1

UNIVERSITY OF LONDON
(LSE)

se py
ly
on
(UOL 3092)
r u Co
ou ot

CORPORATE FINANCE
ry N

(2019 Academic Year)

Fo Do

Daniel Tan
©

Notes
For Full Semester

© Copyright Daniel Tan J H UOL Corporate Finance

1
 2

Key Topics
Lecture No Key Lecture Topics Subject Guide
1 Understanding Time Value of Money Chapter 1
2 Applying TVM and valuation of projects Chapter 1
3 Using TVM to value stocks and bonds Chapter 1
4 Understanding Options and real options Chapter 2

se py
5 Understanding Options and real options Chapter 2

ly
6 Understanding Options and real options Chapter 2

on
7
r u Co Choice of Corporate Capital Structure Chapter 3
8 Choice of Corporate Capital Structure Chapter 3
9 Modigliani and Miller Theorem 2 Chapter 3
10 M and M with Corporate and Personal Tax Chapter 4
11 Capital Structure and Agency Costs Chapter 5
ou ot

12 Capital Structure and Agency Costs (continue) Chapter 5

13 Dividend Policies Chapter 7
ry N

14 Dividend Policies (continue) Chapter 7

15 Merger and Acquisitions Chapter 8
Fo Do

16 Efficient Takeovers and Empirical Studies Chapter 8

17 Equity Financing Chapter 6
18 Equity Financing Chapter 6
19 Risk Management and Hedging Chapter 9
©

20 Risk Management and Hedging Chapter 9

21 Revision -----
22 Revision Week 1
23 Revision Week 2

Recommended Textbook
“Corporate Finance by R Brealey”, SC Myers, F. Allen
“Financial Markets and Corporate Strategy” by M Grinblatt, S. Titman

© Copyright Daniel Tan J H UOL Corporate Finance

2
 3

se py
ly
Topic 1

on
r u Co
ou ot

Time Value of Money

ry N

Capital Budgeting
and
Fo Do

Project Evaluation
©

© Copyright Daniel Tan J H UOL Corporate Finance

3
 4

TOPIC : Capital Budgeting Techniques for

Project Appraisals

Project Appraisals: Why do it?

• Assess feasibility of the projects
• They are investing today’s dollars for future benefits
• The outlay for projects are usually large amounts
• Projects tend to be long term
• Projects invested are not easily liquidated
• Projects can be exclusive or independent – thus, the need for choice

se py
ly
on
r u Co Capital Budgeting Techniques
2 Broad Methods

Non-discounted Cashflow Discounted Cashflows

ou ot

Payback Period (PB) Net Present Value (NPV)

Accounting Rate of Return (ARR) Internal Rate of Return (IRR)
Profitability Index (PI)
ry N

Discounted Payback (DPB)

Fo Do

NOTE:

For POA students, you must know PB, ARR, NPV, IRR
©

For CF students, you must know PB, NPV, IRR, PI

© Copyright Daniel Tan J H UOL Corporate Finance

4
 5

Non-Discounted Methods
Payback Period (PB)

The payback period is the expected number of years required to recover the
original investment in a project i.e. measures the length of time without
discounting.

The maximum acceptable payback period is determined by the company’s

management.

Decision Criteria:

se py
Project’s PB is less than the maximum acceptable PB – ACCEPT

ly
Project’s PB is more than the maximum acceptable PB – REJECT

on
r u Co
Advantages of PB:
• Simple to use and apply
• It is intuitive and considers risks
• Considers the early cash-flows rather than accounting profits (From
perspective of investor who prefers cashflows as returns)
• Considers liquidity (cash coming back to investors) and risk exposure
ou ot

periods (the short payback period)

Disadvantages of PB:
ry N

• The appropriate payback period is a subjectively determined number by

management
• Fails to consider the time value of money
Fo Do

• Ignores the cash-flows after the payback period (since management

prefers shorter recovery period) and is therefore bias against long term
projects (likely not interested in long term and good projects)
• It is not a profit measurement (From perspective of investor who likes
accounting as a measure of return)
• Measures risks based on payback and may not be realistic (recovering
©

cash is not a good measure of risk)

• Does not consider the magnitude of cashflows

© Copyright Daniel Tan J H UOL Corporate Finance

5
 6

Example 1: Consider a company considering 2 projects with the following

investment required and the projected cash-flows.

Project A Project B
Investment $42,000 $45,000

Year Operating Cash Inflows

1 $14,000 $28,000
2 $14,000 $12,000
3 $14,000 $10,000
4 $14,000 $10,000
5 $14,000 $10,000

se py
ly
Solution Process
Project A
Investment $42,000

on
r u Co
Year
1
Op Cash Inflows
$14,000
End of Year
Cumulative Cashflow
$14,000
2 $14,000 $28,000
3 $14,000 $42,000
4 $14,000 $56,000
ou ot

5 $14,000 $70,000 PB is 3 years

Project B
ry N

Investment $45,000
End of Year
Year Op Cash Inflows Cumulative Cashflow
1 $28,000 $28,000
Fo Do

2 $12,000 $40,000
3 $10,000 $50,000
4 $10,000 $60,000
5 $10,000 $70,000 PB is 2.5 years
©

© Copyright Daniel Tan J H UOL Corporate Finance

6
 7

Example 2
Project A Project B
Investment $50,000 $50,000

Year Operating Cash Inflows

1 $ 5,000 $40,000
2 $ 5,000 $ 2,000
3 $40,000 $ 8,000
4 $10,000 $10,000
5 $10,000 $10,000

Answer:

se py
Payback Period 3 years 3 years But which is better?

ly
What is the learning point?

on
r u Co
Example 3
Project A Project B
Investment $10,000 $10,000

Year Operating Cash Inflows

ou ot

1 $5,000 $3,000
2 $5,000 $4,000
3 $1,000 $3,000
ry N

4 $ 100 $4,000
5 $ 100 $3,000

Answer:
Fo Do

Payback Period 2 years 3 years But which is better?

What is the learning point?

©

© Copyright Daniel Tan J H UOL Corporate Finance

7
 8

se py
ly
on
r u Co
ou ot
ry N
Fo Do
©

© Copyright Daniel Tan J H UOL Corporate Finance

8
 9

©
Fo Do
ry N
ou ot
r u Co
se py
on
ly

9
 10

©
Fo Do
ry N
ou ot
r u Co
se py
on
ly

10
 11

©
Fo Do
ry N
ou ot
r u Co
se py
on
ly

11
 12
Instructor Notes

Derivation of Time Value of Money Formulas

Peter F. Colwell
Anyone who has studied business has In other words, we multiply an initial FVAn (1 + i) = A (1 + i)n
at least a passing familiarity with “time dollar amount – a present value – by the (7) + A (1 + i)n-1 .
value of money” formulas. Yet while appropriate future value factor to find a + ... + A (1 + i)
many people can comprehend explan- value that will not exist until n periods Multiplying equation (6) by –1, we find
ations of loan repayment schedules or into the future, but is equivalent to our – FVA n = – A (1 + i)n-1
retirement savings accounts, or even use present value in a time-value adjusted – A (1 + i) n-2 .
(8)
financial calculators, their level of time sense. (This equivalence was explored in – ... – A (1 +i) 0
value understanding may not include any an earlier article on financial mechanics.) Adding equation (7) to equation (8)
sense of where the time value formulas The second of the time value factors simplifies the problem greatly by elimi-

se py
come from, or how the various time value is obtained very simply from the first. nating all but two right-hand terms:

ly
applications are related. This brief article Solving equation (4) for the present value
(9) FVAn [ (1 + i) – 1 ] = A (1 + i)n – A .
presents a derivation of all of the standard produces the following:
(and some less well-known) time value of Simplifying further and solving (9) for
FVn

on
money formulas from the future value of = PV0 . FVAn gives us

r u Co
one dollar factor.
Basic future value applications are
easily understood at an intuitive level.
Suppose you have $1,000 in an account
today. If this amount earns a rate of re-
turn of 10% for a year, the balance grows
(5)
(1 + i)n
Thus, the basic present value of one
dollar factor is

PVFn =
1
(1 + i)n
.
(10) FVA n = A
(1 + i) n – 1 .
i
In this way, we have identified the future
value of an annuity factor:
(1 + i)n – 1 .
to $1,100 (the original $1,000 plus $100 We multiply a future amount by the FVAFn =
ou ot
in earnings). Symbolically, this time present value of one dollar factor to i
value adjustment can be represented as compute an equivalent present amount. Multiplying this factor by the amount of
the regular payment produces the future
(1) PV0 (1 + i) = FV1 ,
ry N

The Annuity Case value that is equivalent, in time-value

an equation in which PV0 is the $1,000 in The third time value of money factor is adjusted terms, to the annuity.
the present, i = .1 or 10%, and FV1 is the more difficult to derive. A level annuity
$1,100 future amount one year hence. is a series of payments or receipts, all Expanding the Analysis
equal in amount and equally spaced in All the remaining factors can be derived
Fo Do

This process can be repeated, in the

sense that we can now view the $1,100 time. The future value of an annuity is from the first three, in ways that seem
as the initial balance in a second future an amount that will not exist until some rather simple compared to the derivation
value analysis. If this amount grows at future date, say at the end of n years, but of the future value of an annuity factor.
10% for one year, the account balance is equal in time-value adjusted terms to a If we solve equation (10) for the periodic
grows to $1,210 by the end of that second specified level annuity. If the payments amount of the annuity, A, we find:
period. Symbolically, fall at the end of each year between today i .
A = FVAn
©

(2) FV1 (1 + i) = FV 2 . and the end of year n, we can specify: (1 + i)n – 1

FVAn = A (1 + i)n-1 So if we know the future value, we can
Substituting equation (1)’s representation + A (1 + i)n-2 ,
(6) easily compute the annuity that is equi-
of FV1 into equation (2) reveals how the + ... + A (1 +i)0 valent, in time-value adjusted terms, to
initial present value can be transformed an equation in which A is the annual pay- the future value. The factor that results
into a future value two years later: ment, and A(1 + i)n -1 is the value at the is often called the sinking fund factor:
PV0 (1 + i)(1 + i) = FV 2 or end of year n of the amount that is depo-
i
2
sited at the end of the first year. This = SFFn .
(3) PV0 (1 + i) = FV 2 . amount grows for n – 1 years. A(1 + i)0 is (1 + i)n – 1
Generalizing for any number of years n, the future value of the amount deposited The sinking fund factor has a number
we have at the end of the nth year; the value at the of uses. Usually, we use it to compute
end of n years of the deposit made at the a periodic amount that is equivalent, in
(4) PV0 (1 + i) n = FV n . end of year n is, of course, simply the time-value adjusted terms, to a future
amount of the deposit (note that any val- cost. An example would be the amount
Thus, we have discovered the first of the
ue raised to the power zero is simply 1). that must be deposited annually so that
standard time value of money factors, the
If we multiply each side of equation the account balance will grow, with
future value of one dollar factor:
(6) by (1 + i), we obtain the following interest, to the cost of replacing a roof
FVFn = (1 + i)n . result: by the end of fifteen years.

page 10 Illinois Real Estate Letter Spring 1999

12
 13
Instructor Notes
Or consider the example of a home composed of two parts, the interest rate Beyond the Basic Six
loan that is fully amortizing, meaning that and the sinking fund factor. Introductory finance textbooks typically
each payment is sufficient to cover the Now consider another tack for devel- address only the six time value situations
period’s interest and some amount of oping the mortgage loan constant. Sup- developed above. In fact, basic finance
principal, such that the principal is fully pose we computed the future value of texts tend to present only four factors,
repaid over the specified time period. a loan. We would be asking, in essence, treating the sinking fund and mortgage
Mortgage borrowers quickly become what single payment would retire the loan constant factors as special cases of
aware that each payment on a standard, loan in full – principal plus all accrued the future value of annuity and present
fully amortizing mortgage loan has both interest – if no payment of any type were value of annuity factors (of which they
interest and principal components. While made until the loan’s maturity date. In are the reciprocals). While this approach
the payments remain the same from other words, we would be viewing this is acceptable (even laudable in its parsi-
month to month, the amount of each pay- loan as a zero coupon bond. The sink- moniousness), real estate texts tradition-
ment accounted for by interest declines ing fund to generate that single future ally have presented the sinking fund and

se py
with each successive installment, and payment would be the product of the loan loan constant factors as separate tools,

ly
the portion accounted for by principal amount, the future value factor, and the perhaps because of the importance in real
increases over time. In fact, interest sinking fund factor: estate analysis of computing loan pay-
payments decline at an increasing rate i i (1 + i) n . ments. Those who studied appraisal in
L (1 + i)n

on
(they fall not only in dollar terms, but in =L days gone by will recall the six columns

r u Co
percentage terms as well), while principal
payments increase at an increasing rate.
Yet there is a different way to con-
ceive of dividing each payment into
interest and principal. Think of the case
of an interest-only loan, in which each
n
(1 + i) – 1 (1 + i)n – 1
This value is simply the product of the
amount borrowed and the mortgage loan
constant. Thus, the mortgage loan con-
stant can be viewed either as the sum of
the interest rate and sinking fund factor,
on each page in the Ellwood Tables.
Yet there are some other significant
time value formulas. One example used
extensively in real estate analysis is the
proportion of a loan’s principal that has
been paid off by the end of some time
payment consists only of interest (the or as the product of the future value period t. We compute this proportion by
ou ot
interest rate multiplied by the amount factor and the sinking fund factor. finding the periodic deposit into a sinking
borrowed), such that no principal is re- Of course, a standard fully amortizing fund sufficient to pay off the loan at the
paid through the regular payment stream mortgage loan, with a fixed interest rate end of the stated term. Then we find the
ry N

(there would have to be a 100% balloon and unchanging payments, is simply the future value of that annuity at time t:
payment at the end of the loan’s life). present value of an annuity. We can, (1 + i)t – 1
i (1 + i)t – 1
Suppose further that the borrower pre- therefore, rewrite equation (11) as: L = L .
(1 + i) n – 1 i (1 + i) n – 1
pares for this eventual balloon payment i (1 + i) n
by making regular deposits into a savings PVAn =A . The factor thereby revealed is the pro-
Fo Do

(1 + i) n – 1
account that earns the same rate of inter- portion paid off, a figure often needed
est that is paid on the loan. The amount Solving for the present value of the annu- by real estate appraisers and lenders:
that should be deposited into this account ity yields
(1 + i) t – 1 .
each month is computed as the sinking (1 + i)n – 1 . Pt =
PVA n = A (1 + i) n – 1
fund factor multiplied by the loan prin- i (1 + i)n
cipal. Putting these two notions together With these steps we have revealed the Of course, the proportion of the loan that
©

(i.e., an interest-only loan combined with sixth (and last) of the time value of has not been repaid, and thus is still owed
a sinking fund) produces the following: money factors, that for the present value at the end of period t, is just one minus
i of an annuity: the proportion that has been paid off:
Li + L = total payment ;
(1 + i)n – 1 (1 + i)n – 1 . (1 + i)n – (1 + i) t
PVAFn = .
i (1 + i)n (12) 1 – P t =
collecting terms over a common denomi- (1 + i)n – 1
nator and simplifying results in: It is possible to put a different spin
Yet we can also approach this idea in
on the derivation of the present value of
n
i (1 + i) a different way. The amount still owed at
= loan payment . an annuity factor. Suppose that we find
(11) L the end of t periods is the present value of
(1 + i)n – 1 the future value of a specified level
all payments that must be made after t:
This exercise reveals yet another of the annuity. Then suppose that we compute
time value of money factors, the mort- the present value of that future value. (1 + i)n-t – 1 .
The result is the product of the level (13) A
gage loan constant, also known as the i (1 + i)n-t
amount to amortize one dollar: annuity amount, the future value of an
We leave it to the reader to prove that
annuity factor, and the present value of
i (1 + i)n one dollar factor:
equation (13) is identical to (12) multi-
= loan constant . plied by the loan amount. (Hint: substi-
(1 + i)n – 1 (1 + i)n – 1 1 (1 + i)n – 1.
A =A tute the loan amount times the mortgage
The mortgage loan constant therefore is i (1 + i) n i (1 + i)n loan constant for A in equation 12.)

Spring 1999 Illinois Real Estate Letter page 11

13
 14

Discounting Methods
Before doing discounting methods, we need to understand the basic of the
Time Value of Money (TVM). This involves Future Valuing (Compounding)
and Present Valuing (Discounting).

While there seem to be many formulas, learn the basics right. We will cover
all the following:

A) The Future Value of a Single Dollar Cash Flow

FV = PV (1 + r ) n

se py
ly
B) The Present Value of a Single Dollar Cash Flow
FV
PV =

on
r u Co (1 + r ) n

C) The Present Value of a Non-Regular Cash Flows (If you know how to do
present valuing of a single dollar cash flow, you will know how to find the
present value of a series of non-similar or irregular cashflows)
ou ot

D) The Present Value of Ordinary Annuity and Annuity Due.

(If you know how to find the present value of a single dollar, you will know
how to find the present value of a series of similar or regular cashflows)
ry N

é1 1 ù PMT é 1 ù
PV of OA = PMT ê - ú= ê1 - ú
êë r r (1 + r ) n úû r ê (1 + r ) n ú
Fo Do

ë û

"1 1 %
PV of AD = PMT $ − ' + PMT
# r r(1+ r)n−1 &
©

E) The Future Value of Ordinary Annuity and Annuity Due.

(If you know how to find the future value of a single dollar, you will know
how to find the future value of a series of similar or regular cashflows)

é (1 + r ) n 1 ù PMT é
FV of OA = PMT ê - ú= (1 + r ) n - 1ù
êë r rú r ëê úû
û
" (1+ r)n 1 %
FV of AD = PMT $ − '[(1+ r)]
# r r&

Students find this confusing because they see all the formulas as different and
assumed to be un-related. Not knowing the basic principle well, other topics
such as NPV, IRR and PI will be deemed difficult to understand. Just make an
effort to LEARN this well and 20% of your effort to get 80% of your results

© Copyright Daniel Tan J H UOL Corporate Finance

14
 15

A) The Future Value of a Single Cash Flow

The most basic formula for compounding returns over time is:

FV = PV (1 + r ) n

Example 1:
A person has $10,000 in his bank account. The bank pays a 5% interest rate
annually. If he leaves the deposit in the bank for the entire 3-year period, what
will be the account worth in 3 years?

se py
FV = 10,000(1 + 0.05) 3 = $11,576.25

ly
Answer is $11,576.25

on
r u Co
Example 2:
If the information above remains the same except that the interest is
compounded twice a year, what will be the account worth in 3 years?

FV = $10,000(1 + 0.025) 6 = $11,596.93

ou ot

Answer is $11,596.93.
ry N

Why is the amount larger than the above and what is the implication?

Example 3:
Fo Do

An investor deposits $1,000 in the bank today. One year later, he deposits
another $3,000 and two years later after that, he deposits $8,000. If the bank
pays 4% interest, compounded annually, what will the balance in the account
be in 5 years after the original deposit and that the investor did not withdraw
any amount during this period?
©

FV = $1,000(1 + 0.04) 5 + $3,000(1 + 0.04) 4 + $8,000(1 + 0.04) 2 = $13,377

Answer is $13,377

Example 4: Different Interest Rates

An investor deposits $10,000 in the bank today. The bank pays 4% per year
for the first 2 years and 6% per year for the following 3 years. What will the
balance in the account be in 5 years after the original deposit and that the
investor did not withdraw any amount during this period?

Answer is $12,882

© Copyright Daniel Tan J H UOL Corporate Finance

15
 16

B) The Present Value of a Single Cash Flow

In finance, the value of any investment is the present value of all the future
cash flows that the investment is expected to generate for the investor.

The present value of a single future cash flow is as follows:

FV
PV =
(1 + r ) n

se py
Example 5:

ly
If Steven expects a return of 15% in any investment to justify the risks he is
going to take, what will he be willing to pay today for an investment that
promises a cash flow of $10,000 in 5-year time?

on
r u Co
PV = $10,000 / (1.15)5 = $10,000(0.497) = $4,972

Answer is $4,972
ou ot

Example 6:
A financial institution agrees to pay 4% interests on its deposits, compounded
quarterly. A depositor wants to save $5,000 in 2-year time. How much must
ry N

be deposited in the bank today in order to have the $5,000 in two years?

$5,000
PV = = $5,000(0.9235) = $4,617
Fo Do

(1 + 0.01)8
Answer is $4,617

Example 7:
©

An investment projects a cash flow of $3,000 next year, $2,000 the following
year and $6,000 two years from today. If the investor expects a required rate
of return of 4% annually, what will he be willing to pay today?

$3,000 $8,000
PV = + = $10,281
(1 + 0.04) (1 + 0.04) 2
1

Answer is $10,281

© Copyright Daniel Tan J H UOL Corporate Finance

16
 17

C) The Present Value of Non-Regular Cash Flows

Example 8:
An investment is expected to generate the following cash flows over the next
5 years:

Year 1 $5,000
Year 2 $2,000
Year 3 $(1000)
Year 4 $ 0
Year 5 3,000

se py
a) If an investor requires 8% return on this investment, what should the

ly
investor be willing to pay for it?

Cashflow Interest Present

on
r u CoYear 1
Factor
5,000 0.9259
Value
4,629.50
Year 2 2,000 0.8573 1,714.60
Year 3 (1000) 0.7938 (793.80)
Year 4 0 0.7350 0
Year 5 3,000 0.6806 2,041.80
ou ot

Total Present Value = $7,592.10

ry N

b) If an investor requires 4% return in years 1 and 2 and a 5% return in

years 3 to 5, what should the investor be willing to pay for it?
Fo Do

Cashflow Interest Present

Factor Value
Year 1 5,000 0.962 4,810
Year 2 2,000 0.925 1,850
Year 3 (1000) 0.952(0.925) (880.6)
©

Year 4 0 0 0
Year 5 3,000 0.864(0.925) 2,397.6

Total Present Value = $8,177

© Copyright Daniel Tan J H UOL Corporate Finance

17
 18

D) The Present Value of an Annuity

There are two types of annuity:

Ordinary Annuities (OA) and Annuities Due (AD).

Most annuities are ordinary annuities (also called “regular” annuities) where
the SAME value cash flow is paid at the end of each financial period (i.e.
year, month, quarter etc.).

Like ordinary annuities, annuity due have similar regular cash flow but paid
at the beginning of each financial period (i.e. year, month, quarter etc).

se py
ly
é1 1 ù PMT é 1 ù
PV of OA = PMT ê - ú= ê1 - ú
êë r r (1 + r ) n úû r êë (1 + r ) n úû

on
r u Co "1 1 %
PV of AD = PMT $ − ' + PMT
# r r(1+ r)n−1 &
ou ot

Example 9: Present Value of an ordinary annuity

A short-term annuity retirement plan that pays $20,000 each year for 5 years
ry N

is available to any retiree who is willing to deposit a lump sum today and will
get the first cash flow at the end of the first year. How much will Mary pay
today if she expects a rate of 12% per year on any investment she chooses?
Fo Do

$20,000 é 1 ù
PV = ê1 - 5ú
= $20,000(3.605) = $72,100
0.12 ë (1 + 0.12 ) û

Answer is $72,100
©

© Copyright Daniel Tan J H UOL Corporate Finance

18
 19

Example 10: Present Value of an annuity due

The present value of an annuity due is simply the PV of an Ordinary Annuity

plus the amount collected immediately today.

An annuity due retirement plan pays $10,000 each year for 5 years. If the
required rate of return is 4%, what is the lump sum amount today?

10, 000 " 1 %

PV = $1− ' + $10, 000
0.04 # (1+ 0.04)4 &
= $10, 000(3.6299) + $10, 000 = $46, 299

se py
ly
Answer is $46,299

on
r u Co
Example 11: Different Interest Rates
An annuity pays $5,000 each year for 5 years starting today. It pays $6,000
per year for year 7 to year 10. The interest rates are 4% for the first 5 years
and 8% for years 6 to 10. What is the present value of these cash-flows?

(To solve this, read and draw the time line of the cash-flows and do remember
ou ot

that the interest changed over the periods)

Answer is $38,274 (rounded to nearest dollar)

ry N
Fo Do
©

© Copyright Daniel Tan J H UOL Corporate Finance

19
 20

E) The Future Value of an Annuity

The future value of ordinary annuity (OA) and Annuity Due (AD) are computed
with the following formulas:

é (1 + r )n 1 ù PMT
FV of OA = PMT ê - ú= é(1 + r )n - 1ù
êë r rú r êë úû
û

" (1+ r)n 1 %

FV of AD = PMT $ − '[(1+ r)]
# r r&

se py
ly
Example 12: Future Value of an ordinary annuity
A person decides to save $10,000 per year at the end of this year into an

on
account to generate a return of 12% per year. He is going to consistently do
r u Co
this deposit at the end of each of the next 5 years. What will be the total
amount in 5-year time?

FV = $10,000(6.3528) = $63,528
ou ot
Answer is $63,528

Example 13: Future Value of an annuity due

ry N

A person decides to save $10,000 per year beginning today into an account
for the next 5 years to generate a return of 12% per year. He is going to
consistently do this deposit at the beginning of each year. What will be the
total amount in 5-year time?
Fo Do

FV = $10,000(6.3528)(1.12) = $63,528(1.12) = $71,152

Answer is $71,152

Example 14: Different Interest Rates

©

Peter decides to put $15,000 per year into a savings account for the next 4
years with the first payment being made at the end of the current year. After 4
years, the amount accumulated would be left in the account for another 5
years. If the account generates 4% in the first 4 years and 6% in the next 5
years, what will be the balance after 9 years?

FV 4 = $15,000(4.2465) = $63,697
FV 9 = $63,697(1.3382) = $85,204

Answer is $85,240

© Copyright Daniel Tan J H UOL Corporate Finance

20
 21

DISCOUNTING METHODS
Process for discounting methods

There are basic steps used in discounting methods

Ø Step 1: Identify the relevant cash-flows over the investment life span

Ø Step 2: Project the magnitude and timing of the cash-flows

Ø Step 3: Discount the future cash flows using appropriate discount rate.
This is usually the cost of capital (Weighted Average Cost of Capital)

se py
which depends on the mix of equity and debt financing employed for the

ly
project.

Net Present Value (NPV)

on
r u Co
Net Present Value is the present value of all of the after-tax cash flows
associated with a project (including the investment itself), using the cost of
capital for the project as the discount rate.

[The weighted average cost of capital is discussed in the later sessions of

ou ot

Corporate Finance]

In other words, it is the net cash flows today when we use the present value of
ry N

the all after-tax future inflows to deduct the initial investment costs incurred
today.
n
é Ct ù
Fo Do

NPV = å ê tú
- Initial Investment
t =1 ë (1 + r ) û

NPV = Total PV of all future after-tax cash-flows – Investment outflow today

©

Decision Criteria
• If NPV > 0, accept the project [implies highest NPV project is the best]
• If NPV < 0, reject the project
• If NPV = 0, we are indifferent

All positive NPV projects are acceptable and priority is given to the highest
NPV project before lower but positive NPV projects are taken. This is
assuming all projects are independent.

(We will further discuss capital constraints and mutually exclusive projects
and projects that are divisible and non-divisible)

© Copyright Daniel Tan J H UOL Corporate Finance

21
 22

Advantages of NPV

• Considers the time value of money

• Absolute measures of project benefits in today’s value
• It has the additive characteristics where all NPV of all projects selected
can be summed to determine the net returns of investment
• Assumes cash flows are reinvested at the required rate of return. (In
future, it will be the WACC which is the weighted cost of borrowing for the
project)

Disadvantages of NPV

se py
• More difficult for non-financial managers to understand

ly
• May not be able to handle capital rationing (limited funds)

Example Investment NPV Choice

on
r u Co
Project A
Project B
(100)
(50)
70
40
1st
3rd
Project C (70) 60 2nd

a) If the firm has only $100 to invest, which project or projects should be
chosen?
ou ot

Highest NPV is chosen first and so management will choose Project A

and get NPV of 70.
ry N

b) If the projects are divisible, which projects should be chosen?

Fo Do

If management choose Project C, the $70 invested will get $60 NPV
With $30 left, management can invest in Project B.

Since the investment is $30/$50 or 60 percent of the cost, the firm

should get 60% of the NPV and 60% of the NPV = (0.6)($40) = $24
©

So, with the same $100 invested in Project C and B, the firm gets
($60 + $24) = $84 (NPV is higher than if only Project A is chosen)

Situations where highest NPV or Positive NPV projects are not selected

• Different Life Span of Projects

• Resource constraints
• Debt Overhang (Covered in Capital Structure Topic)
• Asset Substitution (Risk Shifting) (Covered in Capital Structure Topic)
• Equity Signaling (Covered in Capital Structure Topic)

© Copyright Daniel Tan J H UOL Corporate Finance

22
 23

Calculating the NPV of projects

Step 1 : Present value for all the future cash flows in the project.

Step 2 : Use the PV of all future cash flows calculated in Step 1 and deduct
the investment costs today i.e. point 0.

Step 3 : Decision making on the project based on the criteria stated above.

se py
ly
on
r u Co
ou ot
ry N
Fo Do

For Project A:
NPV = (14,000)(3.791) - $42,000 = $53,701 - $42,000 = $11,071
©

For Project B:
$28,000 $12,000 $10,000 $10,000 $10,000
NPV = + + + + - $45,000
1 2 3 4 5
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)
= ($55,924 - $45,000) = $10,924

© Copyright Daniel Tan J H UOL Corporate Finance

23
 24

Situations where selecting highest NPV projects is wrong

Selecting Projects with different life span

The method to choose the correct project is the Equivalent Annualised

Annuity (EAA)

Example 15
Consider 2 projects, A and B, with expected return rate of 14% and cashflows
as follows:

Years Project A Project B

se py
0 (100) (175)

ly
1 80 43
2 70 50

on
r u Co 3 - 255

Step 1: Calculate the NPV over the project’s life (as taught earlier)

Using expected rate of 14 %, the NPV of A is $_______ and B is $______

ou ot
ry N
Fo Do

Step 2: Use the calculated NPV and compute the annuity over the life of
the project
©

Step 3: Choose the higher annual annuity (if revenue items) or lower
annual annuity (if expense items)

EAA for Project A and B are $ and $ respectively

So since they are revenue related, we should choose Project ____

© Copyright Daniel Tan J H UOL Corporate Finance

24
 25

Example 16

Years Machine A Machine B

0 (60,000) (55,000)
1 20,000 8,000
2 25,000 10,000
3 27,000 12,000
4 14,000
5 15,000
6 18,000

Assuming the discount rate is 8%, which project should be chosen?

se py
ly
Step 1: Calculate the NPV of the project
Years Machine A 8% PVCF Machine B 8% PVCF

on
0
r u Co -60,000 1.000 -60,000 -55,000 1.000 -55,000
1 20,000 0.926 18,519 8,000 0.926 7,407
2 25,000 0.857 21,433 10,000 0.857 8,573
3 27,000 0.794 21,433 12,000 0.794 9,526
4 14,000 0.735 10,290
5 15,000 0.681 10,209
ou ot

6 18,000 0.630 11,343

NPV 1,385 NPV 2,349
ry N

Can you think of a faster way to calculate the NPV for the above machines?

Step 2: Calculate the yearly PMT from the NPV in step 1

Fo Do
©

Step 3: Choose the higher annual annuity (if revenue items) or lower
annual annuity (if expense items)

The EAA for Machine A and B are $ _______ and $ ______ respectively
So since the cashflow is revenue related, we should select Machine ____

© Copyright Daniel Tan J H UOL Corporate Finance

25
 26

Project Selection under Capital Rationing

Profitability Index (PI)

Profitability index measures the return per dollar invested based on the
required rate (cost of capital).

Profitability Index is = PV of all Future CF - Inital Cost Net Present Value

=
Investment cost Investment cost

(In this case, positive NPV project will have greater than zero)

se py
ly
OR alternatively presented as

PV of all Future CF
Profitability Index is =

on
r u Co Investment cost

(In this case, positive NPV project will be greater than 1)

Decision Criteria
ou ot

Using First Formula above

ry N

Ø If PI > 0, implies positive NPV project and thus, accept the project
Ø If PI < 0, implies negative NPV project and therefore, reject the project
Fo Do

Using Second Formula above

Ø If PI > 1, implies positive NPV project and thus, accept the project
Ø If PI < 1, implies negative NPV project and therefore, reject the project
©

Selection Criteria : based on the highest profitability index to the lowest

profitability index until the funds are used up.

© Copyright Daniel Tan J H UOL Corporate Finance

26
 27

Example 17

Investment Net Present Profitability

Cost Value Index
Project A 10,000 35,000 3.50
Project B 20,000 40,000 2.00
Project C 15,000 25,000 1.67
Project D 25,000 30,000 1.20

If all the projects are not divisible and the firm has only $40,000 to invest,
which projects should be chosen?

se py
ly
Investment Net Present Profitability
Cost Value Index
Project D 25,000 30,000 1.20

on
r u Co
Project C 15,000 25,000 1.67

Invest $40,000 with NPV of $55,000

OR
ou ot

Investment Net Present Profitability

Cost Value Index
Project A 10,000 35,000 3.50
ry N

Project B 20,000 40,000 2.00

Invest $30,000 with NPV of $75,000 with $10,000 on hand

Fo Do

If all the projects are divisible and the firm has only $40,000 to invest, which
projects should be chosen?

Investment Net Present Profitability

©

Cost Value Index

Project A 10,000 35,000 3.50
Project B 20,000 40,000 2.00
Project C 10,000/15,000 (2/3)25,000 1.67

Invest $40,000 with NPV of $35,000 + $40,000 + $16,667 =

$91,667

© Copyright Daniel Tan J H UOL Corporate Finance

27
 28

The Internal Rate of Return (IRR)

• The Internal Rate of Return (IRR) is the discount rate that will equate the
present value of the outflows with the present value of the inflows.
• This means IRR makes the NPV = zero
• The IRR is the project’s intrinsic rate of return.
n
é Ct ù
0= å êë (1 + r) úû - Initial Investment
t =1
t

Graph showing IRR

se py
NPV

ly
on
r u Co
%
ou ot
ry N
Fo Do

Process:

Step 1 : Find NPV (as small value as possible) using 2 different interest rates
©

Step 2 : Interpolate to NPV = 0

If discount rate = 0, then NPV is Total inflow – Total Outflows

If discount rate increases, NPV decreases because the PV of cash flows
decreases due to higher interest rates (TVM concept)
If discount rate intercepts the x axis, NPV is 0. This is the IRR.

Decision Criteria :
If IRR > Required rate of return, then ACCEPT project
If IRR < Required rate of return, then REJECT project

The furthest IRR from the cost of capital or discount rate is the better project
to choose.

Note : IRR can be termed as the required rate of return, the discount rate
or the weighted cost of capital

© Copyright Daniel Tan J H UOL Corporate Finance

28
 29

Calculating the Internal Rate of Return (IRR)

Calculate the NPV and IRR of Machine A and Machine B

Years Machine A Machine B

0 (60,000) (55,000)
1 20,000 8,000
2 25,000 12,000
3 27,000 13,000
4 15,000
5 17,000
6 14,000

se py
ly
Process:

on
r u Co
Step 1 : Find NPV (as small value as possible) using 2 different interest rates
ou ot
ry N
Fo Do

Step 2 : Interpolate to NPV = 0

©

Answers if using financial calculator :

Project A’s IRR is about 9.21
Project B’s IRR is about 10.37

© Copyright Daniel Tan J H UOL Corporate Finance

29
 30

Advantages
• Considers the time value of money
• It allows comparison for projects of different sizes because it is a relative
measure

Disadvantages
• May be inconsistent with NPV for mutually exclusive projects as the
choice of projects based on IRR and NPV conflict.

se py
ly
on
r u Co
ou ot

• May not have a unique solution – No IRR at all

ry N
Fo Do
©

• May not have a unique solution - multiple IRRs and the cause of this is
non-conventional cash-flows

• Assumes reinvestment rate is equal to the IRR – and this may not be
realistic.

© Copyright Daniel Tan J H UOL Corporate Finance

30
 31

UOL CF Project Evaluation Questions using NPV

Understand depreciation and accumulated depreciation

Depreciation expense over the years of asset usage reduces the original
value (cost) of the asset.

The total of all depreciation is known as Accumulated Depreciation (AD)

Understand how AD affects Net Book Value of asset

se py
ly
The Net Book Value is = Cost of Asset less Accumulated Depreciation

on
r u Co
Understand how to calculate depreciation

Straight Line Method: (Cost – Residual Value ) / Years of useful life

ou ot
ry N

Reducing Balance Method: % * (Beginning of the year Net book value)

Fo Do

Understand how Gain and Loss is calculated on the Sale of Old Asset
©

Knowing depreciation incurred each year allows you to get the AD.
Knowing AD allows you to calculate the Net Book Value (NBV)

If the selling price is greater than the NBV, there is a gain that will be taxed
If the selling price is lesser than the NBV, there is a loss in the income
statement which will then reduce the amount of taxes paid.

Note that the Income Statement only calculates the profit each year and the
gain or loss value is not a cash flow. Therefore, we cannot use profit to
determine NPV since NPV uses CF for calculations.

We need to convert the profit back to cash flows. Items in the income
statement that are not cash-flow are Depreciation, Gain or Loss on sale of an
asset.

© Copyright Daniel Tan J H UOL Corporate Finance

31
 32

The following table shows the general set up for your solution for UOL.

Note: Where you place numbers depends on the question and not items
listed below are required)

Years 0 1 2 3

Sales (SP/unit x # units sold) + ve + ve + ve

Less Variable costs - ve - ve -ve
Less Relevant Fixed costs -ve -ve -ve
Less Depreciation (tax method) -ve -ve -ve
Less Loss on sale of asset -ve -ve

se py
ly
Add Gain on sale of asset +ve +ve
Less any incremental costs -ve -ve -ve
Less Annual opportunity costs -ve -ve -ve -ve

on
r u Co
Net Profit before tax - ve/+ve +ve +ve -ve
Tax at 20% +ve/-ve -ve -ve +ve
Net Profit after taxes $ $ $ $
ou ot

Add / (Minus) back non cash expenses

Add Depreciation +ve +ve +ve
Add Loss on sale of an asset +ve +ve
ry N

Less Gain on sale of an asset -ve -ve

Add the selling price +ve +ve
Initial investment -ve
Fo Do

Working Capital -ve +ve

Cash Flow -ve $ $ $
Present value factor 1 PV (1,%) PV (2,%) PV (3,%)
Present Value of cashflow ($) $ $ $
©

NPV = PV of all future cashflow less the investment outflow today = $$$

Decision : Show grader the decision:

Example : As the project is positive $$ NPV, it will increase the wealth of the
shareholder and thus, management is recommended to consider the project.

Information not used : ((Show the grader and explain why)) Examples :
market research, survey, development cost incurred BEFORE the start of
project is not relevant.

To be included in the table, the information must

a) be different between the alternatives
b) affect the future (not historical or sunk costs)
c) either incremental or decremental
d) Cashflow in nature

© Copyright Daniel Tan J H UOL Corporate Finance

32
 33

se py
TOPIC 2

ly
on
r u Co
ou ot

Valuation of Financial
ry N

Assets:
Fo Do

Bonds
Ordinary Shares
©

Preferred Shares

© Copyright Daniel Tan J H UOL Corporate Finance

33
 34

Valuing the Assets, Liabilities and Projects

Using the TVM concepts covered, we can now determine the value of any
investment or loans today based on the future expected cash-flows (both
inflows and outflows)

Examples of assets are : ___________________________________

Examples of liabilities are : ___________________________________

Examples of projects are : ___________________________________

se py
ly
General Valuation Models

on
r u Co
All investments (both bonds and stocks) have cash-flows.

Bonds
Are debt instruments
Have regular interest payments i.e. a fixed obligation
Have priority over stocks (equity)
ou ot

Interest paid is tax deductible

Lowest cost of financing
ry N

Preferred Stocks
Pay a fixed dividend each year i.e. a fixed obligation
Dividends paid are not tax deductible
Fo Do

Has higher priority of payments over ordinary shares but after bonds
But lower priority of payments against bonds
Does not have voting rights
Are not the real owners of the company

Ordinary Stocks
©

Pay a variable dividend each year

Dividends paid are not tax deductible
Has the last claim on the company assets after bonds and preferred shares
Have voting rights
Are the real owners of the company

So, the basic premise for valuation is as follows:

The value of an asset, liability or investment today is equivalent to the present

value of all its future cash-flows at the required discounted interest rate.

¥
Future CF ¥
Value today = P0 = PV of ALL Future Cash-flows = å
n =1 (1 + i ) n
= å PVCF
n =1

© Copyright Daniel Tan J H UOL Corporate Finance

34
 I Sa ND ~ E(':}.'1t re i ·
Who ·1~sue feo.~l.J\"e f.
f t>e--\e<m,l.fle co~.\' of- l)eh-t , fc:A.
Cit
35

0
'
©' ' ;"v ' t l
rd:;;: R.f """'"'f'\C\-\\'olr'> + R\ii\:: -+ R\~'ic:..
\'.){"eO\\\JM 1-o
l"\G\-Nri
.
PV :. Pfl'\T [ ..!... _ .-.!.---~"] f fC\ce Vet\lf\~
0 r ("' c\-t'f) c \-\'(') ,,
y,·-e\o Cu\'Ve
A ButD.S
Fo Do
5 .,.L.1.LYL
s P..-d.
e· S\\...cs
T 0
.~. . 1"TM \TM "f'TM
s $hQ'(3!$
ry N
•
Cot'.~10."«'i~ e"l'<coa~ N\ooe\
~
ou ot
t l t r «'c:;o t \ \ I t •°t> \ lV\f. Rltte R'1{i.k
0 I ~ ~ ~ 0 I .l- ~ oC"\

01 t>:t. 0~ DN
• T~-rm t'° Met~~~ r\~\c..
PVo,_-:.. - + (- ..\--~ - PV.fs-:.
C l'+r') \ kf"' )~ t \~'r') · · · • ( H '<")"
r u Co
PVo ::. '(o\l,~aV) RClte R'1~k
se py
-(JllC
on
ly ·0 s=a·t~, ~:4 9:s

35
36

Valuing Bonds
Features of a bond:
• Coupon Rate: rate is used to calculate the annual interest payment to the
investor.
• Maturity date: this is when the term of the bond ends.
• The Face Value: Also known as the Par Value or Maturity value is the
paper value of the bond. It is usually $1,000
• The Purchase Price today: The price the bond is issued at or the price an
investor is willing to pay for the investment.
• The Market Interest Rate: The rate used to compute present value of the
cash-flows in the bond.

se py
ly
Cash-flows of a bond
A bond has a coupon rate that is used to calculate the annual interest

on
payment (cash flow) given to the investor. A bond also pays back the maturity
r u Co
or par value of the bond at the end of the contract.

MV
C1 C2 C3 C4 Cs
t t t t t t
ou ot
Year
0 1 2 3 4 5
ry N

PV C1 C2 MV +CN
= (1 + r )1 + (1 + r )2 + .. ·+ (1 + r )N
Fo Do

Where PV is the price or value of the asset at time O

C is the cash-flow payments expected at the end of different period n
r is the appropriate required rate of return
MV is the maturity or par value or face value of the bond
©

© Copyright Daniel Tan J H UOL Corporate Finance

36
37

Example 1:
If today is October 1, 2012, what is the present value of the following bond?
An XYZ bond pays $115 every September 30 for 5 years (implies coupon rate
is 11.5%). In September 2017 it pays an additional $1,000 and retires the
bond. The expected rate of return for the investor (called the yield to maturity
(YTM)) is 8%

1000
115
115 115 115 115
t t t t t t Year

se py
2011 2012 2013 2014 2015 2016

ly
on
Using Basic TVM concept
r u Co
PV = 115 + 115 + 115 + 115 + (115+1000)
1.08 (1.08 )
2
(1.08 )
3
(1.08 )4 (1.08 y
= $l l3 9 .74
'
Using Formula
ou ot
PV = PV of Ordinary Annuity + PV of Future Single Value (MV)

= ~[1--1 -]+
ry N

PV 5
l,OOO5 = $1139.74
0.08 1.08 1.08 '

Using Financial Table

Fo Do
©

© Copyright Daniel Tan J H UOL Corporate Finance 37

 38

Example 2
In July 2012 you purchase a 3-year US Government bond. The bond has an
annual coupon rate of 4%, paid semi-annually. If investors demand an annual
return of 6%, what is the price of the bond?

se py
ly
Using Basic TVM concept

on
r u Co 20 20 20 20 20 (20 + 1000)
PV = + + + + + = $945.83
1.03 (1.03) (1.03) (1.03) (1.03)
2 3 4 5
(1.03)6

Using Formula
ou ot

PV = PV of Ordinary Annuity + PV of Future Single Value (MV)

20 é 1 ù 1,000
PV = 1- + - 945.83
ry N

ê
0.03 ë 1.036 úû 1.036
Fo Do

Note: interest is paid semi-annually, therefore the interest is (6% / 2 = 3%)

Using Financial Table

©

© Copyright Daniel Tan J H UOL Corporate Finance

38
 39

Yield to Maturity (YTM) of a bond

The yield to maturity measures the compound annual return to an investor

and considers all bond cash flows. It is essentially the bond’s Internal Rate
of Return (IRR) based on the current price.

se py
ly
on
r u Co
ou ot
ry N

Relationship between coupon rate, yield to maturity and the price of a bond
• For par valued bonds, the Coupon Rate is = YTM (IRR of the bond)
• For premium bonds, the Coupon Rate is > YTM (IRR of the bond)
Fo Do

• For discount bonds, the Coupon Rate is < YTM (IRR of the bond)
©

© Copyright Daniel Tan J H UOL Corporate Finance

39
 40

Valuing Stocks
Single Period Stock Valuation
Consider a 1 period stock valued at P0 today.
At the end of Period 1, it pays dividend (D1) and the Price increase to PN at
the end of 1 period.

The price today is represented by:

Div1 PN
P0 = +
(1 + r )1
(1 + r ) N

se py
ly
Where N is the time (usually in years)

on
Multiple Period Stock Valuation
r u Co
If the stock pays multiple dividends over different period and the price
increases to Pn at the end of n period, P0 will be

Div1 Div2 DivN + PN

P0 = + + ... +
ou ot
(1 + r )1
(1 + r ) 2
(1 + r ) N
ry N

Where N is the time (usually in years)

Fo Do
©

© Copyright Daniel Tan J H UOL Corporate Finance

40
 41

The Constant Dividend Growth Model

The constant dividend growth or dividend discount model or Gordon Growth
Model assumes that the stock will pay dividends that grow at a constant rate
each year, year after year.

The formula is derived as follows:

D1 D2 D3 D¥
P0 = + + + ... +
(1 + re ) (1 + re ) (1 + re )
1 2 3
(1 + re )¥

se py
ly
And is finally represented simply as

D1 D (1+ g )
P0 = = 0

on
r u Co re - g re - g

where g is the constant growth rate of the dividend and re is the expected
return
ou ot

Rearranging the formula, we can find the expected return as follows:

D1
re = +g
ry N

Po

Where r (the return rate) is the sum of Dividend Yield and capital gain
Fo Do

The formula can be applied at any time frame and is represented as:
D
Pn = n+1
re - g
©

Problems with the Gordon Growth Model

To use Gordon Growth Model, the following must be satisfied.

• g < re
• Dividend is paid during the year for the stock
• g is expected to be constant forever into the future
• while g must be a long term growth rate, it cannot be > re i,e, it may grow
but still must be < re in the long run.

© Copyright Daniel Tan J H UOL Corporate Finance

41
 42

Example 3
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and
$3.50 over the next three years, respectively. At the end of three years you
anticipate selling your stock at a market price of $94.48. What is the price of
the stock given a 12% expected return?

se py
ly
3.00 3.24 3.50 + 94.48
PV = + + = $75.00

on
r u Co (1 + .12) (1 + .12)
1 2
(1 + .12)3

Example 4
If stock expecting a 12% return rate is selling for $100 in the stock market,
what might the market be assuming about the growth in dividends?
ou ot
ry N
Fo Do
©

© Copyright Daniel Tan J H UOL Corporate Finance

42
43

Variable Growth Rate

The non-constant dividend or variable growth model assumes that the stock
will pay dividends that grow at one rate during one period, and at another rate
in another year or thereafter. This implies there are at least 2 growth rates

Example 5
What would an investor be willing to pay for a stock if she just received a
dividend of $2.50, her required return is 15%, and she expected dividends to
grow at a rate of 10% per year for the first two years, and then at a rate of 5%
thereafter.

se py
ly
2.50 2.50(1+0.10) 2.50(1+0.10)2 3.03(1+0.05)
=2.75 =3.03 = 3.18

t t1 t t

on
r u Co t t
n Year
0 2 3 4

Using the Gordon Growth Model, compute the value at P2 for all dividends
growing at 5%
ou ot
Solution:
The formula can be applied at any time frame and is represented as:
ry N

3 8
P2 = __!!__!__ = .1 = $31.80
r - g 0.15 - 0.05
Fo Do

Now find the PV of each of the cash flow at 01 ($ 2.75) and 02 ($ 34.83)

PV of $2.75at15% = $2.39
PV of $34.83 (02 + P2) at 15% = $26.34

Total PV of cash flow= (2.39 + 26.34) = $28.73

©

© Copyright Daniel Tan J H UOL Corporate Finance 43

 44

Zero Growth Rate

The zero dividend growth model assumes that the stock will pay the same
dividend each year, year after year –means g is zero. Preferred stocks
behave like this.

This type of continual cash flow is called a perpetuity.

So a perpetuity is a special kind of annuity where the periodic annuity i.e.
regular cash flow continue forever into the future.

D1
P0 =
re - g

se py
ly
D1
if g = 0, then P0 =
re

on
r u Co
Example 6
How much would I have to deposit today in order to withdraw $1,000 each
year forever if I can earn 8% on my deposit?
ou ot
ry N

Example 7
What if g is not given directly?
Fo Do

If interest rate is 10% and assuming it is end of 2017 today, what is the price
of this stock with an expected constant dividend growth rate?

Year Dividend Paid

2014 $1.25
©

2015 $1.40
2016 $1.55
2017 $1.59

© Copyright Daniel Tan J H UOL Corporate Finance

44
 45

Proving the Perpetuity formula

To prove the perpetuity formula, we used the present value of the annuity as
the basis of proof.

é1 1 ù
The formula is PV of annuity = Pmt ´ ê - nú
ë i i(1 + i ) û
Pmt é 1 ù
PV of annuity = ´ ê1 - ú [take out the common factor ‘i’]
i ë (1 + i )n û

se py
ly
If n goes into infinity, (1+i)n becomes infinity

é 1 ù

on
r u Co
Therefore, ê n ú tends to zero and we are left with
ë (1 + i ) û
Pmt
PV of perpetuity =
i
ou ot
ry N

Question: Do you know how to derive the formula for PV of ordinary annuity?
Fo Do
©

© Copyright Daniel Tan J H UOL Corporate Finance

45