and has an interest rate of 7% per year. What will
your annual payment be if you sign up for this mortgage?
4. You are considering purchasing a warehouse. The cost to purchase the
warehouse is £509,000. Renting the equivalent space costs £19,400 per year.
The annual interest rate is 5.9%.

(a) If rental costs are constant (forever) should you buy or rent?

(b) At what rate must the rental cost increase each year to make the cost of
renting comparable to purchasing?