Chapter 3&4

The Time Value

of Money
• Future Value
Single amount: one-time (or lump) sum
Annuity: same amount per year for a number of years
Future Value of an Annuity Due
Uneven Cash Flow Streams
• Present Value
Single amount: one-time (or lump) sum
Annuity: same amount per year for a number of years
Present Value of an Annuity Due
Uneven Cash Flow Streams
• The Rule of 72
• Compounding Periods
• Amortization
• Deferred Annuity
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 3.1 Future Value and
Compounding Interest
• The value of money at the end of the stated
period is called the future or compound
value of that sum of money.
– Determine the attractiveness of alternative
investments
– Figure out the effect of inflation on the future
cost of assets, such as a car or a house.

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 3.1 (A) The Single-Period
Scenario
FV = PV + PV x interest rate, or
FV = PV(1+interest rate)
(in decimals)

Example 1: Let’s say John deposits $200 for a

year in an account that pays 6% per year. At
the end of the year, he will have:

FV = $200 + ($200 x .06) = $212

= $200(1.06) = $212

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 3.1 (B) The Multiple-Period Scenario

FV = PV x (1+r)n
Example 2: If John closes out his account after 3
years, how much money will he have accumulated?
How much of that is the interest-on-interest
component? What about after 10 years?

FV3 = $200(1.06)3 = $200*1.191016 = $238.20,

where, 6% interest per year for 3 years = $200 x.06 x 3=$36
Interest on interest = $238.20 - $200 - $36 =$2.20

FV10 = $200(1.06)10 = $200 x 1.790847 = $358.17

where, 6% interest per year for 10 years = $200 x .06 x 10 =
$120
Interest on interest = $358.17 - $200 - $120 = $38.17

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 3.1 (C) Methods of Solving
Future Value Problems
• Method 1: The formula method
– Time-consuming, tedious
• Method 2: The financial calculator approach
– Quick and easy
• Method 3: The spreadsheet method
– Most versatile
• Method 4: The use of Time Value tables:
– Easy and convenient but most limiting in scope

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 3.1 (C) Methods of Solving Future
Value Problems (continued)

Example 3: Compounding of Interest

Let’s say you want to know how much money

you will have accumulated in your bank account
after 4 years, if you deposit all $5,000 of your
high-school graduation gifts into an account that
pays a fixed interest rate of 5% per year. You
leave the money untouched for all four of your
college years.

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 3.1 (C) Methods of Solving Future
Value Problems (continued)
Example 3: Answer
Formula Method:
FV = PV x (1+r)n$5,000(1.05)4=$6,077.53
Calculator method:
PV =-5,000; N=4; I/Y=5; PMT=0; CPT FV=$6077.53
Spreadsheet method:
Rate = .05; Nper = 4; Pmt=0; PV=-5,000; Type =0;
FV=6077.53
Time value table method:
FV = PV(FVIF, 5%, 4) = 5000*(1.215506)=6077.53,
where (FVIF, 5%,4) = Future value interest factor listed
under the 5% column and in the 4-year row of the Future
Value of $1 table.

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 3.1 (C) Methods of Solving Future
Value Problems (continued)

Example 4: Future Cost due to

Inflation
Let’s say that you have seen your dream
house, which is currently listed at
$300,000, but unfortunately, you are not
in a position to buy it right away and will
have to wait at least another 5 years
before you will be able to afford it. If
house values are appreciating at the
average annual rate of inflation of 5%,
how much will a similar house cost after
5 years?
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 3.1 (C) Methods of Solving Future
Value Problems (continued)

Example 4 (Answer)

PV = current cost of the house = $300,000;

n = 5 years;
r = average annual inflation rate = 5%.
Solving for FV, we have
FV = $300,000*(1.05)(1.05)(1.05)(1.05)(1.05)
= $300,000*(1.276282)
= $382,884.5

So the house will cost $382,884.5 after 5 years

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 3.1 (C) Methods of Solving Future
Value Problems (continued)

Calculator method:
PV =-300,000; N=5; I/Y=5; PMT=0; CPT
FV=$382,884.5
Spreadsheet method:
Rate = .05; Nper = 5; Pmt=0; PV=-$300,000;
Type =0; FV=$382,884.5
Time value table method:
FV = PV(FVIF, 5%, 5) =
300,000*(1.27628)=$382,884.5;
where (FVIF, 5%,5) = Future value interest factor
listed under the 5% column and in the 5-year row
of the future value of $1 table=1.276
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 3.2 Present Value and
Discounting
• Involves discounting the interest that would have
been earned over a given period at a given rate of
interest.
• It is therefore the exact opposite or inverse of
calculating the future value of a sum of money.
• Such calculations are useful for determining today’s
price or the value today of an asset or cash flow
that will be received in the future.
• The formula used for determining PV is as follows:
PV = FV x 1/ (1+r)n

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 3.2 (A) The Single-Period
Scenario

When calculating the present or discounted

value of a future lump sum to be received
one period from today, we are basically
deducting the interest that would have been
earned on a sum of money from its future
value at the given rate of interest.
i.e. PV = FV/(1+r) since n = 1
So, if FV = 100; r = 10%; and n =1;
PV = 100/1.1=90.91

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 3.2 (B) The Multiple-Period
Scenario

When multiple periods are involved…

The formula used for determining PV is as
follows:
PV = FV x 1/(1+r)n
where the term in brackets is the present
value interest factor for the relevant rate of
interest and number of periods involved,
and is the reciprocal of the future value
interest factor (FVIF)

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 3.2 Present Value and
Discounting (continued)

Example 5: Discounting Interest

Let’s say you just won a jackpot of $50,000
at the casino and would like to save a
portion of it so as to have $40,000 to put
down on a house after 5 years. Your bank
pays a 6% rate of interest. How much
money will you have to set aside from the
jackpot winnings?

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 3.2 Present Value and
Discounting (continued)
Example 5 (Answer)
FV = amount needed = $40,000
N = 5 years; Interest rate = 6%;
• PV = FV x 1/ (1+r)n
• PV = $40,000 x 1/(1.06)5
• PV = $40,000 x 0.747258
• PV = $29,890.33 Amount needed to set
aside today

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 3.2 Present Value and
Discounting (continued)
Calculator method:
FV 40,000; N=5; I/Y =6%; PMT=0; CPT PV=-$29,890.33
Spreadsheet method:
Rate = .06; Nper = 5; Pmt=0; Fv=$40,000; Type =0;
Pv=-$29,890.33
Time value table method:
PV = FV(PVIF, 6%, 5) = 40,000*(0.7473)=$29,892
where (PVIF, 6%,5) = Present value interest factor listed
under the 6% column and in the 5-year row of the Present
Value of $1 table=0.7473

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 3.2 (C) Using Time Lines

• When solving time value of money

problems, especially the ones involving
multiple periods and complex combinations
(which will be discussed later) it is always a
good idea to draw a time line and label the
cash flows, interest rates and number of
periods involved.

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 3.2 (C) Using Time Lines
(continued)

FIGURE 3.1 Time lines of growth rates (top)

and discount rates (bottom) illustrate
present value and future value.

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 3.3 One Equation and Four
Variables
• Any time value problem involving lump sums -- i.e.,
a single outflow and a single inflow--requires the
use of a single equation consisting of 4 variables
i.e. PV, FV, r, n
• If 3 out of 4 variables are given, we can solve the
unknown one.
FV = PV x (1+r)n solving for future value
PV = FV X [1/(1+r)n] solving for present value
r = [FV/PV]1/n – 1 solving for unknown rate n
= [ln(FV/PV)/ln(1+r)] solving for # of periods

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 3.4 Applications of the Time
Value of Money Equation
• Calculating the amount of saving required
for retirement
• Determining future value of an asset
• Calculating the cost of a loan
• Calculating growth rates of cash flows
• Calculating number of periods required to
reach a financial goal.

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 Example 3.3 Saving for
retirement

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 Example 3.3 Saving for
retirement (continued)

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 Example 3.3 Saving for
retirement (continued)

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 Example 3.4 Let’s make a deal
(future value)

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 Example 3.4 Let’s make a deal
(continued)

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 Example 3.4 Let’s make a deal
(continued)

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 Example 3.5 What’s the cost of
that loan?

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 Example 3.5 What’s the cost of
that loan? (continued)

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 Example 3.5 What’s the cost of
that loan? (continued)

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 Example 3.6 Boomtown, USA
(growth rate)

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 Example 3.6 Boomtown, USA
(continued)

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 Example 3.6 Boomtown, USA
(continued)

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 Example 3.7 When will I be rich?

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 Example 3.7 When will I be rich?
(continued)

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 Example 3.7 When will I be rich?
(continued)

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 3.5 Doubling of Money: The Rule
of 72
• The Rule of 72 estimates the number of
years required to double a sum of money at
a given rate of interest.
– For example, if the rate of interest is 9%, it would
take 72/9  8 years to double a sum of money
• Can also be used to calculate the rate of
interest needed to double a sum of money
by a certain number of years.
– For example, to double a sum of money in 4
years, the rate of return would have to be
approximately 18% (i.e. 72/4=18).

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 Special Considerations in Time
Value Analysis
• Certain contractual agreements may require
semiannual, quarterly, or monthly
compounding periods.
– In such cases, to determine n, multiply the
number of years by the number of compounding
periods during the year.
– The factor of i is determined by dividing the
quoted annual interest rate by the number of
compounding periods.

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 4.1 Future Value of Multiple Payment
Streams

• With unequal periodic cash flows, treat each

of the cash flows as a lump sum and
calculate its future value over the relevant
number of periods.
• Sum up the individual future values to get
the future value of the multiple payment
streams.

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 Figure 4.1 The time line of a nest
egg

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 4.1 Future Value of Multiple
Payment Streams (continued)

Example 1: Future Value of an Uneven Cash

Flow Stream:
Jim deposits $3,000 today into an account that
pays 10% per year, and follows it up with 3 more
deposits at the end of each of the next three years.
Each subsequent deposit is $2,000 higher than the
previous one. How much money will Jim have
accumulated in his account by the end of three
years?

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 4.1 Future Value of Multiple Payment
Streams (Example 1 Answer)

FV = PV x (1+r)n
FV of Cash Flow at T0 = $3,000 x (1.10)3 = $3,000 x 1.331 =
$3,993.00
FV of Cash Flow at T1 = $5,000 x (1.10)2 = $5,000 x 1.210 =
$6,050.00
FV of Cash Flow at T2 = $7,000 x (1.10)1 = $7,000 x 1.100 =
$7,700.00
FV of Cash Flow at T3 = $9,000 x (1.10)0 = $9,000 x 1.000 =
$9,000.00
Total = $26,743.00

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 4.1 Future Value of Multiple Payment
Streams (Example 1 Answer)

ALTERNATIVE METHOD:
Using the Cash Flow (CF) key of the calculator, enter the
respective cash flows.
CF0=-$3000;CF1=-$5000;CF2=-$7000;
CF3=-$9000;
Next calculate the NPV using I=10%; NPV=$20,092.41;
Finally, using PV=-$20,092.41; n=3; i=10%;PMT=0;
CPT FV=$26,743.00

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 4.2 Future Value of an Annuity
Stream
• Annuities are equal, periodic outflows/inflows., e.g. rent,
lease, mortgage, car loan, and retirement annuity payments.
• An annuity stream can begin at the start of each period
(annuity due) as is true of rent and insurance payments or at
the end of each period, (ordinary annuity) as in the case of
mortgage and loan payments.
• The formula for calculating the future value of an annuity
stream is as follows:
FV = PMT * (1+r)n -1
r
• where PMT is the term used for the equal periodic cash flow, r
is the rate of interest, and n is the number of periods
involved.

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 4.2 Future Value of an Annuity
Stream (continued)

Example 2: Future Value of an Ordinary

Annuity Stream
Jill has been faithfully depositing $2,000 at the end
of each year since the past 10 years into an account
that pays 8% per year. How much money will she
have accumulated in the account?

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 4.2 Future Value of an Annuity
Stream (continued)
Example 2 Answer

Future Value of Payment One = $2,000 x 1.089 = $3,998.01

Future Value of Payment Two = $2,000 x 1.088 = $3,701.86
Future Value of Payment Three = $2,000 x 1.087 = $3,427.65
Future Value of Payment Four = $2,000 x 1.086 = $3,173.75
Future Value of Payment Five = $2,000 x 1.085 = $2,938.66
Future Value of Payment Six = $2,000 x 1.084 = $2,720.98
Future Value of Payment Seven = $2,000 x 1.083 = $2,519.42
Future Value of Payment Eight = $2,000 x 1.082 = $2,332.80
Future Value of Payment Nine = $2,000 x 1.081 = $2,160.00
Future Value of Payment Ten = $2,000 x 1.080 = $2,000.00
Total Value of Account at the end of 10 years $28,973.13

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 4.2 Future Value of an Annuity
Stream (continued)
Example 2 (Answer)
FORMULA METHOD
FV = PMT * (1+r)n -1
r
where, PMT = $2,000; r = 8%; and n=10.
FVIFA [((1.08)10 - 1)/.08] = 14.486562,
FV = $2000*14.486562  $28,973.13

USING A FINANCIAL CALCULATOR

N= 10; PMT = -2,000; I = 8; PV=0; CPT FV = 28,973.13

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 4.2 Future Value of an Annuity
Stream (continued)

USING AN EXCEL SPREADSHEET

Enter =FV(8%, 10, -2000, 0, 0); Output = $28,973.13

Rate, Nper, Pmt, PV,Type

Type is 0 for ordinary annuities and 1 for annuities due
USING FVIFA TABLE (A-3)

Find the FVIFA in the 8% column and the 10 period row;

FVIFA = 14.486
FV = 2000*14.4865 = $28.973.13

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 FIGURE 4.3 Interest and principal
growth with different interest rates
for $100-annual payments.

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 4.3 Present Value of an Annuity

To calculate the value of a series of equal

periodic cash flows at the current point in time,
we can use the following simplified formula:
  1 
1   
 1  r n

PV  PMT  
r
The last portion of the equation, is the
Present Value Interest Factor of an Annuity (PVIFA).

Practical applications include figuring out the nest egg needed

prior to retirement or lump sum needed for college expenses.

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 FIGURE 4.4 Time line of present
value of annuity stream.

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 4.3 Present Value of an Annuity
(continued)

Example 3: Present Value of an Annuity.

John wants to make sure that he has saved up
enough money prior to the year in which his
daughter begins college. Based on current
estimates, he figures that college expenses will
amount to $40,000 per year for 4 years (ignoring
any inflation or tuition increases during the 4
years of college). How much money will John
need to have accumulated in an account that
earns 7% per year, just prior to the year that his
daughter starts college?

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 4.3 Present Value of an Annuity
(continued)

Example 3 Answer
Using the following equation:

  1 
1  
n 
  1 r  
PV  PMT 
r

1. Calculate the PVIFA value for n=4 and r=7%3.387211.

2. Then, multiply the annuity payment by this factor to get
the PV,
PV = $40,000 x 3.387211 = $135,488.45

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 4.3 Present Value of an Annuity
(continued)

Example 3 Answer—continued

FINANCIAL CALCULATOR METHOD:

Set the calculator for an ordinary annuity (END mode) and
then enter:
N= 4; PMT = 40,000; I = 7; FV=0; CPT PV = 135,488.45
SPREADSHEET METHOD:
Enter =PV(7%, 4, 40,000, 0, 0); Output = $135,488.45

Rate, Nper, Pmt, FV, Type

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 4.3 Present Value of an Annuity
(continued)
Example 3 Answer—continued

PVIFA TABLE (APPENDIX A-4) METHOD

For r =7% and n = 4; PVIFA =3.3872
PVA = PMT*PVIFA = 40,000*3.3872
= $135,488 (Notice the slight rounding error!)

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 4.4 Annuity Due and Perpetuity

A cash flow stream such as rent, lease, and

insurance payments, which involves equal periodic
cash flows that begin right away or at the beginning
of each time interval is known as an annuity due.

Figure 4.5 An ordinary annuity versus an annuity

due.

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 4.4 Annuity Due and Perpetuity

PV annuity due = PV ordinary annuity x (1+r)

FV annuity due = FV ordinary annuity x (1+r)
PV annuity due > PV ordinary annuity
FV annuity due > FV ordinary annuity
Can you see why?

Financial calculator
Mode  BGN for annuity due
Mode END for an ordinary annuity
Spreadsheet
Type” =0 or omitted for an ordinary annuity
Type = 1 for an annuity due.
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 4.4 Annuity Due and Perpetuity
(continued)
Example 4: Annuity Due versus Ordinary
Annuity
Let’s say that you are saving up for retirement
and decide to deposit $3,000 each year for the
next 20 years into an account which pays a rate
of interest of 8% per year. By how much will
your accumulated nest egg vary if you make
each of the 20 deposits at the beginning of the
year, starting right away, rather than at the end
of each of the next twenty years?

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 4.4 Annuity Due and Perpetuity
(continued)
Example 4 Answer
Given information: PMT = -$3,000; n=20; i= 8%; PV=0;

FV  PMT 
1 r   1
n

FV ordinary annuity = $3,000 * [((1.08)20 - 1)/.08]

= $3,000 * 45.76196
= $137,285.89
FV of annuity due = FV of ordinary annuity * (1+r)
FV of annuity due = $137,285.89*(1.08) = $148,268.76

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 4.4 Annuity Due and Perpetuity
(continued)

Perpetuity
A Perpetuity is an equal periodic cash flow
stream that will never cease.
The PV of a perpetuity is calculated by using
the following equation:

PMT
PV 
r

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 4.4 Annuity Due and Perpetuity
(continued)
Example 5: PV of a perpetuity
If you are considering the purchase of a consol that
pays $60 per year forever, and the rate of interest
you want to earn is 10% per year, how much
money should you pay for the consol?
Answer:
r=10%, PMT = $60; and PV = ($60/.1) = $600
$600 is the most you should pay for the consol.

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 4.5 Three Loan Payment
Methods

Loan payments can be structured in one of 3

ways:
1) Discount loan
• Principal and interest is paid in lump sum at end
2) Interest-only loan
• Periodic interest-only payments, principal due at end.
3) Amortized loan
• Equal periodic payments of principal and interest

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 4.5 Three Loan Payment
Methods (continued)
Example 6: Discount versus Interest-only versus
Amortized loans

Roseanne wants to borrow $40,000 for a period of 5 years.

The lenders offers her a choice of three payment structures:
1) Pay all of the interest (10% per year) and principal in one lump sum
at the end of 5 years;
2) Pay interest at the rate of 10% per year for 4 years and then a final
payment of interest and principal at the end of the 5th year;
3) Pay 5 equal payments at the end of each year inclusive of interest
and part of the principal.

Under which of the three options will Roseanne pay the least interest
and why? Calculate the total amount of the payments and the amount
of interest paid under each alternative.

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 4.5 Three Loan Payment
Methods (continued)
Method 1: Discount Loan.
Since all the interest and the principal is paid at the
end of 5 years we can use the FV of a lump sum
equation to calculate the payment required, i.e.
FV = PV x (1 + r)n
FV5 = $40,000 x (1+0.10)5
= $40,000 x 1.61051
= $64, 420.40
Interest paid = Total payment - Loan amount
Interest paid = $64,420.40 - $40,000 = $24,420.40

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 4.5 Three Loan Payment
Methods (continued)
Method 2: Interest-Only Loan.
Annual Interest Payment (Years 1-4)
= $40,000 x 0.10 = $4,000
Year 5 payment
= Annual interest payment + Principal payment
= $4,000 + $40,000 = $44,000
Total payment = $16,000 + $44,000 = $60,000
Interest paid = $20,000

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 4.5 Three Loan Payment
Methods (continued)

Method 3: Amortized Loan.

n = 5; I = 10%; PV=$40,000; FV = 0;CPT PMT=$10,551.9
Total payments = 5*$10,551.8 = $52,759.5
Interest paid = Total Payments - Loan Amount
= $52,759.5-$40,000
Interest paid = $12,759.5
Loan Type Total Payment Interest Paid
Discount Loan $64,420.40 $24,420.40
Interest-only Loan $60,000.00 $20,000.00
Amortized Loan $52,759.31 $12,759.5

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 4.6 Amortization Schedules

Tabular listing of the allocation of each loan payment

towards interest and principal reduction
Helps borrowers and lenders figure out the payoff
balance on an outstanding loan.

Procedure:
1) Compute the amount of each equal periodic payment
(PMT).
2) Calculate interest on unpaid balance at the end of
each period, minus it from the PMT, reduce the loan
balance by the remaining amount,
3) Continue the process for each payment period, until
we get a zero loan balance.
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 4.6 Amortization Schedules
(continued)

Example 7: Loan amortization schedule.

Prepare a loan amortization schedule for the
amortized loan option given in Example 6
above. What is the loan payoff amount at
the end of 2 years?

PV = $40,000; n=5; i=10%; FV=0;

CPT PMT = $10,551.89

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 4.6 Amortization Schedules
(continued)
Year Beg. Bal Payment Interest Prin. Red End. Bal

1 40,000.00 10,551.89 4,000.00 6,551.89 33,448.11

2 33,448.11 10,551.89 3,344.81 7,207.08 26,241.03

3 26,241.03 10,551.89 2,264.10 7,927.79 18,313.24

4 18,313.24 10,551.89 1,831.32 8,720.57 9,592.67

5 9,592.67 10,551.89 959.27 9,592.67 0

The loan payoff amount at the end of 2

years is $26,241.03
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 4.7 Waiting Time and Interest
Rates for Annuities

Problems involving annuities typically have 4

variables, i.e. PV or FV, PMT, r, n
If any 3 of the 4 variables are given, we can easily
solve for the fourth one.
This section deals with the procedure of solving
problems where either n or r is not given.
For example:
– Finding out how many deposits (n) it would take to reach a
retirement or investment goal;
– Figuring out the rate of return (r) required to reach a
retirement goal given fixed monthly deposits,

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 4.7 Waiting Time and Interest
Rates for Annuities (continued)

Example 8: Solving for the number of

annuities involved
Martha wants to save up $100,000 as soon
as possible so that she can use it as a down
payment on her dream house. She figures
that she can easily set aside $8,000 per
year and earn 8% annually on her deposits.
How many years will Martha have to wait
before she can buy that dream house?

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 4.7 Waiting Time and Interest
Rates for Annuities (continued)
Example 8 Answer
Method 1: Using a financial calculator
INPUT ? 8.0 0 -8000
100000
TVM KEYS N I/Y PV PMT FV
Compute 9.00647
Method 2: Using an Excel spreadsheet
Using the “=NPER” function we enter the following:
Rate = 8%; Pmt = -8000; PV = 0;
FV = 100000; Type = 0 or omitted;
i.e. =NPER(8%,-8000,0,100000,0)
The cell displays 9.006467.

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 4.8 Solving a Lottery Problem

In the case of lottery winnings, 2 choices

1) Annual lottery payment for fixed number of
years, OR
2) Lump sum payout.
How do we make an informed judgment?
Need to figure out the implied rate of return
of both options using TVM functions.

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 4.8 Solving a Lottery Problem
(continued)

Example 9: Calculating an implied rate

of return given an annuity
Let’s say that you have just won the state
lottery. The authorities have given you a
choice of either taking a lump sum of
$26,000,000 or a 30-year annuity of
$1,625,000. Both payments are assumed to
be after-tax. What will you do?

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 4.8 Solving a Lottery Problem
(continued)

Example 9 Answer
Using the TVM keys of a financial calculator, enter:
PV=26,000,000; FV=0; N=30; PMT = -1,625,000;
CPT I = 4.65283%
4.65283% = rate of interest used to determine the 30-
year annuity of $1,625,000 versus the $26,000,000 lump
sum pay out.
Choice: If you can earn an annual after-tax rate of
return higher than 4.65% over the next 30 years,
go with the lump sum.
Otherwise, take the annuity option.

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 4.9 Ten Important Points about
the TVM Equation
1. Amounts of money can be added or subtracted
only if they are at the same point in time.
2. The timing and the amount of the cash flow are
what matters.
3. It is very helpful to lay out the timing and amount
of the cash flow with a timeline.
4. Present value calculations discount all future cash
flow back to current time.
5. Future value calculations value cash flows at a
single point in time in the future

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 4.9 Ten Important Points about
the TVM Equation (continued)

6. An annuity is a series of equal cash payments at

regular intervals across time.
7. The time value of money equation has four variables
but only one basic equation, and so you must know
three of the four variables before you can solve for
the missing or unknown variable.
8. There are three basic methods to solve for an
unknown time value of money variable:
(1) Using equations and calculating the answer;
(2) Using the TVM keys on a calculator;
(3) Using financial functions from a spreadsheet.

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 4.9 Ten Important Points about
the TVM Equation (continued)

9. There are 3 basic ways to repay a loan:

(1) Discount loans,
(2) Interest-only loans, and
(3) Amortized loans.
10. Despite the seemingly accurate answers from
the time value of money equation, in many
situations not all the important data can be
classified into the variables of present value, i.e.,
time, interest rate, payment, or future value.

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 Additional Problems with Answers
Problem 4

Computing Annuity Payment: The Corner Bar & Grill

is in the process of taking a five-year loan of $50,000
with First Community Bank. The bank offers the
restaurant owner his choice of three payment options:
1) Pay all of the interest (8% per year) and principal
in one lump sum at the end of 5 years;
2) Pay interest at the rate of 8% per year for 4 years
and then a final payment of interest and principal
at the end of the 5th year;
3) Pay 5 equal payments at the end of each year
inclusive of interest and part of the principal.
Under which of the three options will the owner pay the
least interest and why?
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 Table 4.2 Amortization Schedule for a
$25,000 Loan at 8% with Six Annual
Payments

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 Table 3.1 Annual Interest Rates at 10% for
$100 Initial Deposit (Rounded to Nearest
Penny)

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 Table 3.2 Variable Match for
Calculator and Spreadsheet

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 Table 3.1 Annual Interest Rates at 10% for
$100 Initial Deposit (Rounded to Nearest
Penny)

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 Table 3.2 Variable Match for
Calculator and Spreadsheet

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 Table 3.3 Doubling Time in Years
for Given Interest Rates

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 Chapter 6

Bonds and Bond

Valuation
 Learning Objectives
1. Understand basic bond terminology and apply the
time value of money equation in pricing bonds.
2. Understand the difference between annual and
semiannual bonds and note the key features of
zero-coupon bonds.
3. Explain the relationship between the coupon rate
and the yield to maturity.
4. Delineate bond ratings and why ratings affect
bond prices.
5. Appreciate bond history and understand the
rights and obligations of buyers and sellers of
bonds.
6. Price government bonds, notes, and bills.

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 6.1 Application of the Time Value
of Money Tool: Bond Pricing
• Bond: A financial contract that typically has a
stated maturity and periodic interest payments.
• Bonds - Long-term debt instruments
• Provide periodic interest income – annuity series
• Return of the principal amount at maturity – future
lump sum
• Prices can be calculated by using present value
techniques i.e. discounting of future cash flows.
• Combination of present value of an annuity and of
a lump sum

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 Table 6.1 Bond Information
August 1, 2008

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 6.1 (A) Key Components of a
Bond
Figure 6.1 Merrill Lynch • Par value : Typically $1000
corporate bond. • Coupon rate: Annual rate of
interest paid.
• Coupon: Regular interest
payment received by holder
per year.
• Maturity date: Expiration
date of bond when par value
is paid back.
• Yield to maturity: Expected
rate of return based on price
of bond

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 6.1 (A) Key Components of a
Bond

Example 1: Key components of a

corporate bond
Let’s say you see the following price quote
for a corporate bond:
Issue Price Coupon(%) Maturity YTM% Current Yld. Rating
Hertz Corp. 91.50 6.35 15-Jun-2010 15.438 6.94 B

Price = 91.5% of $1000$915; Annual coupon = 6.35% *1000  $63.50

Maturity date = June 15, 2010; If bought and held to maturityYield = 15.438%
Current Yield = $ Coupon/Price = $63.5/$915  6.94%

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 6.1 (B) Pricing a Bond in Steps

Since bonds involve a combination of an annuity

(coupons) and a lump sum (par value) its price
is best calculated by using the following steps:

Figure 6.2 How to price a bond.

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 6.1 (B) Pricing a Bond in Steps
(continued)

Example 2: Calculating the price of a corporate bond.

Calculate the price of an AA-rated, 20-year, 8% coupon (paid
annually) corporate bond (Par value = $1,000) which is
expected to earn a yield to maturity of 10%.

Year 0 1 2 3 18 19 20

$80 $80 $80 … $80 $80 $80

$1,000

Annual coupon = Coupon rate * Par value = .08 * $1,000 = $80 = PMT
YTM = r = 10%
Maturity = n = 20
Price of bond = Present Value of coupons + Present Value of par value

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 6.1 (B) Pricing a Bond in Steps
(continued)

Example 2: Calculating the price of a corporate bond

 1 
 1 
PMT   1 r 
n

Present value of coupons =  r 
 
 

 1 
 1 
$80   1  0.10 
20

 0.10 
=  
 

= $80 x 8.51359 = $681.09

1
FV 
Present Value of Par Value = 1  r n
1
$1,000 
Present Value of Par Value = 1  0.10 20

Present Value of Par Value = $1,000 x 0.14864 = $148.64

Price of bond = $681.09 + $148.64
= $829.73

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 6.1 (B) Pricing a Bond in Steps
(continued)

Method 2. Using a financial calculator

Mode: P/Y=1; C/Y = 1

Input: N I/Y PV PMT FV

Key: 20 10 ? 80 1000
Output -829.73

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 6.2 Semiannual Bonds and
Zero-Coupon Bonds
• Most corporate and government bonds pay coupons on a
semiannual basis.
• Some companies issue zero-coupon bonds by selling them at
a deep discount.
• For computing price of these bonds, the values of the inputs
have to be adjusted according to the frequency of the
coupons (or absence thereof).
– For example, for semi-annual bonds, the annual coupon is
divided by 2, the number of years is multiplied by 2, and
the YTM is divided by 2.
– The price of the bond can then be calculated by using the
TVM equation, a financial calculator, or a spreadsheet.

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 6.2 Semiannual Bonds and Zero-
Coupon Bonds (continued)

Figure 6.4 Coca-Cola semiannual corporate bond.

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 6.2 Semiannual Bonds and Zero-
Coupon Bonds (continued)
Figure 6.5
Future
cash flow
of the
Coca-Cola
bond.

Using TVM Equation

Using Financial Calculator

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 6.2 Semiannual Bonds and Zero-
Coupon Bonds (continued)

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 6.2 (A) Pricing Bonds after
Original Issue

The price of a bond is a function of the remaining

cash flows (i.e. coupons and par value) that would
be paid on it until expiration.

As of August, 2008 the 8.5%, 2022 Coca-Cola bond

has only 27 coupons left to be paid on it until it
matures on Feb. 1, 2022

Figure 6.6 Remaining cash flow of the

Coca-Cola bond.
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 6.2 (A) Pricing Bonds after
Original Issue (continued)
Example 3: Pricing a semi-annual coupon bond after
original issue:
Four years ago, the XYZ Corporation issued an 8% coupon
(paid semi-annually), 20-year, AA-rated bond at its par value
of $1000. Currently, the yield to maturity on these bonds is
10%. Calculate the price of the bond today.
Remaining number of semi-annual coupons
= (20-4)*2 = 32 coupons = n
Semi-annual coupon = (.08*1000)/2 = $40
Par value = $1000
Annual YTM = 10% YTM/25% = r

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 6.2 (A) Pricing Bonds after
Original Issue (continued)

Method 1: Using TVM equations

 1 
 1 n 
Bond Price = Par Value 
1
 Coupon   1 r  
1 r n  r 
 
 
 1 
 1 
Bond Price = $1,000 
1
 $40   1 0.05 
32

1 0.05 32  0.05 
 
 
Bond Price = $1000 x 0.209866 + $40 x 15.80268
Bond Price = $209.866 + $632.107
Bond Price = $841.97

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 6.2 (A) Pricing Bonds after
Original Issue (continued)

Method 2: Using a financial calculator

Mode: P/Y=2; C/Y = 2

Input: N I/Y PV PMT FV

Key: 32 10 ? 40 1000
Output -841.97

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 6.2 (B) Zero-Coupon Bonds

• Known as “pure” discount bonds and sold at

a discount from face value
• Do not pay any interest over the life of the
bond.
• At maturity, the investor receives the par
value, usually $1000.
• Price of a zero-coupon bond is calculated by
merely discounting its par value at the
prevailing discount rate or yield to maturity.

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 6.2 (C) Amortization of a Zero-
Coupon Bond
Table 6.2
Amortized
Interest on a
Zero-Coupon
Bond

• The discount on a zero-coupon bond is amortized over its life.

• Interest earned is calculated for each 6-month period.
• for example .04*790.31=$31.62
• Interest is added to price to compute ending price.
• Zero-coupon bond investors have to pay tax on annual price
appreciation even though no cash is received.

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 6.2 (C) Amortization of a Zero-
Coupon Bond (continued)
Example 4: Price of and taxes due on a
zero-coupon bond:
John wants to buy a 20-year, AAA-rated, $1000 par
value, zero-coupon bond being sold by Diversified
Industries Inc. The yield to maturity on similar
bonds is estimated to be 9%.
a) How much would he have to pay for it?
b) How much will he be taxed on the investment
after 1 year, if his marginal tax rate is 30%?

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 6.2 (C) Amortization of a Zero-
Coupon Bond (continued)
Example 4 Answer
Method 1: Using TVM equation
Bond Price = Par Value * [1/(1+r)n]
Bond Price = $1000*(1/(1.045)40
Bond Price = $1000 * .1719287 = $171.93

Method 2: Using a financial calculator

Mode: P/Y=2; C/Y = 2

Input: N I/Y PV PMT FV

Key: 40 9 ? 0 1000
Output -171.93

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 6.2 (C) Amortization of a Zero-
Coupon Bond (continued)
Example 4 (Answer) (continued)
Calculate the price of the bond at the end of 1
year.
Mode: P/Y=2; C/Y = 2
Input: N I/Y PV PMT FV
Key: 38 9 ? 0 1000
Output -187.75

Taxable income = $187.75 - $171.93 = $15.82

Taxes due = Tax rate * Taxable income =
0.30*$15.82 = $4.75

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 6.2 (C) Amortization of a Zero-
Coupon Bond (continued)
Example 4 (Answer) (continued)
Alternately, we can calculate the semi-annual
interest earned, for each of the two semi-annual
periods during the year.
 $171.93 * .045 = $7.736  Price after 6 months
 $171.93+7.736 = $179.667
 $179.667 * .045=$8.084 Price at end of year
 $179.667+8.084 = $187.75
 Total interest income for 1 year = $7.736+$8.084
 $15.82
 Tax due = 0.30 * $15.82 = $4.75

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 6.3 Yields and Coupon Rates

• A bond’s coupon rate differs from its yield to

maturity (YTM).
• Coupon rate -- set by the company at the
time of issue and is fixed (except for newer
innovations which have variable coupon
rates)
• YTM is dependent on market, economic, and
company-specific factors and is therefore
variable.

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 6.3 (A) The First Interest Rate:
Yield to Maturity
• Expected rate of return on a bond if held to
maturity.
• The price that willing buyers and sellers settle
at determines a bond’s YTM at any given point.
• Changes in economic conditions and risk
factors will cause bond prices and their
corresponding YTMs to change.
• YTM can be calculated by entering the coupon
amount (PMT), price (PV), remaining number of
coupons (n), and par value (FV) into the TVM
equation, financial calculator, or spreadsheet.

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 6.3 (B) The “Other” Interest
Rate: Coupon Rate
• The coupon rate on a bond is set by the
issuing company at the time of issue
• It represents the annual rate of interest that
the firm is committed to pay over the life of
the bond.
• If the rate is set at 7%, the firm is
committing to pay .07*$1000 = $70 per
year on each bond,
• It is paid either in a single check or two
checks of $35 paid six months apart.

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
• An issuing firm gets the bond rated by a rating agency
such as Standard & Poor’s or Moody’s.
• Then, based on the rating and planned maturity of the
bond, it sets the coupon rate to equal the expected
yield as indicated in the Yield Book (available in the
capital markets at that time) and sells the bond at par
value ($1000).
• Once issued, if investors expect a higher yield on the
bond, its price will go down and the bond will sell
below par or as a discount bond and vice-versa.
• Thus, a bond’s YTM can be equal to (par bond), higher
than (discount bond) or lower than (premium bond) its
coupon rate.

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate (continued)
Table 6.3 Premium Bonds, Discount Bonds, and
Par Value Bonds

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate (continued)

Figure 6.8 Bond prices and interest rates

move in opposite directions.

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate (continued)
Example 5: Computing YTM

Last year, The ABC Corporation had issued 8% coupon

(semi-annual), 20-year, AA-rated bonds (Par value =
$1000) to finance its business growth. If investors are
currently offering $1200 on each of these bonds, what
is their expected yield to maturity on the investment?
If you are willing to pay no more than $980 for this
bond, what is your expected YTM?

Remaining number of coupons = 19*2 = 38

Semi-annual coupon amount =( .08*$1000)/2 = $40

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate (continued)

Example 5 Answer
PV = $1200
Mode: P/Y=2; C/Y = 2
Input: N I/Y PV PMT FV
Key: 38 ? -120 40 1000
Output 6.19

Note: This is a premium bond, so it’s YTM

< Coupon rate of 8%

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Formula for Bond Yield

• Weighted average is used to get the average

investment over 15 year holding period.

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 Yield to Maturity

• YTM is the average rate of return earned on

a bond if it is held to maturity

Annual Accrued
Approximate yield interest  capital gains

to maturity Average value of bond

 M - Vd 
INT   
  N 
 2 Vd   M 
 
 3 

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate (continued)

Example 5 Answer (continued)

PV = $980
Mode: P/Y=2; C/Y = 2
Input: N I/Y PV PMT FV
Key: 38 ? -980 40 1000
Output 8.21%

Note: This would be a discount bond,

so it’s YTM>Coupon rate of 8%

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 6.4 Bond Ratings

• Ratings are produced by Moody’s, Standard and Poor’s, and Fitch

• Range from AAA (top-rated) to C (lowest-rated) or D (default).

• Help investors gauge likelihood of default by issuer.

• Assist issuing companies establish a yield on newly-issued

bonds.

– Junk bonds: is the label given to bonds that are rated below BBB.
These bonds are considered to be speculative in nature and carry higher
yields than those rated BBB or above (investment grade).

– Fallen angels: is the label given to bonds that have had their ratings
lowered from investment to speculative grade.

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Table 6.4
Bond Ratings

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 Chapter 7

Stocks and
Stock Valuation
 Learning Objectives

1. Explain the basic characteristics of common

stock.
2. Define the primary market and the secondary
market.
3. Calculate the value of a stock given a history of
dividend payments.
4. Explain the shortcomings of the dividend pricing
models.
5. Calculate the price of preferred stock.

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 7.1 Characteristics of Common
Stock

• Major financing vehicle for corporations

• Provides holders with an opportunity to
share in the future cash flows of the issuer.
• Holders have ownership in the company.
• Unlike bonds, no maturity date and variable
periodic income.

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 7.1 (A) Ownership

• Share in the residual profits of the company.

• Claim to all its assets and cash flow once the
creditors, employees, suppliers, and taxes
are paid off.
• Voting rights
– participate in the management of the company
– elect the board of directors which selects the
management team that runs the company’s day-
to-day operations.

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 7.1 (B) Claim on Assets and
Cash Flow (Residual Claim)

• In case of liquidation…
Shareholders have a claim on the residual assets
and cash flow of the company.
Known as “residual” rights.

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 7.1 (C) Vote (Voice in
Management)
• Standard voting rights: Typically, one vote
per share provided to shareholders to vote
in board elections and other key changes to
the charter and bylaws.
• Can be altered by issuing several classes of
stock.
– Non-voting stock, which is usually for a
temporary period of time,
– Super voting rights, which provide the holders
with multiple votes per share, increasing their
influence and control over the company.

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 7.1 (D) No Maturity Date

• Considered to be permanent financing

• Infinite life, i.e. no maturity date
• No promised date when investment is
returned.

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 7.2 Stock Markets

Stocks are traded in two types of markets;

1. the primary or “first sale” market, and the
2. secondary or “after-sale” market,

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 7.3 Stock Valuation

• Value of a share of stock the present value

of its expected future cash flow…
– Cash dividends paid (if any).
– Future selling price of the stock.
– The discount rate i.e. risk-appropriate rate of
return to be earned on the investment.
• No guaranteed cash flow information.
• No maturity date.
• Valuation is more of an “art” than a science.

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 7.3 Stock Valuation (continued)

Table 7.1 Differences between Bonds and

Stocks

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 7.3 Stock Valuation (continued)

Example 1: Stock price with known

dividends and sale price.

Agnes wants to purchase common stock of New

Frontier Inc. and hold it for 3 years. The
directors of the company just announced that
they expect to pay an annual cash dividend of
$4.00 per share for the next 5 years. Agnes
believes that she will be able to sell the stock for
$40 at the end of three years. In order to earn
12% on this investment, how much should Agnes
pay for this stock?
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 7.3 Stock Valuation (continued)
Example 1 Answer
 1 
 1 n 
Price = Future Price 
1  1 r  
n  Dividend Stream   
1 r  
r

 

 1 
 1  
1  1 0.12 4 
Price = $40.00 
4
 $4.00   
1 0.12  
0.12

 
 

Price = $40.00 x 0.635518 + $4.00 x 3.03734

Price = $25.42 + $12.149 = $37.57

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 7.3 Stock Valuation (continued)

4 variations of a dividend pricing model have been

used to value common stock

1. The constant dividend model with an infinite

horizon
2. The constant dividend model with a finite horizon
3. The constant growth dividend model with a finite
horizon
4. The constant growth dividend model with an
infinite horizon

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Dividend Valuation Model

• Where,
• = Price of stock today;
• D = Dividend for each year;
• = the required rate of return for common stock (discount
rate).
• This formula, with modifications is generally applied to
three different situations:
– No growth in dividends.
– Constant growth in dividends.
– Variable growth in dividends.

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No Growth in Dividends

• The common stock pays a constant dividend as in the case of a

preferred stock.
• This is not a very popular option.

• Where,
• = Price of the common stock; = Current annual common stock
dividend (constant); = Required rate of return for common stock.

• Assuming = $1,86 and = 12%, the price of the stock would be:

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Constant Growth in Dividends

• The general valuation process is shown:

• Where,
• = Price of common stock today;
• = Dividend in year 1, ;
• = Dividend in year 2, , and so on;
• g = Constant growth rate in dividends;
• = Required rate of return for common stock (discount rate).

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Constant Growth Dividend Valuation
Model
• Where:

• = Price of the stock today;

• = Dividend at the end of the first year;
• = Required rate of return (discount rate);
• g = Constant growth rate in dividends.

• Based on the current example; = $2.00; = .12; g = .07.

is computed as:

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 Variable Growth in Dividends –
No Dividends
• Approach 1: though no dividend is paid
currently
– The stockholders will be paid a cash dividend at a
later date.
• The present value of their deferred payments may be
used.
• Approach 2:
– Take the present value of earnings per share for
a number of periods.
– Add that to the present value of the future
anticipated stock price.

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 Stock Valuation under Supernormal
Growth Analysis

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 7.3 (A) The Constant Dividend
Model with an Infinite Horizon
Assumes that the firm is paying the same dividend
amount in perpetuity.
i.e. Div1 = Div2 = Div3 = Div4 = Div5 =
Div∞
For perpetuities,
PV = PMT/r
where r the required rate and PMT is the cash flow.

Thus, for a stock that is expected to pay the same

dividend forever,
Price = Dividend/Required rate of return
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 7.3 (A) The Constant Dividend Model
with an Infinite Horizon (continued)

Example 2. Quarterly dividends forever

Let’s say that the Peak Growth Company is paying a

quarterly dividend of $0.50 and has decided to pay the
same amount forever. If Joe wants to earn an annual
rate of return of 12% on this investment, how much
should he offer to buy the stock at?

Answer
Quarterly dividend = $0.50
Quarterly rate of return = Annual rate/4= 12%/4 = 3%
PV = Quarterly dividend/Quarterly rate of return
Price = 0.50/.03 = $16.67

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 7.3 (C) The Constant Growth Dividend
Model with an Infinite Horizon (cont’d)

QuickFix Enterprises’ Annual Dividends

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
$0.50 $0.55 $0.61 $0.67 $0.73 $0.81 $0.89 $0.98 $1.08 $1.25
Required rate of return = 14%
Compound growth rate “g” = (FV/PV)1/n -1
Where FV = $1.25; PV = 0.50; n = 9
g = (1.25/0.50)1/9 – 1 10.72%
Div1 = Div0(1+g)$1.25*(1.1072)$1.384
P0 = Div1/(r-g)  $1.384/(.14-.1072)$42.19

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 7.4 Dividend Model
Shortcomings
• Need future cash flow estimates and a required rate of return,
therefore difficult to apply universally.
– Erratic dividend patterns,
– Long periods of no dividends,
– Declining dividend trends
• Need a pricing model that is more inclusive than the dividend
model, one that can estimate expected returns for stocks
without the need for a stable dividend history.
• The capital asset pricing model (CAPM), or the security
market line (SML), which will be covered in Chapter 8, is one
option.
• SML can be used to estimate expected returns for companies
based on their risk, the premium for taking on risk, and the
reward for waiting and not on their historical dividend
patterns.

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 7.5 Preferred Stock

Pays constant dividend as long as the stock is outstanding.

Typically has infinite maturity, but some are convertible into

common stock at some pre-determined ratio.

Have “preferred status” over common stockholders in the case of

dividend payments and liquidation payouts.

Dividends can be cumulative or non-cumulative

To calculate the price of preferred stock, we use the PV of a

perpetuity equation, i.e. Price0 = PMT/r

PMT = Annual dividend (dividend rate * par value); and

r = investor’s required rate of return.
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 Div  1 g   1 g n 
Price  0  1    + Pricen
0 r  g  1 r 
 
 1 r n



• Price = $1.00 × (1.03) / (0.15 – 0.03) × [1 – ((1.03) / (1.15))5]

= $1.03 / 0.12 × [1 - 0.5764] = $8.58 × [0.4236] = $3.64

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• Price = $1.00 × (1.03) / (0.15 – 0.03) × [1
– ((1.03) / (1.15))5]
• = $1.03 / 0.12 × [1 - 0.5764] =
$8.58 × [0.4236] = $3.64

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 Chapter 9

Capital
Budgeting
Decision Models
 Learning Objectives
1. Explain capital budgeting and differentiate between short-term and
long-term budgeting decisions.
2. Explain the payback model and its two significant weaknesses and how
the discounted payback period model addresses one of the problems.
3. Understand the net present value (NPV) decision model and appreciate
why it is the preferred criterion for evaluating proposed investments.
4. Calculate the most popular capital budgeting alternative to the NPV,
the internal rate of return (IRR); and explain how the modified internal
rate of return (MIRR) model attempts to address the IRR’s problems.
5. Understand the profitability index (PI) as a modification of the NPV
model.
6. Compare and contrast the strengths and weaknesses of each decision
model in a holistic way.

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 9.1 Short-Term and Long-Term
Decisions
• Long-term decisions vs. short-term
decisions
– longer time horizons,
– cost larger sums of money, and
– require a lot more information to be collected as
part of their analysis, than short-term decisions.
• Capital budgeting meets all 3 criteria

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 9.1 Short-Term and Long-Term
Decisions (continued)
Three keys things to remember about capital
budgeting decisions include:

1. Typically a go or no-go decision on a product,

service, facility, or activity of the firm.
2. Requires sound estimates of the timing and
amount of cash flow for the proposal.
3. The capital budgeting model has a predetermined
accept or reject criterion.

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 9.2 Payback Period

• The length of time in which an investment pays back its

original cost.
• Payback period  the cutoff period and vice-versa.
• Thus, its main focus is on cost recovery or liquidity.
• The method assumes that all cash outflows occur right at the
beginning of the project’s life followed by a stream of inflows
• Also assumes that that cash inflows occur uniformly over the
year.
• Thus if Cost = $40,000; CF = $15,000 per year for 3 years;
PP = 2 .67 yrs.

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 9.2 Payback Period (continued)

• Example 1 Payback period of a new machine

• Let’s say that the owner of Perfect Images Salon
is considering the purchase of a new tanning bed.
• It costs $10,000 and is likely to bring in after-tax
cash inflows of $4,000 in the first year, $4,500 in
the second year, $10,000 in the 3rd year, and
$8,000 in the 4th year.
• The firm has a policy of buying equipment only if
the payback period is 2 years or less.
• Calculate the payback period of the tanning bed
and state whether the owner would buy it or not.

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 9.2 Payback Period (continued)
Example 1 Answer
Cash Yet to be Percent of Year
Year flow recovered Recovered/Inflow

0 (10,000) (10,000)

1 4,000 (6,000)

2 4,500 (1,500)

0
3 10,000 (recovered) 15%
Not used in
4 8,000 decision

Payback Period
= 2.15yrs. Reject,  2 years

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 9.2 Payback Period (continued)

• The payback period method has two major flaws:

1. It ignores all cash flow after the initial
cash outflow has been recovered.
2. It ignores the time value of money.

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 9.2 (A) Discounted Payback
Period
• Calculates the time it takes to recover the
initial investment in current or discounted
dollars.
• Incorporates time value of money by adding
up the discounted cash inflows at time 0,
using the appropriate hurdle or discount
rate, and then measuring the payback
period.
• It is still flawed in that cash flows after the
payback are ignored.

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 9.2 (A) Discounted Payback
Period (continued)

Example 2: Calculate Discounted

Payback Period

Calculate the discounted payback period of

the tanning bed, stated in Example 1 above,
by using a discount rate of 10%.

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 9.2 (A) Discounted Payback Period
(continued) Example 2 Answer
Cash Discounted Yet to be Percent of Year
Year flow CF recovered Recovered/Inflow

0 (10,000) (10,000) (10,000)

1 4,000 3,636 (6,364)

2 4,500 3,719 (2,645)

3 10,000 7,513 4,869 35%

Not used
in
4 8,000 5,464 decision

Discounted
Payback =
2.35 years

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 9.3 Net Present Value (NPV)

• Discounts all the cash flows from a project

back to time 0 using an appropriate discount
rate, r:

• A positive NPV implies that the project is

adding value to the firm’s bottom line and
therefore when comparing projects, the
higher the NPV the better.

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 9.3 Net Present Value (NPV) (continued)

Example 3: Calculating NPV.

Using the cash flows for the tanning bed given in Example 2
above, calculate its NPV and indicate whether the
investment should be undertaken or not.

Answer
NPV bed= -$10,000 + $4,000/(1.10) + $4,500/(1.10) 2 +
$10,000/(1.10)3 + $8,000/(1.10)4
=-$10,000 + $3,636.36 + $3719.01 + $7513.15
+ $5,464.11
=$10,332.62
Since the NPV > 0, the tanning bed should be purchased.

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 9.3 (A) Mutually Exclusive
versus Independent Projects
NPV approach useful for independent as well as mutually
exclusive projects.
A choice between mutually exclusive projects arises when:
1.There is a need for only one project, and both projects
can fulfill that need.
2.There is a scarce resource that both projects need, and
by using it in one project, it is not available for the
second.
NPV rule considers whether or not discounted cash inflows
outweigh the cash outflows emanating from a project.
Higher positive NPVs would be preferred to lower or
negative NPVs.
Decision is clear-cut.

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 9.3 (A) Mutually Exclusive versus
Independent Projects (continued)

Example 4: Calculate NPV for choosing between

mutually exclusive projects.
The owner of Perfect Images Salon has a dilemma. She
wants to start offering tanning services and has to decide
between purchasing a tanning bed and a tanning booth. In
either case, she figures that the cost of capital will be 10%.
The relevant annual cash flows with each option are listed
below:
Year Tanning Bed Tanning Booth
0 -10,000 -12,500
1 4,000 4,400
2 4,500 4,800
3 10,000 11,000
4 8,000 9,500

Can you help her make the right decision?

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 9.3 (A) Mutually Exclusive versus
Independent Projects (continued)

Example 4 Answer
Since these are mutually exclusive options, the one with the higher
NPV would be the best choice.
NPV bed = -$10,000 + $4,000/(1.10)+ $4,500/(1.10)2 +
$10,000/(1.10)3+$8,000/(1.10)4
=-$10,000 +$3636.36+$3719.01+$7513.15+
$5464.11
=$10,332.62
NPV booth = -$12,500 + $4,400/(1.10)+ $4,800/(1.10)2 +
$11,000/(1.10)3+$9,500/(1.10)4
=-$12,500 +$4,000+$3,966.94+$8,264.46+
$6,488.63
=$10,220.03
Thus, the less expensive tanning bed with the higher NPV
(10,332.62>10,220.03) is the better option.

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 9.4 Internal Rate of Return

• The Internal Rate of Return (IRR) is the discount rate

which forces the sum of all the discounted cash flows
from a project to equal 0, as shown below:

• The decision rule that would be applied is as follows:

• IRR > discount rate  NPV > 0  Accept project
• The IRR is measured as a percent while the NPV is
measured in dollars.

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 9.4 Internal Rate of Return

Example 7. Calculating IRR with a financial

calculator.
Using the cash flows for the tanning bed given in
Example 1 above calculate its IRR and state your
decision.

CF0 =-$10,000; CF1 = $4,000; CF2=$4,500; CF3

= $10,000; CF4 = $8,000

I or discount rate = 10%

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 9.4 (A) Appropriate Discount
Rate or Hurdle Rate
• Discount rate or hurdle rate is the minimum
acceptable rate of return that should be
earned on a project given its riskiness.
• For a firm, it would typically be its weighted
average cost of capital (covered in later
chapters).
• Sometimes, it helps to draw an NPV profile
– i.e. A graph plotting various NPVs for a range of
incremental discount rates, showing at which
discount rates the project would be acceptable
and at which rates it would not.

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 9.4 (A) Appropriate Discount
Rate or Hurdle Rate (continued)
TABLE 9.2 NPVs for
Copier A with Varying
Risk Levels
The point where the NPV line cuts the X-
axis is the IRR of the project i.e. the
discount rate at which the NPV = 0. Thus,
at rates below the IRR, the project would
have a positive NPV and would be
acceptable and vice-versa.

Figure 9.3 Net

present value profile
of copier A.

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 9.4 (B) Problems with the
Internal Rate of Return
• In most cases, NPV decision = IRR decision
– That is, if a project has a positive NPV, its IRR will
exceed its hurdle rate, making it acceptable.
Similarly, the highest NPV project will also generally
have the highest IRR.
• However, there are some cases when the IRR
method leads to ambiguous decisions or is
problematic. In particular, we can have 2
problems with the IRR approach:
1. Multiple IRRs; and
2. An unrealistic reinvestment rate assumption.

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 9.4 (C) Multiple Internal Rates
of Return
Projects which have non-normal cash flows (as
shown below) i.e. multiple sign changes during
their lives often end up with multiple IRRs.

Figure 9.4 Pay

Me Later
Franchise
Company
multiple
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internal rates
3-170
 9.4 (C) Multiple Internal Rates
of Return (continued)
• Typically happens when a project has non-normal
cash flows, i.e. the cash inflows and outflows are
not all clustered together i.e. all negative cash flows
in early years followed by all positive cash flows
later, or vice-versa.
• If the cash flows have multiple sign changes during
the project’s life, it leads to multiple IRRs and
therefore ambiguity as to which one is correct.
• In such cases, the best thing to do is to draw an
NPV profile and select the project if it has a positive
NPV at our required discount rate and vice-versa.

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 9.5 Profitability Index

• If faced with a constrained budget choose projects

that give us the best “bang for our buck.”
• The Profitability Index can be used to calculate the
ratio of the PV of benefits (inflows) to the PV of the
cost of a project as follows:

• In essence, it tells us how many dollars we are

getting per dollar invested.

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 9.5 Profitability Index
(continued)
Example 10: PI calculation.
Using the cash flows listed in Example 8, and a discount rate of
10%, calculate the PI of each project Which one should be
accepted, if they are mutually exclusive? Why?
Year A B
0 -10,000 -7,000
1 5,000 9000
2 7000 5000
3 9000 2000

NPV@10% $7,092.41 $6,816.68

Answer
PIA= (NPV + Cost)/Cost = ($17,092.41/$10,000) = $1.71
PIB = (NPV + Cost)/Cost = ($13,816.68/$7,000) = $1.97
PROJECT B, HIGHER PI

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 9.6 Overview of Six Decision Models

1. Payback period
– simple and fast, but economically unsound.
– ignores all cash flow after the cutoff date
– ignores the time value of money.
2. Discounted payback period
– incorporates the time value of money
– still ignores cash flow after the cutoff date.
3. Net present value (NPV)
– economically sound
– properly ranks projects across various sizes, time
horizons, and levels of risk, without exception for all
independent projects.

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 9.6 Overview of Six Decision
Models (continued)
4. Internal rate of return (IRR)
– provides a single measure (return),
– has the potential for errors in ranking projects.
– can also lead to an incorrect selection when there are two
mutually exclusive projects or incorrect acceptance or rejection
of a project with more than a single IRR.
5. Modified internal rate of return (MIRR)
– corrects for most of, but not all, the problems of IRR and gives
the solution in terms of a return.
– the reinvestment rate may or may not be appropriate for the
future cash flows, however.
6. Profitability index (PI)
– incorporates risk and return,
– but the benefits-to-cost ratio is actually just another way of
expressing the NPV.

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 9.6 Overview of Six Decision
Models (continued)
Table 9.4 Summary of Six Decision
Models

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 9.6 (A) Capital Budgeting Using
a Spreadsheet
NPV, MIRR, and IRR can be easily solved once data is
entered into a spreadsheet.

For NPV we enter the following  NPV(rate, CF1:CFn) +

CF0
Note: for the NPV we have to add in the Cash
outflow in Year 0 (CF0), at the end, i.e.to the PV of
CF1…CFn

For IRR we enter the following  IRR(CF0:CFn)

For MIRR MIRR(CF0:CFn,discount rate, reinvestment

rate); where the discount rate and the reinvestment rate
would typically be the same i.e. the cost of capital of the
firm.

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 9.6 (A) Capital Budgeting Using
a Spreadsheet (continued)

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 9.6 (A) Capital Budgeting Using
a Spreadsheet (continued)

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 Additional Problems with Answers
Problem 1
Computing Payback Period and Discounted
Payback Period.
Regions Bank is debating between two the purchase
of two software systems; the initial costs and annual
savings of which are listed below. Most of the
directors are convinced that given the short lifespan
of software technology, the best way to decide
between the two options is on the basis of a payback
period of 2 years or less.
Compute the payback period of each option and
state which one should be purchased.
One of the directors states, “I object! Given our
hurdle rate of 10%, we should be using a discounted
payback period of 2 years or less.” Accordingly,
evaluate the projects on the basis of the DPP and
state your decision.
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 Additional Problems with Answers
Problem 1 (Answer)

Software Software
Option A PVCF@10% Option B PVCF@10%

($1,875,000) $ (1,875,000.00) ($2,000,000) $ (2,000,000.00)

$1,050,000 $ 954,545.45 1,250,000 $ 1,136,363.64
$900,000 $ 743,801.65 $800,000 $ 661,157.02
$450,000 $ 338,091.66 $600,000 $ 450,788.88
Payback period of Option A = 1 year + (1,875,000-1,050,000)/900,000 = 1.92
years
Payback period of Option B = 1year + (2,000,000-1,250,000)/800,000 = 1.9375
years.
Based on the Payback Period, Option A should be
chosen.

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 Additional Problems with Answers
Problem 1 (Answer) (continued)

For the discounted payback period, we first discount the cash

flows at 10% for the respective number of years and then add
them up to see when we recover the investment.

DPP A = -1,875,000 + 954,545.45+743,801.65=-176652.9

 still to be recovered in Year 3
 DPP A = 2 + (176652.9/338091.66) = 2.52 years
DPP B = -2,000,000+1, 136,363.64+661157.02 = -202479.34
still to be recovered in Year 3
DPPB = 2 + (202479.34/450788.88) = 2.45 years.

Based on the Discounted Payback Period and a 2 year cutoff, neither

option is acceptable.

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 Additional Problems with Answers
Problem 2

Computing Net Present Value –

Independent projects:
Locey Hardware Products is expanding its product
line and its production capacity. The costs and
expected cash flows of the two projects are given
below. The firm typically uses a discount rate of
15.4 percent.
a. What are the NPVs of the two projects?
b. Which of the two projects should be accepted
(if any) and why?

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 Additional Problems with Answers
Problem 2 (Answer)

Year Product Line Production

Expansion Capacity
Expansion
0 $ (2,450,000) $ (8,137,250)
1 $ 500,000 $ 1,250,000
2 $ 825,000 $ 2,700,000
3 $ 850,000 $ 2,500,000
4 $ 875,000 $ 3,250,000
5 $ 895,000 $ 3,250,000

NPV @15.4% = $86,572.61 $20,736.91

Decision: Both NPVs are positive, and the projects are

independent, so assuming that Locey Hardware has the
required capital, both projects are acceptable.

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 Additional Problems with Answers
Problem 3

KLS Excavating needs a new crane. It has received

two proposals from suppliers.
Proposal A costs $ 900,000 and generates cost savings of
$325,000 per year for 3 years, followed by savings of
$200,000 for an additional 2 years.
Proposal B costs $1,500,000 and generates cost savings of
$400,000 for 5 years.
If KLS has a discount rate of 12%, and prefers
using the IRR criterion to make investment
decisions, which proposal should it accept?

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 Additional Problems with Answers
Problem 3 (Answer)

Year Crane A Crane B

0 $ (900,000) $ (1,500,000)
1 $ 325,000 $ 400,000
2 $ 325,000 $ 400,000
3 $ 325,000 $ 400,000
4 $ 200,000 $ 400,000
5 $ 200,000 $ 400,000
Required rate of return 12%

IRR 17.85% 10.42%

Decision Accept Crane A IRR>12%

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 Additional Problems with Answers
Problem 5
Using multiple methods with mutually exclusive projects:
The Upstart Corporation is looking to invest one of 2 mutually
exclusive projects, the cash flows for which are listed below. Their
director is really not sure about the hurdle rate that he should use
when evaluating them and wants you to look at the projects’ NPV
profiles to better assess the situation and make the right decision.

Year A B
0 -454,000 ($582,000)
1 $130,000 $143,333
2 $126,000 $168,000
3 $125,000 $164,000
4 $120,000 $172,000
5 $120,000 $122,000

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 Additional Problems with Answers
Problem 5 (Answer) (continued)

So, it’s clear that the NPV profiles will cross-over

at a discount rate of 5.2%.

Project A has a higher IRR than Project B, so at

discount rates higher than 5.2%, it would be the
better investment, and vice-versa (higher NPV
and IRR), but if the firm can raise funds at a rate
lower than 5.2%, then Project B will be better,
since its NPV would be higher.

To check this let’s compute the NPVs of the 2

projects at 0%, 3%, 5.24%, 8%, 10.2%, and
11.6%...
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 Additional Problems with Answers
Problem 5 (Answer) (continued)

Rate NPV(A) NPV(B)

0.00% 167,000 187,333
3.00% 115,505 123,656
5.24% 81,353 81,353
8.00% 43,498 34,393
10.2% 15,810 0
11.6% 0 -19,658
Note that the two projects have equal NPVs at
the cross-over rate of 5.24%. At rates below
5.24%, Project B’s NPVs are higher; whereas
at rates higher than 5.24%, Project A has the
higher NPV.

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 FIGURE 9.1 Initial cash outflow and future
cash inflow of Copiers A and B.

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 TABLE 9.1 Discounted Cash Flow
of Copiers A and B

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 FIGURE 9.2 Net present value of
a low-tech packaging machine.

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 TABLE 9.2 NPVs for Copier A
with Varying Risk Levels

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 FIGURE 9.3 Net present value
profile of Copier A

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 TABLE 9.3 Project Rankings Based on
the Internal Rate of Return and the
Net Present Value

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 TABLE 9.5 Corporate Use of Different
Decision Models: What Capital Budgeting
Decision Models Do You Use?

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Chapter 11

The Cost of
Capital
Chapter 11

The Cost of
Capital
 Learning Objectives

1. Understand the different kinds of financing available to a

company: debt financing, equity financing, and hybrid equity
financing.
2. Understand the debt and equity components of the weighted
average cost of capital (WACC) and explain the tax
implications on debt financing and the adjustment to the
WACC.
3. Calculate the weights of the components using book values or
market values.
4. Explain how the WACC is used in capital budgeting models
5. Determine the beta of a project and its implications in capital
budgeting problems.
6. Select optimal project combinations for a company’s portfolio
of acceptable potential projects.

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 11.1 The Cost of Capital: A
Starting Point
3 broad sources of financing available or raising
capital: debt, common stock (equity), and preferred
stock (hybrid equity).
Each has its own risk and return profile and
therefore its own rate of return required by
investors to provide funds to the firm.

Figure 11.1 Component sources of

capital.
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 11.1 The Cost of Capital: A
Starting Point

The weighted average cost of capital

(WACC) is estimated by multiplying each
component weight by the component cost
and summing up the products.
The WACC is essentially the minimum
acceptable rate of return that the firm
should earn on its investments of average
risk, in order to be profitable.
WACC discount rate for computing NPV
 IRR > WACC for acceptance of project.

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 11.1 The Cost of Capital: A
Starting Point (continued)
Example 1: Measuring weighted average cost of a mortgage
Jim wants to refinance his home by taking out a single mortgage and
paying off all the other sub-prime and prime mortgages that he took
on while the going was good. Listed below are the balances and rates
owed on each of his outstanding home-equity loans and mortgages:

Lender Balance Rate

First Cut-Throat Bank $ 150,000 7.5%
Second Considerate Bank $ 35,000 8.5%
Third Pawn Mortgage Co. $ 15,000 9.5%

Below what rate would it make sense for Jim to consolidate all these
loans and refinance the whole amount?

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 11.1 The Cost of Capital: A
Starting Point (continued)
Example 1 Answer

Jim’s weighted average cost of borrowing

= Proportion of each loan * Rate
(10,000/200,000)*.075+(35,000/200,000)
*.085+(15,000/200,000)*.095
(.75*.075) + (.175*.085) (+.075*.095)
= .07825 or 7.825%

Jim’s average cost of financing his home is 7.825%.

Any rate below 7.825% would be beneficial.

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 11.2 Components of the Weighted Average Cost of
Capital

To determine a firm’s WACC we need to know

how to calculate:
1. the relative weights and
2. costs of the debt, preferred stock, and
common stock of a firm.

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 Cost of Debt

• Measured by interest rate, or yield, paid to

bondholders
– Example: $1,000 bond paying $100 annual
interest – 10% yield
– Calculation is complex if a bond is priced at
discount or premium from par value
• To determine the cost of a new debt in the
marketplace:
– The firm will compute the yield on its currently
outstanding debt

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Formula for Bond Yield

• Weighted average is used to get the average

investment over 15 year holding period.

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Adjusting Yield
for Tax Considerations (cont’d)
• The after-tax cost of debt is calculated as
shown below:
Kd (Cost of debt) = Y(1 – T)

• Assuming: Yield = 10.84% and Tax rate =

35%
Kd (Cost of debt) = Y(1 – T)
Kd (Cost of debt) = 10.84% (1 – 0.35)
= 10.84% × 0.65
= 7.05%

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 11.2 (B) Preferred Stock
Component

Preferred stock holders receive a constant

dividend with no maturity point;
The cost of preferred (Rp)can be estimated
by dividing the annual dividend by the net
proceeds (after floatation cost) per share of
preferred stock:
Rp = Dp/Net price

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 11.2 (B) Preferred Stock
Component (continued)
Example 3: Cost of Preferred Stock

Kellogg’s will also be issuing new preferred stock

worth $1 million. They will pay a dividend of $4 per
share which has a market price of $40. The
floatation cost on preferred will amount to $2 per
share. What is their cost of preferred stock?

Answer
Net price on preferred stock = $38;
Dividend on preferred = $4
Cost of preferred = Rp = $4/$38 = 10.53%
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 11.2 (C) Equity Component

The cost of equity (Re) is essentially the rate

of return that investors are demanding or
expecting to make on money invested in a
company’s common stock.

The cost of equity can be estimated by using

either the SML approach (covered in Chapter
8) or the Dividend Growth Model (covered in
Chapter 7).

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 11.2 (C) Equity Component
(continued)

The Security Market Line Approach:

calculates the cost of equity as a function
of the risk-free rate (rf) the market risk-
premium [E(rm)-rf], and beta (βi).
That is,

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 11.2 (C) Equity Component
(continued)
Example 4: Calculating Cost of Equity with the SML
equation
Remember Kellogg’s from the earlier 2 examples? Well, to
reach their desired capital structure their CEO has decided to
utilize all of their expected retained earnings in the coming
quarter. Kellogg’s beta is estimated at 0.65 by Value Line. The
risk-free rate is currently 4%, and the expected return on the
market is 15%. How much should the CEO put down as one
estimate of the company’s cost of equity?
Answer
Re = rf + [E(rm)-rf]βi
Re=4%+[15%-4%]0.65
Re= 4%+7.15% = 11.15%

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 11.2 (C) Equity Component
(continued)
The Dividend Growth Approach to Re: The Gordon
Model, introduced in Chapter 7, is used to calculate the
price of a constant growth stock.
However, with some algebraic manipulation it can be
transformed into Equation 11.6, which calculates the
cost of equity, as shown below:

where Div0 = last paid dividend per share;

Po = Current market price per share; and
g = constant growth rate of dividend.

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 11.2 (C) Equity Component
(continued)

For newly issued common stock, the price

must be adjusted for floatation cost
(commission paid to investment banker) as
shown in Equation 11.7 below:

where F is the floatation cost in percent.

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 11.2 (C) Equity Component
(continued)
Example 5: Applying the Dividend Growth
Model to calculate Re
Kellogg’s common stock is trading at $45.57 and
its dividends are expected to grow at a constant
rate of 6%.
The company paid a dividend last year of $2.27.
If the company issues stock they will have to
pay a floatation cost per share equal to 5% of
selling price.
Calculate Kellogg’s cost of equity with and
without floatation costs.

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 11.2 (C) Equity Component
(continued) Example 5 Answer
Cost of equity without floatation cost:

Re = (Div0*(1+g)/Po) + g
 ($2.27*(1.06)/$45.57)+.0611.28%

Cost of equity with floatation cost:

Re = [$2.27*(1.06)/(45.57*(1-.05)]+.06
11.56%
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 11.2 (C) Equity Component
(continued)

Depending on the availability of data, either

of the two models, or both, can be used to
estimate Re.
With two values, the average can be used as
the cost of equity.
For example, in Kellogg’s case we have
(11.15%+11.28%)/211.22% (without
floatation costs)
or (11.15%+11.56%) /211.36%(with
floatation costs)

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 11.2 (D) Retained Earnings

Retained earnings does have a cost, i.e. the

opportunity cost for the shareholders not being able
to invest the money themselves.
The cost of retained earnings can be calculated by
using either of the above two approaches, without
including floatation cost.
Also, since interest expenses are tax deductible, the
cost of debt, must be adjusted for taxes, as shown
below, prior to including it in the WACC calculation:
After-tax cost of debt = Rd*(1-Tc)
So if the YTM (with floatation cost) = 7.6%,
and the company’s marginal tax rate is 30%,
the after-tax cost of debt7.6%*(1-
3)5.32%
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 Cost of Components
in the Capital Structure

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 Cost of Components
in the Capital Structure

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 11.3 (B) Adjusted Weighted
Average Cost of Capital
• Equation 11.9 can be used to combine all
the weights and component costs into a
single average cost which can be used as
the firm’s discount or hurdle rate:

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 11.4 Using the Weighted Average
Cost of Capital in a Budgeting
Decision (continued)
Using a discount rate of 12%, the project’s NPV would
be determined as follows:

Since the NPV > 0 this would be an acceptable project.

Alternatively, the IRR could be determined using a
financial calculator14.85%
Again, since IRR>12%, this would be an acceptable
project.

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 11.4 (A) Individual Weighted Average
Cost of Capital for Individual Projects

To adjust for risk, we would need to get

individual project discount rates based on each
project’s beta.
Using a risk-free rate of 3%; a market risk
premium of 9%; a before-tax cost of 10%, a
tax rate of 30%; equally-weighted debt and
equity levels, and varying project betas we can
compute each project’s hurdle rate as follows:

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 Additional Problems with Answers
Problem 1

Cost of debt for a firm: You have been assigned the

task of estimating the after-tax cost of debt for a firm
as part of the process in determining the firm’s cost of
capital.
After doing some checking, you find out that the firm’s
original 20-year 9.5% coupon bonds (paid semi-
annually), currently have 14 years until they mature
and are selling at a price of $1,100 each.
You are also told that the investment bankers charge a
commission of $25 per bond when new bonds are sold.
If these bonds are the only debt outstanding for the
firm, what is the after-tax cost of debt for this firm if
the marginal tax rate for the firm is 34 percent?

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 Additional Problems with Answers
Problem 1 (Answer)

Calculate the YTM on the currently outstanding

bonds, after adjusting the price for the $25
commission.

i.e. Net Proceeds = $1100-$25 $1075

Set P/Y=2 and C/Y = 2

Input 28 ? -1075 47.51000
Key N I/Y PV PMT FV
Output 8.57%

After-tax cost of debt = 8.57%(1-.34) 5.66%

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 Additional Problems with Answers
Problem 2

Cost of Equity for a firm: R.K. Boats Inc. is in the

process of making some major investments for
growth and is interested in calculating their cost of
equity so as to be able to correctly estimate their
adjusted WACC.
The firm’s common stock is currently trading for
$43.25 and their annual dividend, which was paid
last year, was $2.25, and should continue to grow
at 6% per year.
Moreover, the company’s beta is 1.35, the risk-free
rate is at 3%, and the market risk premium is 9%.
Calculate a realistic estimate of RKBIs cost of
equity. (Ignore floatation costs.)

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 Additional Problems with Answers
Problem 2 (Answer)

Using the SML Approach:

Rf =3%; Rm-Rf = 9%; β = 1.35; Re=3%+(9%)*1.35
15.15%

Using the Dividend Growth Model (constant growth)

P0 = $43.25; Do=$2.25; g=6%;
($2.25*(1.06)/$43.25)+.0611.51%

A realistic estimate of RKBIs cost of equity = Average

of the 2 estimates
(15.15%+11.51%)/213.33%

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 Additional Problems with Answers
Problem 3

Calculating capital component weights: T.J. Enterprises is trying to determine the

weights to be used in estimating their cost of capital.
The firm’s current balance sheet and market information regarding the price and
number of securities outstanding are listed below.
TJ Enterprises
Balance Sheet
(in thousands)
Current Assets: $50,000 Current Liabilities: $0
Long-Term Assets: $60,000 Long-Term Liabilities
Bonds Payable $48,000
Owner’s Equity
Preferred Stock $15,000
Common Stock $47,000
Total Assets: $110,000 Total L & OE $110,000

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 Additional Problems with Answers
Problem 3 (continued)
Market Information
Debt Preferred Stock Common
Stock
Outstanding 48,000 102,000 1,300,000
Market Price $850 $95.40 $40
Calculate the firm’s capital component weights using
book values as well as market values.

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 Additional Problems with Answers
Problem 3 (Answer)

Based on book values:

Weight of Debt = $48,000/$110,000 43.64%
Weight of P/S= $15,000/$110,000 13.64%
Weight of C/S = $47,000/$110,00042.72%
Based on market value:
Market value of Debt =$40,800,000
Market Value of P/S= $9,730,800
Market Value of C/S= $52,000,000
Total Market Value= $102,530,000

Weight of Debt = $40,800/$102,530 39.79%

Weight of P/S= $9,730.8/$102,530 9.49%
Weight of C/S = $52,000/$102,53050.72%

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 Additional Problems with Answers
Problem 4
Computing WACC: New Ideas Inc. currently has 30,000 of its 9% semi-
annual coupon bonds outstanding (Par value =1000).
– The bonds will mature in 15 years and are currently priced at $1,340
per bond.
– The firm also has an issue of 1 million preferred shares outstanding
with a market price of $11.00. The preferred shares offer an annual
dividend of $1.20.
– New Ideas Inc. also has 2 million shares of common stock
outstanding with a price of $30.00 per share. The firm is expected to
pay a$3.20 common dividend one year from today, and that dividend
is expected to increase by 7 percent per year forever.
– The firm typically pays floatation costs of 2% of the price on all
newly issued securities.
If the firm is subject to a 35 percent marginal tax rate, then what is the
firm’s weighted average cost of capital?

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 Additional Problems with Answers
Problem 4 (Answer)

1) Determine the component costs

Cost of Debt:
P=1340; F=2%; Net proceeds=P(1-F)
Net proceeds = $1340*(1-.02)=$1273

Set P/Y=2 and C/Y = 2

Input 30 ? -1273 45 1000
Key N I/Y PV PMT FV
Output 6.18%
Before-tax Rd 6.18%

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 Additional Problems with Answers
Problem 4 (Answer) (continued)

Cost of preferred stock:

Dp=$1.20; Pp=$11; F=2%

Rp = Dp/Pp(1-F)  $1.20/($11(.98)1.20/10.7811.13%

Cost of common stock:

Pc=$30; D1=$3.2; g=7%; F=2%

Using the constant dividend growth model:

Re = [D1/(P(1-F])+g[3.2/$30(.98)]+.0717.88%

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 Additional Problems with Answers
Problem 4 (Answer) (continued)

3) Calculate the adjusted WACC

WACC = .5396*17.88%
+ .0989*11.13%
+.3615*6.18%*(1-.35)

=9.65 +1.10%+1.45%  12.2%

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 Chapter 14

Financial Ratios
and Firm
Performance
 Learning Objectives

1. Create, understand, and interpret

common-size financial statements.
2. Calculate and interpret financial ratios.
3. Compare different company performances
using financial ratios, historical financial
ratio trends, and industry ratios.

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 Ratios and their Classification

A. Profitability ratios
1. Profit margin
2. Return on assets (investment)
3. Return on equity
B. Asset utilization ratios
4. Receivable turnover
5. Average collection period
6. Inventory turnover
7. Fixed asset turnover
8. Total asset turnover

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 Ratios and their Classification
(cont’d)
C. Liquidity ratios
9. Current ratio
10. Quick ratio
11. Cash Ratio = Cash / CL
12. NWC to Total Assets = NWC / TA
D. Debt utilization ratios
13. Debt to total assets
14. Times interest earned
15. Fixed charge coverage
E. Market value ratios
16. Earnings per share (EPS)
17. Price/Earnings (P/E) ratio
18. Book value per share
19. Market/Book (M/B) ratio
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 14.1 Financial Statements

Just like a doctor takes a look at a patient’s x-rays or

cat-scan when diagnosing health problems, a
manager or analyst can take a look at a firm’s primary
financial statements i. e. the income statement and
the balance sheet, when trying to gauge the status or
performance of a firm.
Income statement: periodic recording of the sources
of revenue and expenses of a firm,
Balance sheet: provides a point in time snap shot of
the firm’s assets, liabilities and owner’s equity.

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 14.1 (A) Benchmarking

• The financial statements constitute fairly complex

documents involving a whole bunch of numbers.
• Absolute values
– tell us something about the amount of assets, liabilities,
equity, revenues, expenses, and taxes of a firm,
– difficult to really gauge what’s going on, primarily because
of size and maturity differences among firms.
– requires “benchmarking” against some standard.
• One common method of benchmarking a is to
compare a firm’s current performance against that of
its own performance over a 3-5 year period (trend
analysis), by looking at the growth rate in various
key items such as sales, costs, and profits.

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 14.1 (A) Benchmarking
(continued)
Table 14.1 Cogswell Cola’s Abbreviated Income Statements
($ in thousands)

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 14.1 (A) Benchmarking
(continued)

• Another useful way to make some sense

out of this mess of numbers, is to re-cast
the income statement and the balance
sheet into common size statements, by
expressing each income statement item
as a percent of sales and each balance
sheet item as a percent of total assets.

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 14.1 (A) Benchmarking
(continued)
Figure 14.3

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 14.1 (A) Benchmarking
(continued)
Figure 14.4

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 14.1 (A) Benchmarking
(continued)
• Benchmarking is a good starting point to
detect trends (if any) in a firm’s
performance and to make quick
comparisons of key financial statement
values with competitors on a relative basis.

• More in-depth diagnosis requires individual

item analyses and comparisons which are
best done by conducting ratio analysis.

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 14.2 Financial Ratios

• Financial ratios are relationships between

different accounts from financial statements—
usually the income statement and the
balance sheet—that serve as performance
indicators

• Being relative values, financial ratios allow for

meaningful comparisons across time,
between competitors, and with industry
averages.

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 14.2 Financial Ratios
(continued)
5 key areas of a firm’s performance can be analyzed using
financial ratios:
1. Liquidity ratios: Can the company meet its obligations over the
short term?
2. Solvency ratios: (also known as financial leverage ratios): Can
the company meet its obligations over the long term?
3. Asset management ratios: How efficiently is the company
managing its assets to generate sales?
4. Profitability ratios: How well has the company performed overall?
5. Market value ratios: How does the market (investors) view the
company’s financial prospects?
Can also conduct a Du Pont analysis which involves a breakdown of the
return on equity into its three components, i.e. profit margin, turnover,
and leverage.

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 14.2 (A) Short-Term Solvency:
Liquidity Ratios
• Measure a company’s ability to cover its
short-term debt obligations in a timely
manner:
• 3 key liquidity ratios include: The current
ratio, quick ratio, and cash ratio.

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 14.2 (A) Short-Term Solvency:
Liquidity Ratios

Table 14.2 Liquidity Ratios 2011 for

Cogswell Cola and Spacely Spritzers

Cogswell has better liquidity and short-term solvency than Spacely, but,
higher investment in current assets also means that lower yields are
being realized since current assets are typically low yielding.
So, we need to look at the other areas and inter-related effects of the
firm’s various accounting items.

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 14.2 (B) Long-Term Solvency:
Solvency or Financial Leverage Ratios

• Measure a company’s ability to meet its

long-term debt obligations based on its
overall debt level and earnings capacity.
• Failure to meet its interest obligation could
put a firm into bankruptcy.
• Equations 14.4, 14.5, and 14.6 can be used
to calculate 3 key financial leverage ratios:
the debt ratio, times interest earned ratio,
and cash coverage ratio.

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 14.2 (B) Long-Term Solvency: Long-Term
Solvency: Solvency or Financial Leverage
Ratios

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 14.2 (B) Long-Term Solvency: Long-
Term Solvency: Solvency or Financial
Leverage Ratios
Table 14.3 Financial Leverage Ratios 2011
for Cogswell Cola and Spacely Spritzers

Cogswell Cola has relatively less debt and a significantly greater ability to cover its
interest obligations by using either its EBIT (times interest earned ratio) or its net
cash flow (cash coverage ratio) than Spacely Spritzers.

Leverage must be analyzed as a combination of debt level and coverage. If a firm is

heavily leveraged but has good interest coverage, it is using the interest
deductibility feature of taxes to its benefit. Having a high leverage with low
coverage could put the firm into a risk of bankruptcy.

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 14.2 (C) Asset Management
Ratios
• Measure how efficiently a firm is using its assets to generate
revenues or how much cash is being tied up in other assets
such as receivables and inventory.
• Equations 14.7 – 14.11 can be used to calculate 5 key asset
management ratios.

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 14.2 (C) Asset Management
Ratios
Table 14.4 Asset Management Ratios 2011
for Cogswell Cola and Spacely Spritzers

While Cogswell is more efficient at managing its

inventory, Spacely seems to be doing a better job
of collecting its receivables and utilizing its total
assets in generating revenues

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 14.2 (D) Profitability Ratios
Profitability ratios such as net profit margin, returns on
assets, and return on equity, measure a firm’s
effectiveness in turning sales or assets into profits.

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 14.2 (D) Profitability Ratios
(continued)

Table 14.5 Profitability Ratios 2011 for

Cogswell Cola and Spacely Spritzers

As far as profitability is concerned, Cogswell is

outperforming Spacely by about 3%.

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 14.2 (E) Market Value Ratios

Used to gauge how attractive or reasonable a firm’s

current price is relative to its earnings, growth rate, and
book value.

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 14.2 (E) Market Value Ratios
(continued)

• Potential investors and analysts often use these

ratios as part of their valuation analysis.
• Typically, if a firm has a high price to earnings and
a high market to book value ratio, it is an indication
that investors have a good perception about the
firm’s performance.
• However, if these ratios are very high it could also
mean that a firm is over-valued.
• With the price/earnings to growth ratio (PEG ratio),
the lower it is, the more of a bargain it seems to be
trading at, vis-à-vis its growth expectation.
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 14.2 (E) Market Value Ratios
(continued)

Ratio Cogswell Cola Spacely Spritzers

P/E 15.41 13.01

PEG 1.28 0.86
P/B 5.49 4.17

The ratios seem to indicate that investors in both firms

seem to have good expectations about their performance
and are therefore paying fairly high prices relative to their
earnings book values.

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 14.2 (F) DuPont analysis

Involves breaking down ROE into three components

of the firm:
1) operating efficiency, as measured by the profit
margin (net income/sales);
2) asset management efficiency, as measured by
asset turnover (sales/total assets); and
3) financial leverage, as measured by the equity
multiplier (total assets/total equity).

Equation 14.19 shows that if we multiply a firm’s

net profit margin by its total asset turnover ratio
and its equity multiplier, we will get its return on
equity.

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 14.2 (F) DuPont analysis
(continued)

Cogswell has better operational efficiency, i.e. it is better

able to move sales dollars into income, but Spritzer is more
efficient at utilizing its assets, and since it uses more debt, it
is able to get more of its earnings to its shareholders.
Although these 14 ratios are not the only ones that can be
used to assess a firm’s performance, they are the most
popular ones.
It is important to look at the overall picture of the firm in all 5
areas and accordingly reach conclusions or make
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Ratio Analysis

The Du Pont Chart

– a chart designed to show the relationships
among return on investment, asset turnover, the
profit margin, and leverage
- Return on Assets = Net Profit Margin ×Total
AssetsTurnover
Modified Du Pont Equation:
Return on Equity(ROE) = Net Profit Margin × Total
Assets Turnover × Equity Multiplier( Total Assets/
Equity)
The Du Pont equation helps us analyze factors
that contribute to a firm’s return on
assets(equity).

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 DuPont System of Analysis

• A satisfactory return on assets might be

derived through:
– A high profit margin
– A rapid turnover of assets (generating more sales
per dollar of its assets)
– Or both

Return on assets (investment) = Profit margin ×

Asset turnover

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 DuPont System of Analysis
(cont’d)
• A satisfactory return on equity might be
derived through:
– A high return on total assets
– A generous utilization of debt
– Or a combination of both
– Return on equity = Return on assets (investment)
(1 – Debt/Assets)

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 DuPont Analysis

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 14.3 External Uses of Financial
Statements and Industry Averages

Financial statements of publicly traded companies and

industry averages of key items provide the raw
material for analysts and investors to make
investment recommendations and decisions

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 14.3 (A) Cola Wars
Table 14.6 Key Financial Ratios
and Accounts for PepsiCo and
Coca-Cola (as of December 31,
2010)

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 14.3 (A) Cola Wars
Table 14.7 Some Key Ratios for
PepsiCo and Coca-Cola (Five-Year
Period)

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 14.3 (A) Cola Wars (continued)

• One of the first things we notice in looking over the five years
of data is how similar many of the ratios are from year to
year, showing remarkable consistency for these two
companies.
• We also can see that the gross margin of Coca-Cola is
consistently higher than that of PepsiCo.
• The debt to equity ratio of both firms is mostly falling over the
five-year period.
• We also can see that ROE has been very good for both
companies, although slightly better for PepsiCo.
• Finally, PepsiCo has very strong and growing earnings per
share over this period, outperforming Coca-Cola’s EPS, but
PepsiCo is also more expensive (higher current price per
share).

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 14.3 (B) Industry ratios:

Table 14.8 Financial Ratios: Industry

Averages

• Industry ratios are often used as benchmarks for financial

ratio analysis of individual firms.
• There can be significant differences in various key areas
across industries, which is why comparing company ratios
with industry averages can be very useful and more
informative.
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 Additional Problems with Answers
Problem 1
Constructing an Income Statement.
Using the income and expense account
information for Tri-Mark Products Inc.
listed below, construct an incomest
statement for the year ended 31
December, 2009.
Shares outstanding: 1,575,000
Tax rate: 35%
Interest expense: $3,540,000
Revenue: $950,500,000
Depreciation: $50,000,000
Selling, general, and administrative
expense: $85,000,000
Other income: $1,350,000
Research and development: $5,200,000
Cost of goods sold: $730,000,000

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 Additional Problems with Answers
Problem 1 (Answer)

Tri-mark Products Incorporated

Income Statement for the year ended 31st Dec. 2009 ('000s)
Revenue $ 950,500
Cost of goods sold $ 730,000
Gross Profit $ 220,500
Operating expenses
Selling, general and administrative
expenses $ 85,000
R&D $ 5,200
Depreciation $ 50,000
Operating Income $ 80,300
Other Income $ 1,350
EBIT $ 81,650
Interest Expense $ 3,540
Taxable Income $ 78,110
Taxes $ 27,339
Net Income $ 50,772
Shares Outstanding $ 16,740
EPS $ 3.03

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 Additional Problems with Answers
Problem 2
Constructing a Balance Sheet. Construct Tri-Mark Incorporated’s
2009 year-end Balance Sheet using the asset, liability, and equity
accounts listed below:
Retained Earnings $60,500,000
Accounts Payable $57,000,000
Accounts Receivable $43,000,000
Common Stock $89,676,000
Cash $6,336,000
Short Term Debt $1,500,000
Inventory $42,000,000
Goodwill $30,000,000
Long Term Debt $74,000,000
Other Non-Current Liabilities $15,000,000
PP&E $225,000,000
Other Non-Current Assets $14,000,000
Long-Term Investments $25,340,000
Other Current Assets $12,000,000

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 Additional Problems with Answers
Problem 2 (Answer)
Tri-mark Products Inc.
Balance Sheet as at year ended
31st December 2009 (‘000s)
Liabilities:
Current Assets Current Liabilities
Accounts
Cash $6,336 Payable $57,000
Accts.
Rec. $43,000 Short Term Debt $1,500
TOTAL Current
Inventory $42,000 Liabilities. $58,500
Other
Current $12,000 Long Term Debt $74,000
Total
Current $103,336 Other Liabilities $15,000
L- T Inv. $25,340 Total Liabilities $147,500
PP&E $225,000 Owner’s Equity
Goodwill $30,000 Common Stock $189,676
Other Retained
Assets $14,000 Earnings $60,500
Total OE $250,176
Total Total Liab. And
Assets $397,676 OE $397,676

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 Additional Problems with Answers
Problem 3

• Common size statements: Re-state Tri-

Mark Incorporated’s 2009 financial
statements as common-size statements and
comment on them

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 Additional Problems with Answers
Problem 3 (Answer)
% of % of
Total Total
Assets: Assets Liabilities: Assets
Current
Current Assets Liabilities
Accounts
Cash $6,336 0.02 Payable $57,000 0.14
Short
Accts. Term
Rec. $43,000 0.11 Debt $1,500 0.00
TOTAL
Inventory $42,000 0.11 Current Liab. $58,500 0.15
Long
Other Term
Current $12,000 0.03 Debt $74,000 0.19
Total Other
Current $103,336 0.26 Liabilities $15,000 0.04
Total
L- T Inv. $25,340 0.06 Liabilities $147,500 0.37
Owner’s
PP&E $225,000 0.57 Equity
Common
Goodwill $30,000 0.08 Stock $189,676 0.48
Other Retained
Assets $14,000 0.04 Earnings $60,500 0.15
Total Assets $397,676 1.00 Total OE $250,176 0.63
Total Liab.
And OE $397,676 1.00

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 Additional Problems with Answers
Problem 4

Compute and analyze financial ratios.

Using the 2009 income statement and
balance sheet of Trimark Products Inc., as
constructed in problems 1 and 2 above,
compute its financial ratios. How is the firm
doing relative to its industry in the areas of
liquidity, asset management, leverage, and
profitability?

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 Additional Problems with Answers
Problem 4 (continued)

Industry
Ratio Average
Current Ratio 2.200
Quick Ratio (or Acid
Test Ratio) 1.500
Cash Ratio 0.135
Debt Ratio 0.430
Cash Coverage 10.600
Day’s Sales in
Receivables 29.000
Total Asset Turnover 2.800
Inventory Turnover 20.100
Day’s Sales in
Inventory 11.500
Receivables Turnover 32.000
Profit Margin 0.045
Return on Assets 0.126
Return on Equity 0.221

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 Additional Problems with Answers
Problem 4 (Answer)

Industry
Trimark Average
Current Ratio 1.766 2.200
Quick Ratio (or Acid
Ratio Test) 1.048 1.500
Cash Ratio 0.108 0.135
Debt Ratio 0.371 0.430
Cash Coverage 37.189 10.600
Day’s Sales in
Receivables 16.512 12.000
Total Asset
Turnover 2.390 2.800
Inventory
Turnover 28.808 30.100
Day’s Sales in
Inventory 12.670 11.500
Receivables
Turnover 22.105 30.000
Profit Margin 0.053 0.045
Return on Assets 0.128 0.126
Return on Equity 0.203 0.221

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 Additional Problems with Answers
Problem 4 (Answer) (continued)
Analysis:
Liquidity: Trimark’s liquidity ratios are below the industry
average indicating that they might need to look into their
management of current assets and liabilities.
Leverage: Trimark’s debt ratio is much lower than the industry
average and its cash coverage is more than 3 time the average,
indicating that if it needs to borrow long-term debt it should
not have much of a problem.
Asset management: Trimark’s asset turnover ratios are all
below the average. It needs to tighten up collections, and
manage its inventory more efficiently.
Profitability: Trimark has a good control on cost of goods sold.
Its net profit margin is better than the industry and so is its
ROA. The industry, however, is returning a higher rate to the
shareholders on average, primarily due to the higher debt
levels.
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 Additional Problems with Answers
Problem 5

DuPont Analysis. Based on the ratios

calculated in problem 4 above, and in
conjunction with the industry averages
given, conduct a DuPont analysis on
Trimark’s key profitability ratios.

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 Additional Problems with Answers
Problem 5 (Answer)

According to the Du Pont breakdown, we have

ROE = Net Profit Margin * Total Asset Turnover * Equity Multiplier
 ROE = NI/S * S/TA * TA/Equity

Note: since we don’t have the accounting information for the average,
we have to figure out the industry’s equity multiplier by some
algebraic manipulation.

Equity Multiplier = Total Assets/Equity

Now, debt ratio = Total Debt/Total Assets
Total Assets = Total Debt + Equity
 (Total Debt/Total Assets) +( Equity/Total assets) = 1
 Equity/Total Assets = 1 – (Total Debt/Total Assets)
 TA/E = 1/(1-TD/TA)

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 Additional Problems with Answers
Problem 5 (Answer) (continued)
Trimark Industry

Debt Ratio 0.371 0.430

Total Asset Turnover 2.390 2.800
Profit Margin 0.053 0.045
Return on Assets 0.128 0.126
Return on Equity 0.203 0.221

Equity multiplier
= 1/(1-debt ratio) 1.59 1.75
Despite a lower Total Asset Turnover ratio, Trimark’s
ROA (12.8%) is better than that of the industry (12.6%),
primarily due to its higher net profit margin. The
industry, however, has a higher ROE (22.1%) due to its
higher debt ratio and correspondingly higher equity
multiplier.
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Ratio Analysis

The Du Pont Chart

– a chart designed to show the relationships
among return on investment, asset turnover, the
profit margin, and leverage
- Return on Assets = Net Profit Margin ×Total Assets
Turnover
Modified Du Pont Equation:
Return on Equity(ROE) = Net Profit Margin × Total
Assets Turnover × Equity Multiplier( Total Assets/
Equity)
The Du Pont equation helps us analyze factors that
contribute to a firm’s return on assets(equity).

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 DuPont System of Analysis

• A satisfactory return on assets might be

derived through:
– A high profit margin
– A rapid turnover of assets (generating more sales
per dollar of its assets)
– Or both

Return on assets (investment) = Profit margin ×

Asset turnover

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 DuPont System of Analysis (cont’d)

• A satisfactory return on equity might be

derived through:
– A high return on total assets
– A generous utilization of debt
– Or a combination of both

Return on equity = Return on assets (investment)

(1 – Debt/Assets)

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 DuPont Analysis

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 Figure 14.1 Cogswell Cola
Balance Sheet

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 Figure 14.2 Cogswell Cola
Income Statement

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