Chapter 01 – Introduction to Finance

Areas of Finance:
1. Financial Services: 2. Managerial Finance:
Design and delivery of financial advices and Duties of financial manager.
products. • Financial Manager:
• Banking Actively manages the financial affairs of
• Personal Financial Planning all types of businesses, whether private
• Investment or public, large or small, profit seeking
• Real Estate or not for profit.
• Insurance

Responsibilities of a Treasurer:
✓ Managing the firm’s cash and marketable securities.
✓ Planning how the firm is financed and when funds are raised.
✓ Managing risk.
✓ Overseeing the corporate pension fund.
✓ Supervision of the credit manager, the inventory manager, and the director of capital budgeting.

Finance in a Business Organization (Career Opportunities in Managerial Finance):

1. Financial Analyst:
 Prepares the firm's financial plans and budgets.
 Other duties include financial forecasting, performing financial comparisons, and working closely
with accounting.
2. Capital Expenditures Manager:
 Evaluates and recommends proposed long-term investments.
 May be involved in the financial aspects of implementing approved investments.
3. Project Finance Manager:
 Arranges financing for approved long-term investments.
 Coordinates consultants, investment bankers, and legal counsel.
4. Cash Manager:
 Maintains and controls the firm's daily cash balances.
 Frequently manages the firm's cash collection and disbursement activities and short-term
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investments and coordinates short-term borrowing and banking relationships.

5. Credit Analyst/Manager:
 Administers the firm's credit policy by evaluating credit applications, extending credit, and
monitoring and collecting accounts receivable.
6. Pension Fund Manager:
 Oversees or manages the assets and liabilities of the employees' pension fund.
7. Foreign Exchange Manager:
 Manages specific foreign operations and the firm's exposure to fluctuations in exchange rates.

Finance in Nonfinance Areas:

Economics

Accounting Finance Marketing

Management

 Economics & Finance:

Financial managers should understand economic activity and economic policy for decision making.

 Accounting & Finance:

Accounting information assists financial managers to evaluate past performance and future planning.

 Management & Finance:

✓ Formulation of financial policies to fit management decisions.
✓ Impact of management decisions on financial well-being.

 Marketing & Finance:

Marketing, advertising and promotion activities affect financial resources.
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Classification of Finance:

An individual's finances for goals like financial security,

Personal Finance homeownership, and retirement through budgeting, saving,
Public investing, and debt management.
Finance

Finance
Concerns financial management for businesses, aiming for
Private
Business Finance stability, growth, and profitability by planning, budgeting,
Finance allocating capital, and risk management

Specializes in fundraising and allocating funds for nonprofit

NPOs Finance organizations to support their missions through grant
management, budgeting, and financial transparency.

Functions of Financial Manager:

Current Assets
(Working Capital Management)
Investment Decision
Long-term Assets
(Capital Budgeting)

Current Liabilities

Functions of Financial
Manager
Financing Decison Long-term Liabilities

Owner's Equity

Allocation of Dividend

Dividend Decision
Retention of Earnings

 Investment Decision:
 Investing in assets which will maximize the profit.
 Investment can be –
 short term (Current Assets)
 long term (Fixed Assets)
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 Financing Decision:
 How much of finance is required to meet the long-term and short-term investment decisions?
 What are the sources of financing these investment decisions?
 What should be the financial mix?

 Dividend Decision:
 Allocation of dividend among stockholders (that is – determining ‘Dividend Payout Ratio’).
 Optimum ‘Dividend Payout Ratio’ –
✓ Retention of earnings – gives the firm the opportunity to expand in future (the higher the retained
earnings, the higher will be the firm’s scope for internal source of financing).
✓ Satisfies the stockholders.

Forms of Business Organization:

Forms of Business

Sole Proprietorship Partnership Corporation

Owned by one person who An entity created by law which is

Two or more owners doing
operates it for his or her own separate and distinct from its
business together for profit
profit owners and managers

A corporation has the legal

Partnerships are common in the powers of an individual; it can
Owner receives all profits and has
finance, insurance, and real sue and be sued, make and be
unlimited liability
estate industries party to contracts, and acquire
property in its own name

The typical sole proprietorship is Most partnerships are

Owners are called stockholders
small such as a bike shop, established by a written contract
who enjoy limited liability
personal trainer, or plumber known as Articles of Partnership

In a general (or regular)

The majority of sole
partnership, all partners have
proprietorships operate in the Ownership can be in the form of
unlimited liability and each
wholesale, retail, service, and common or preferred stock
partner is legally liable for all of
construction industries
the debts of the partnership
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 Sole Proprietorship:
Strengths: Weaknesses:
 Easily and inexpensively formed.  The owner has unlimited liability.
 Subject to few government regulations.  Limited fund-raising power.
 The owner receives all profits.  Proprietor must be jack-of-all-trades.
 Low organizational costs.  Difficult to give employees long-run career
 Taxed like an individual, thus, earnings are opportunities.
taxed only once.  Lacks continuity when proprietor dies.
 Independence and Secrecy.  Transferring ownership is somewhat
 Ease of dissolution. difficult.

 Partnership:
Strengths: Weaknesses:
 Formation is easy and relatively  Owners have unlimited liability and may
inexpensive. have to cover the debts of other partners.
 Subject to few government regulations.  Partnership is dissolved when a partner
 Can raise more funds than sole dies.
proprietorships.  Difficult to liquidate or transfer
 Borrowing power enhanced by more partnership.
owners.
 More available brain power and
managerial skill.
 Income is taxed like an individual, not a
corporation.

 Corporation:
Strengths: Weaknesses:
 Limited liability.  More expensive to organize than other
 Unlimited life. business forms.
 Ownership (stock) is readily transferable.  Double taxation.
 Better access to financing.  Subject to greater government regulation.
 Can achieve large size via sale of  Lacks secrecy.
ownership (stock).
 Can hire professional managers.

Goals of Business:
1. Profit Maximization: The financial objective of a company to generate the highest possible profit in
a specific period, often in the short term.
2. Wealth Maximization: The long-term financial objective of a company that places a strong emphasis
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on enhancing shareholder wealth by increasing the overall value of the company and its stock.
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1. Profit Maximization:
According to the Weston and Brigham, “The maximization of the firm’s net income is called profit
maximization”. If total income is more than the total expenses, then it is called profit. That means,
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
The profit maximization criterion implies that the investment, financing, and dividend policy decisions of a
firm should be oriented to the maximization of profit.

Some people believe that the owner’s objective is always to maximize profits. To achieve the goal of profit
maximization the financial manager takes only those actions that are expected to make a major contribution
to the firm’s overall profits. For corporations profits can be measured by EPS (Earning Per Share) – Earnings
available for the common stockholders by the number of shares outstanding.
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑇𝐴𝑋
𝐸𝑃𝑆 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒𝑠
Example:
Earnings Per Share (EPS)
Investment Year-1 Year-2 Year-3 Total
X 1.40 1.00 0.40 2.80
Y 0.60 1.00 1.40 3.00

According to this goal (profit maximization), project Y is preferable.

 Rationale behind Profit Maximization:

Profit is the yardstick of efficiency: Firm takes different types of decision regarding production, business
expansion, principal, buy, sell, dividend policy etc. and profit act as significant yard stick to evaluate the
firm’s decision. It provides the yardstick by which economic performance can be judged.

 Criticism of Profit Maximization:

 Ambiguity or Vague: The term profit is vague or ambiguous. It has no precise definition. It indicates
different meanings to different people. Profit may be –
→ Short Term or Long Term.
→ Total Profit or Net Profit.
→ Before Tax or After Tax.
 Ignores Timing of Return: Profit maximization does not properly consider the timing of cash flows to
be received by the firm.
Profit (Tk.)
Investment
Year-1 Year-2 Year-3 Total
A 5,000 2,000 2,000 9,000
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B 2,000 2,000 6,000 10,000

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 According to the profit maximization objective, investment B should be accepted. Though total
earning from investment A is smaller than those from B, the investment A provides much greater
earnings in the first years. The larger earnings in year 1 could be reinvested to provide greater future
earnings, but this aspect is not considered by the profit maximization goal. So, profit maximization
does not consider the timing of return.

 Ignores Cash Flow Concept: A firm’s earnings do not represent cash flows available to the
stockholders. A greater EPS does not necessarily mean that dividend payments will increase.
Furthermore, a higher EPS does not necessarily translate into higher stock price. When a company's
earnings increase, its stock price may not necessarily go up, but it's more likely to rise when those
earnings lead to greater future cash flow.

 Ignores Risk: Profit maximization disregards risk. A fundamental concept in managerial finance is that
a trade-off exists between risk and return. For higher risk, stockholders expect higher return and vice
versa.

Year-wise profit distribution

Project Year-1 Year-2 Year-3 Year-4 Year-5 Total
A 200 -100 200 -300 650 650
B 50 100 110 150 200 610

Chart: Year-wise profit distribution

800

600

400

200

0
Year-1 Year-2 Year-3 Year-4 Year-5

-200

-400

Project A Project B

This figure and graphs show that project-A is riskier than project-B. Profit maximization avoids this
typical of variability. It only notices whether total profit after a certain period is increasing or not. So,
we can easily say that profit maximization does not consider the risk dimension of financial decision.
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  Ignores the Effect of Dividend Policy on the Market Price of the Share: If the only objective is to
maximize the EPS or profit, the firm would never pay dividends. It could always improve EPS or profit
by retaining earnings and investing them at any positive rate of return, however small. To the extent
that the payment of dividends can affect the value of the stock, the maximization of earnings per
share or profit will not be a satisfactory objective.

2. Wealth Maximization:
Wealth maximization is also known as value maximization or net present worth maximization. Wealth
maximization means maximization of the wealth of the firm as well as shareholders. Shareholders are the
owners of the firm. They hire managers to run the firm for them. The firms borrow money from banks or
by issuing bonds. So, maximization of the wealth of the shareholders should be the objective of the firm.
Therefore, only those actions that are expected to increase the share price should be undertaken. The
wealth of corporate owners is measured by the share price of the stock.

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝑊𝑒𝑎𝑙𝑡ℎ = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑤𝑛𝑒𝑑 × 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

 Wealth maximization is considered as better measure than profit maximization because of following
reasons:
 Clear Concept of Wealth: Wealth is precisely defined. There is no difference between a firm’s wealth
and shareholder’s wealth. Net cash flow is considered in order to get a clear idea of wealth.

 Considers Time Value of Money: Value of money is changing according to the change of time. In the
profit maximization concept, it gives emphasis on quantities measure of profit. But in wealth
maximization it gives emphasis on qualitative measure of profit.

 Focuses on Market Price of Share: The main objective of financial management is the economic
welfare of the owner. Economic welfare is ensured when share price is increased.

 Considers Risk: The project in which profit is higher, risk is also higher. The wealth maximization
concept suggests investing in such types of projects which can earn regular and certain income with
the lower risk.

 Looks for Growth: Wealth maximization concept gives emphasize on sales and look for sustainable
growth. If sustainable growth is ensured, ultimately share price will increase.
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Principles of Finance:

1. Principles of Profitability:
This principle states that a firm should not distribute all its profit as dividends to shareholders. If the firm
distributes all its profit, it may not be able invest in profitable investment alternatives. So, a portion of
the profit should be retained by the firm as a reserve to meet financial need in future. It increases the
firm’s capability of internal financing and reduces the dependency on external financing.

2. Principles of Liquidity and Profitability:

A firm can earn profit by investing in different profitable projects. But it does not mean that a firm should
invest all their capital in assets, rather they should have cash in hand to maintain their day-to-day
activities and to run the organization properly. Liquidity means having enough money in the form of cash,
or near-cash assets, to meet financial obligations. Since Liquidity and Profitability has inverse or negative
relationship, a large amount of investment in assets increases firm’s profitability; but reduces firm’s cash
in hand (or liquidity). On the other hand, if the firm maintains large amounts of cash in hand (or liquidity),
it reduces the firm’s investment capability which in turn reduces the firm’s profitability. So, the
management should maintain an adequate amount of liquidity as well as invest in assets to earn a profit.

3. Principles of Risk and Return:

This principle states that investment decisions
should depend on the risk and return relationship
of alternative investment projects. As we know,
“The higher the risk, the higher the return”, but it
does not mean that the firm should always invest
in risky projects. A firm should invest in a project
which has “Optimum Risk-Return Relationship”.

4. Principles of Time Value of Money:

Time value of money is very important when taking financial decisions. As the value of money decreases
with the passage of time. A fixed amount of money available today is more valuable than the same
amount of money available in the future. In the period of investment, Taka 100 today is not valued equally
to the Taka 100 after 1 year.
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5. Principles of Diversity:
Financial Managers use this principle in the time of asset management. The main idea of this principle is
that “Do not put all your eggs in one bucket”. A financial manager should not invest all their capital or
funds in one project or asset, rather the investment should be in multiple projects to reduce the risk of
loss. A financial manager should invest in projects with negative relationships. By doing this the risk of
loss can be minimized.

Here the return over time for security A are cyclical in that time they move with the economy in general.
Returns for security B, however, are perfectly counter cyclical. An equal amount invested in both
securities will reduce the dispersion of return and hence the risk. Benefits of diversification occur as long
as the securities are not perfectly, positively correlated.

Managers’ Roles as Agents of Stockholders:

Agency Relationship:
An agency relationship exists when one or more individuals, who are called the principals, hire another
person, the agent, to perform a service and delegate decision making authority to that agent.

Agency Problem:
Agency problem is a potential conflict of interest between outside shareholders (owners) and managers who
make decisions about how to operate the firm. An agency problem arises when –
- Managers place personal goals ahead of the goals of shareholders.
- The agent makes decisions that are not in the best interests of the principals.

Agency Cost:
Costs arising from agency problems that are borne by shareholders and represent a loss of shareholder
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wealth.
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Ways to Minimize Agency Problems:

 Managerial Compensation (Incentives): A common method used to motivate managers to operate in a

manner consistent with stock price maximization is to tie managers’ compensation to the company’s
performance. Such compensation packages should be developed so that managers are rewarded on the
basis of the firm’s performance over a long period of time, not on the performance in any particular year.

 Monitoring: Implement rigorous monitoring and supervision of management actions and conduct
regular audits of financial reports to reduce the potential for misconduct or self-serving decisions.

 Shareholder Intervention: Institutional investors monitor corporations to promote wealth maximization,

proposing remedies and resolutions to realign management decisions with the interest of shareholders.
While stockholder-sponsored proposals aren't binding, they strongly influence corporate management.
In situations where a few large institutions own significant stock blocks, they can potentially remove
management teams not acting in shareholders' best interests.

 Threat of Takeover (Hostile Takeovers): When a company's stock is worth less than it could be because
of bad management, the company is more likely to resist being bought by someone else. In a hostile
takeover, the managers of the acquired firm generally are fired, and those who do stay on typically lose
the power they had prior to the acquisition. Thus, managers have a strong motivation to take actions that
maximize stock prices.

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Chapter 02 – Financial Markets and Institutions

Financial Markets:
A financial market is a system consisting of individuals, institutions, instruments, and procedures – that brings
together borrowers and savers.
It is a conceptual “mechanism” rather than a physical location or a specific type of organization or structure.

Types of Financial Markets:

1. Money vs Capital Markets
2. Debt vs Equity Markets
3. Primary vs Secondary Markets

1. Money vs Capital Markets:

Money Markets: The money market is a financial market where short-term debt securities, such as
treasury bills, commercial paper, and certificates of deposit – are bought and sold.
 Maturities less than or equal to one year.
Capital Markets: The capital market is a financial market where long-term securities, such as stocks and
bonds – are bought and sold.
 Maturities greater than one year.

2. Debt vs Equity Markets:

Debt Markets: The debt market, also known as the bond market, is a financial market where debt
securities, such as bonds – are bought and sold.
 Loans/liabilities/debts are traded.
Equity Markets: The equity market, also known as the stock market, is a financial market where
ownership shares in publicly traded companies (stocks or equity) are bought and sold.
 Corporate Stocks/Ownerships are traded.

3. Primary vs Secondary Markets:

Primary Markets: The primary market is where newly issued securities, such as stocks and bonds, are sold
for the first time by issuers to investors.
 New securities are traded.
 The only market in which the issuer is directly involved in the transaction.
Secondary Markets: The secondary market is where previously issued securities are bought and sold
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among investors.
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 Preowned securities (those that are not new issues) are traded.
Financial Institutions:
Financial institutions (also called financial intermediaries) facilitate the transfer of funds from savers to
borrowers through different financial products. The process is called financial intermediation.

Key Customers of Financial Institutions:

→ Individuals
→ Businesses
→ Government

Benefits of Financial Intermediary:

1. Reduced Cost: Intermediaries are more cost efficient than individuals for two reasons –
- they create combinations of financial products that better match the funds provided by
savers with the needs of borrowers, and
- they spread the costs associated with these activities over large numbers of transactions.

2. Risk Diversification: The loan portfolios of intermediaries generally are well diversified because they
provide funds to a large number and variety of borrowers by offering many types of loans. Thus,
intermediaries spread their risk by “not putting all their financial eggs in one basket”.

3. Funds Pooling: Intermediaries can pool funds from individual savers and then offer loans or other
financial products to borrowers with different denominations. That is, an intermediary can offer a large
loan to a single borrower by combining the funds provided by many small savers.

4. Financial Flexibility: Because intermediaries offer a variety of financial products, both savers and
borrowers have greater choices or financial flexibility. For instance, banks offer savers products such as
regular savings accounts, certificates of deposit, and money market accounts, and they offer borrowers
products such as commercial loans, mortgages, and credit cards. In general, the financial products
created by intermediaries are quite varied with respect to denominations, maturities, and other
characteristics; hence, intermediaries attract many different types of savers and borrowers.

Major Financial Intermediaries:

1. Commercial Banks 4. Insurance Companies

2. Non-Banking Financial Institutions (NBFI) 5. Mutual Fund

3. Investment Banks 6. Brokerage Firm

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1. Commercial Banks: A financial institution working as an intermediary between depositors and borrowers.
 It receives money from those who want to save in the form of deposits, and it lends money
to those who need it.
 Financial depository institutions allowed or licensed by the central banks to accept
deposits for doing lending business.

2. Non-Banking Financial Institutions (FIs/NBFIs): A financial institution that does not have a full banking
license or is not supervised by a national or international banking regulatory agency.
Main differences between banks and FIs are:
 FIs cannot issue cheques, pay-orders, or demand drafts.
 FIs cannot receive demand deposits.
 FIs cannot be involved in foreign exchange financing.

3. Investment Banks: Institutions that assist companies in raising capital, advise firms on major transactions
such as mergers or financial restructurings, and engage in trading and market making activities.

4. Insurance Companies: Cooperative device to spread the loss caused by a particular risk over a number
of persons who are exposed to it and who agree to ensure themselves against that risk.

5. Mutual Funds: Pool funds from savers and then use those funds to buy various types of financial assets,
thus reducing risk.

6. Brokerage Firm: A financial institution that facilitates the buying and selling of financial securities
between a buyer and a seller.

Financial Systems of Bangladesh:

1. Formal Sector 2. Semi-formal Sector 3. Informal Sector

1. Formal Sector:
Institutions which are regulated by enacted financial regulators like Bangladesh Bank, IDRA, MRA, or
BSEC. Institutions such as –
 Banks:
 Bank Company Act, 1991
 Example: UCB, SBL, SIBL, IBBL etc.

 Non-Bank Financial Institutions (NBFIs):

 Financial Institution Act, 1993
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 Example: IDLC Finance, LankaBangla Finance, MIDAS Financing etc.

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  Insurance Companies:
 Insurance Act, 2010
 Example: Metlife Alico, Sunlife, Dhaka Insurance etc.

 Micro Finance Institutions (MFIs):

 Microcredit Regulatory Authority Act, 2006
 Example: BRAC, Proshika, ASA etc.

 Capital Market Intermediaries (such as Brokerage Houses, Merchant Banks etc.):

 SEC (Stock Dealer, Stockbroker and Authorized Representative) Rules, 2000
 SEC (Merchant Banker and Portfolio Manager) Rules, 1996
 Example: LankaBangla Securities, City Brokerage, MTB Capital, Union Capital, EBL
Investments etc.

2. Semi-Formal Sector:
Institutions which are regulated, but do not fall under the jurisdiction of enacted financial regulators like
Central Bank, Insurance Authority, Securities and Exchange Commission or any other.
 This sector is mainly represented by Specialized Financial Institutions.
 Example: House Building Finance Corporation (HBFC), Palli Karma Sahayak Foundation
(PKSF), Samabay Bank, Grameen Bank etc.

3. Informal Sector:
The informal sector includes private intermediaries which are completely unregulated.

Formal Sector Regulators of Bangladesh:

 Bangladesh Bank (Central Bank of Bangladesh)

✓ Regulates 61 scheduled banks, 5 non-scheduled banks, and 34 Non-Banking Financial Institutions.

 Bangladesh Securities and Exchange Commission (BSEC)

✓ Regulates Stock Exchanges, Stock Dealers and Brokers, Merchants Banks, Asset Management
Company (AMCs), Credit Rating Agencies etc.

 Insurance Development & Regulatory Authority (IDRA)

✓ Regulates 18 Life Insurance and 44 Non-Life Insurance Companies.

 Microcredit Regulatory Authority (MRA)

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✓ Regulates 599 Micro Finance Institutions (MFIs).

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Chapter 03 – Time Value of Money

Concept of Time Value of Money –

- The concept states that money which is available at the present time is worth more than the same
amount in the future due to its potential earning capacity.
- A dollar was worth more yesterday than today and a dollar today is worth more than a dollar
tomorrow.

Reasons behind the change in value of money:

1. Consumption preference: Delay in consumption.
2. Inflation: Tho tendency of prices to increase over time resulting in lesser purchasing capacity of
money.
3. Uncertainty: Taking the risk of not getting back the loaned money.
4. Investment opportunities: There are different options or opportunities for investment.

Price of Money:
The time value of money is generally expressed in terms of “interest”.

❑ Two types of interests:

1. Simple interest is calculated based on the principal only.
2. Compound interest is calculated on both the initial principal and the accumulated interest.

Cash Flow:
The flows of money in an entity.

❑ Direction of the flow of money:

1. Cash Outflows (–): Cash flows outward from an entity.
2. Cash Inflows (+): Cash flows inward to an entity.

❑ Change of direction over the periods:

1. Conventional Cash Flow: A series of cash flow with only one change in the direction of cash flow
during a period.
2. Non-conventional Cash Flows: A series of cash flow with multiple (more than one) changes in the
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direction of cash flow during a period.

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❑ Pattern of Cash Flow:
1. Single Amount: Only one payment – cash inflow/outflow.
2. Annuity: A series of equal payments made in regular intervals over a specific period of time.
3. Mixed Stream: A series of unequal payments made in regular intervals over a specific period of
time.

1. Single Amount:

i. Future Value (FV): The value or amount to which a cash flow or series of cash flows will grow over a
given period of time at a given rate of compound interest.
 Compounding: The process of determining the future value of a cash flow or a series of cash flows
by using a compound rate of interest.
 Compounding Frequency: Number of compounding periods within a year.
 Continuous Compounding: Compounded infinitely withing a year.

𝐅𝐨𝐫𝐦𝐮𝐥𝐚: 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 𝑖 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

𝑚𝑛
𝑖 𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
𝐹𝑉 = 𝑃𝑉 (1 + )
𝑚 𝑚 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

𝐹𝑜𝑟 𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔,

𝐹𝑉 = 𝑃𝑉 × 𝑒 (𝑖×𝑛)

ii. Present Value (PV): The value of any future cash flow(s) expressed in current worth after discounting
at a given discount rate. [The current dollar value of a future amount]
 Discounting: The process of determining the present value of a cash flow or a series of cash flows
received (paid) in the future. [Reverse process of compounding]

𝐹𝑉
𝐅𝐨𝐫𝐦𝐮𝐥𝐚: 𝑃𝑉 = 𝑖 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
(1 + 𝑖)𝑛
𝐹𝑉 𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
𝑃𝑉 =
𝑖 𝑚𝑛 𝑚 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
(1 + 𝑚)
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2. Annuity:
A series of equal payments made in regular intervals over a specific period of time.

 Ordinary Annuity: Cash flow at the end of period.

𝑌𝑒𝑎𝑟 0 1 2 3 4 5
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐶𝐹 𝐶𝐹 𝐶𝐹 𝐶𝐹 𝐶𝐹
𝐶𝐹 𝐶𝐹 𝐶𝐹 𝐶𝐹 𝐶𝐹
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4 (1 + 𝑟)5
𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 𝐶𝐹(1 + 𝑟)4 𝐶𝐹(1 + 𝑟)3 𝐶𝐹(1 + 𝑟)2 𝐶𝐹(1 + 𝑟)1 𝐶𝐹

( 𝟏 + 𝒓) 𝒏 − 𝟏
𝐅𝐨𝐫𝐦𝐮𝐥𝐚: 𝑷𝑽𝑨𝑶 = 𝑪 × [ ]
𝒓 × (𝟏 + 𝒓)𝒏
𝑃𝑉𝐴𝑂 = 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑎𝑛𝑛𝑢𝑖𝑡𝑦
(1 + 𝑟)𝑛 − 1
𝐹𝑉𝐴𝑂 =𝐶×[ ] × (1 + 𝑟)𝑛 𝐹𝑉𝐴𝑂 = 𝑓𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑎𝑛𝑛𝑢𝑖𝑡𝑦
𝑟 × (1 + 𝑟)𝑛
𝐶 = 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
(𝟏 + 𝒓)𝒏 − 𝟏
𝑭𝑽𝑨𝑶 =𝑪×[ ]
𝒓

 Annuity Due: Cash flow at the beginning of period.

𝑌𝑒𝑎𝑟 0 1 2 3 4 5

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐶𝐹 𝐶𝐹 𝐶𝐹 𝐶𝐹 𝐶𝐹
𝐶𝐹 𝐶𝐹 𝐶𝐹 𝐶𝐹
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝐶𝐹
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4
𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 𝐶𝐹(1 + 𝑟)5 𝐶𝐹(1 + 𝑟)4 𝐶𝐹(1 + 𝑟)3 𝐶𝐹(1 + 𝑟)2 𝐶𝐹(1 + 𝑟)1

(𝟏 + 𝒓)𝒏 − 𝟏
𝐅𝐨𝐫𝐦𝐮𝐥𝐚: 𝑷𝑽𝑨𝑫 =𝑪×[ ] × (𝟏 + 𝒓)
𝒓 × (𝟏 + 𝒓)𝒏
𝑃𝑉𝐴𝐷 = 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑑𝑢𝑒
(1 + 𝑟)𝑛 − 1
𝐹𝑉𝐴𝐷 =𝐶×[ ] × (1 + 𝑟) × (1 + 𝑟)𝑛 𝐹𝑉𝐴𝐷 = 𝑓𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑑𝑢𝑒
𝑟 × (1 + 𝑟)𝑛
𝐶 = 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
(𝟏 + 𝒓)𝒏 − 𝟏
𝑭𝑽𝑨𝑫 =𝑪×[ ] × (𝟏 + 𝒓)
𝒓

 Perpetuity: An annuity with an infinite life.

𝑪𝑭 𝑃𝑉 = 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦

𝐅𝐨𝐫𝐦𝐮𝐥𝐚: 𝑷𝑽 =
𝒓
18

𝐶𝐹 = 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
Page
3. Mixed Stream:
 Cash flow at the end of each period:

𝑌𝑒𝑎𝑟 0 1 2 3 4 5
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4 (1 + 𝑟)5
𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 𝐶𝐹1 (1 + 𝑟)4 𝐶𝐹2 (1 + 𝑟)3 𝐶𝐹3 (1 + 𝑟)2 𝐶𝐹4 (1 + 𝑟)1 𝐶𝐹5

𝐅𝐨𝐫𝐦𝐮𝐥𝐚:
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝒏−𝟏 𝑪𝑭𝒏
𝑷𝑽 = + + ⋯ + +
(𝟏 + 𝒓)𝟏 (𝟏 + 𝒓)𝟐 (𝟏 + 𝒓)𝒏−𝟏 (𝟏 + 𝒓)𝒏
𝑭𝑽 = 𝑪𝑭𝟏 (𝟏 + 𝒓)𝒏−𝟏 + 𝑪𝑭𝟐 (𝟏 + 𝒓)𝒏−𝟐 + ⋯ + 𝑪𝑭𝒏−𝟏 (𝟏 + 𝒓)𝟏 + 𝑪𝑭𝒏

 Cash flow at the beginning of each period:

𝑌𝑒𝑎𝑟 0 1 2 3 4 5
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5
𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝐶𝐹1
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4
𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 𝐶𝐹1 (1 + 𝑟)5 𝐶𝐹2 (1 + 𝑟)4 𝐶𝐹3 (1 + 𝑟)3 𝐶𝐹4 (1 + 𝑟)2 𝐶𝐹5 (1 + 𝑟)1

𝐅𝐨𝐫𝐦𝐮𝐥𝐚:
𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝒏−𝟏 𝑪𝑭𝒏
𝑷𝑽 = 𝑪𝑭𝟏 + 𝟏
+ 𝟐
+ ⋯+ 𝒏−𝟐
+
(𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓)𝒏−𝟏
𝑭𝑽 = 𝑪𝑭𝟏 (𝟏 + 𝒓)𝒏 + 𝑪𝑭𝟐 (𝟏 + 𝒓)𝒏−𝟏 + 𝑪𝑭𝟑 (𝟏 + 𝒓)𝒏−𝟐 + ⋯ + 𝑪𝑭𝒏−𝟏 (𝟏 + 𝒓)𝟐 + 𝑪𝑭𝒏 (𝟏 + 𝒓)𝟏

Interest Rate:
 Nominal Annual Rate: It is the contractual annual rate of interest quoted/stated by a lender or a
borrower.
 Effective Annual Rate (EAR): It is the annual rate of interest actually paid or earned. The effective
annual rate reflects the effects of compounding frequency, whereas the nominal annual rate does
not.

𝒊 𝒎 𝑖 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒

𝐅𝐨𝐫𝐦𝐮𝐥𝐚: 𝑬𝑨𝑹 = (𝟏 + ) − 𝟏
𝒎 𝑚 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠
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Amortized Loan:
A loan that is repaid in equal payments over its life.

 Loan Amortization:
▪ The determination of equal periodic loan payments.
▪ These payments provide a lender with a specified interest return and repay the loan principal over a
specified period.
▪ The loan amortization process involves finding the future payments, over the term of the loan, whose
present value at the loan interest rate equals the amount of initial principal borrowed.

 Loan Amortization Schedule:

▪ A schedule of equal payments to repay a loan.
▪ It shows the allocation of each loan payment to interest and principal.
▪ Lenders use a loan amortization schedule to determine these payment amounts and the allocation of
each payment to interest and principal.

 Loan Amortization Schedule (For Mathematical Problems):

Interest Principal End of Year

Beginning of the
Year Loan Payment Payment Payment Principal
year Principal
(𝟏) × 𝒊 (𝟐) − (𝟑) (𝟏) − (𝟒)

(1) (2) (3) (4) (5)

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Formulas:

EAR 𝑖 𝑚
Effective Annual Rate 𝐸𝐴𝑅 = (1 + ) − 1
𝑚
EAR
𝐸𝐴𝑅 = 𝑒 𝑖 − 1
(Continuously Compounding)

𝑛
𝑖 𝑚𝑛
Future Value 𝐹𝑉 = 𝑃𝑉(1 + 𝑖) = 𝑃𝑉 (1 + )
𝑚
𝐹𝑉 𝐹𝑉
𝑃𝑉 = =
Single Amount Present Value (1 + 𝑖)𝑛 𝑖 𝑚𝑛
(1 + 𝑚)

Continuous
𝐹𝑉 = 𝑃𝑉 × 𝑒 (𝑖×𝑛)
Compounding

(1 + 𝑟)𝑛 − 1
Future Value 𝐹𝑉 = 𝐶 × [ ]
𝑟
Ordinary Annuity
(1 + 𝑟)𝑛 − 1
Present Value 𝑃𝑉 = 𝐶 × [ ]
𝑟 × (1 + 𝑟)𝑛

(1 + 𝑟)𝑛 − 1
Future Value 𝐹𝑉 = 𝐶 × [ ] × (1 + 𝑟)
𝑟
Annuity Due
(1 + 𝑟)𝑛 − 1
Present Value 𝑃𝑉 = 𝐶 × [ ] × (1 + 𝑟)
𝑟 × (1 + 𝑟)𝑛

Perpetuity (an annuity 𝐶𝐹

Present Value 𝑃𝑉 =
with infinite life) 𝑟
𝐹𝑉 = 𝐶𝐹1 (1 + 𝑖)𝑛−1 + 𝐶𝐹2 (1 + 𝑖)𝑛−2 + ⋯
Future Value
Mixed Stream +𝐶𝐹𝑛−1 (1 + 𝑖)1 + 𝐶𝐹𝑛
(Payment at the end of
each period) 𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛
Present Value 𝑃𝑉 = + + ⋯ +
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)𝑛

𝐹𝑉 = 𝐶𝐹1 (1 + 𝑖)𝑛 + 𝐶𝐹2 (1 + 𝑖)𝑛−1 + ⋯

Mixed Stream Future Value
+𝐶𝐹𝑛−1 (1 + 𝑖)2 + 𝐶𝐹𝑛 (1 + 𝑖)1
(Payment at the
beginning of each
𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑛
period) Present Value 𝑃𝑉 = 𝐶𝐹1 + 1
+ 2
+ ⋯+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛−1
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Mathematical Problems

Activity 01 (Slide 10)

Jane Farber places $800 in a savings account paying 6% interest compounded annually. She wants to know
how much money will be in the account at the end of 5 years.

Solution:
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 𝐻𝑒𝑟𝑒, 𝑛=5
= 800 × (1 + 0.06)5 𝑃𝑉 = $800
= $𝟏, 𝟎𝟕𝟎. 𝟓𝟖 𝑖 = 6% = 0.06

Activity 02 (Slide 10)

If Bob and Judy combine their savings of $1,260 and $975, respectively, and deposit this amount into an
account that pays 2% annual interest, compounded monthly, what will the account balance be after 4 years?

Solution:
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 𝐻𝑒𝑟𝑒, 𝑛=4
= 2,235 × (1 + 0.02)4 𝑃𝑉 = $1,260 + $975 = $2,235
= $𝟐, 𝟒𝟏𝟗. 𝟐𝟒 𝑖 = 2% = 0.02

Activity 03 (Slide 11)

You have $100 to invest. If you can earn 12% interest, about how long does it take for your $100 investment
to grow to $200?

Solution:
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 𝐻𝑒𝑟𝑒,
𝐹𝑉 200 𝑃𝑉 = $100
𝑙𝑛 (𝑃𝑉 ) 𝑙𝑛 (100)
⇒𝑛= = 𝐹𝑉 = $200
𝑙𝑛(1 + 𝑖) 𝑙𝑛(1 + 0.12)
⇒ 𝑛 = 𝟔. 𝟏𝟐 𝒚𝒆𝒂𝒓𝒔 = 𝟔 𝒚𝒆𝒂𝒓𝒔 𝟏 𝒎𝒐𝒏𝒕𝒉 𝑖 = 12% = 0.12

Activity 04 (Slide 11)

Suppose you are evaluating two investments, both of which require you to pay $5,500 today. Investment A
will pay you $7,020 in five years, whereas Investment B will pay you $8,126 in eight years. Based only on the
return you would earn from each investment, which is better?
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Solution:
1 1
𝐻𝑒𝑟𝑒,
𝐹𝑉 𝑛 𝐹𝑉 𝑛
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ⇒ 1+𝑖 =( ) ⇒𝑖 =( ) −1
𝑃𝑉 𝑃𝑉 𝑃𝑉 = $5,500

𝐹𝑜𝑟 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐴, 𝐹𝑜𝑟 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐴,

1 1
𝐹𝑉 𝑛 7,020 5 𝐹𝑉 = $7,020, 𝑛=5
𝑖=( ) −1=( ) − 1 = 𝟎. 𝟎𝟓𝟎𝟎 = 𝟓%
𝑃𝑉 5,500
𝐹𝑜𝑟 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐵,
𝐹𝑜𝑟 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐵, 𝐹𝑉 = $8,126, 𝑛=8
1 1
𝐹𝑉 𝑛 8,126 8
𝑖=( ) −1=( ) − 1 = 𝟎. 𝟎𝟒𝟗𝟗 = 𝟒. 𝟗𝟗%
𝑃𝑉 5,500

𝑆𝑜, 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐴 𝑖𝑠 𝑠𝑙𝑖𝑔ℎ𝑡𝑙𝑦 𝑏𝑒𝑡𝑡𝑒𝑟 𝑡ℎ𝑎𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐵.

Activity 05 (Slide 14)

Paul has an opportunity to receive $300 one year from now. If he can earn 6% on his investments in the
normal course of events, what is the most he should pay now for this opportunity?

Solution:
𝐹𝑉 𝐻𝑒𝑟𝑒, 𝑛 = 1
𝑃𝑉 =
(1 + 𝑖)𝑛
𝐹𝑉 = $300,
300
= = $𝟐𝟖𝟑. 𝟎𝟐 𝑖 = 6% = 0.06
(1 + 0.06)1

Activity 06 (Slide 14)

Pam Valenti wishes to find the present value of $1,700 that she will receive 8 years from now. Pam’s
opportunity cost is 8%.

Solution:
𝐹𝑉 𝐻𝑒𝑟𝑒, 𝑛 = 8
𝑃𝑉 =
(1 + 𝑖)𝑛
𝐹𝑉 = $1,700,
1,700
= = $𝟗𝟏𝟖. 𝟓𝟎 𝑖 = 8% = 0.08
(1 + 0.08)8

Activity 07 (Slide 14)

Jim has been offered an investment that will pay him $500 three years from today. If his opportunity cost is
23

7% compounded annually, what value should he place on this opportunity today?

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Solution:
𝐹𝑉 𝐻𝑒𝑟𝑒, 𝑛 = 3
𝑃𝑉 =
(1 + 𝑖)𝑛
𝐹𝑉 = $500,
500
= = $𝟒𝟎𝟖. 𝟏𝟓 𝑖 = 7% = 0.07
(1 + 0.07)3

Class Review Test (3) (Slide 15)

Assume a firm makes a $2,500 deposit into its money market account. If this account is currently paying 0.7%,
what will the account balance be after 1 year?

Solution:
𝐹𝑉 = 𝑃𝑉(1 + 𝑟)𝑛 𝐻𝑒𝑟𝑒, 𝑛 = 1
= 2,500 × (1 + 0.007)1 = $𝟐, 𝟓𝟏𝟕. 𝟓 𝑃𝑉 = $2,500
𝑖 = 0.7% = 0.007

Class Review Test (4) (Slide 15)

What single investment made today, earning 12% annual interest, will be worth $6,000 at the end of 6 years?

Solution:
𝐹𝑉 𝐻𝑒𝑟𝑒, 𝑛 = 6
𝑃𝑉 =
(1 + 𝑟)𝑛 𝐹𝑉 = $6,000
6,000
= = $𝟑, 𝟎𝟑𝟗. 𝟕𝟗 𝑖 = 12% = 0.12
(1 + 0.12)6

Class Review Test (5) (Slide 15)

Suppose you are going to receive $2000 at the end of each year for 5 years. What is the present value if the
discount rate is 10%?

Solution:
(1 + 𝑖)𝑛 − 1 𝐻𝑒𝑟𝑒, 𝑛 = 5
𝑃𝑉 = 𝐶 × [ ]
𝑖 × (1 + 𝑖)𝑛 𝐶 = $2,000
5
(1 + 0.1) − 1 𝑖 = 10% = 0.10
= 2,000 × [ ] = $𝟕, 𝟓𝟖𝟏. 𝟓𝟕
0.1 × (1 + 0.1)5

Activity 08 (Slide 18)

24

Suppose you are going to receive $1000 at the end of each year for 4 years. What is the present value if the
Page

discount rate is 10%?

Solution:
(1 + 𝑟)𝑛 − 1 𝐻𝑒𝑟𝑒, 𝑛 = 4
𝑃𝑉 = 𝐶 × [ ]
𝑟 × (1 + 𝑟)𝑛 𝐶 = $1,000
4
(1 + 0.1) − 1 𝑖 = 10% = 0.1
= 1,000 × [ ] = $𝟑, 𝟏𝟔𝟗. 𝟖𝟕
0.1 × (1 + 0.1)4

Activity 09 (Slide 18)

If you invest $1,000 at the end of each year for four years and your funds grow at the rate of 10%. What will
be the future value of your investment at the end of year 4?

Solution:
(1 + 𝑟)𝑛 − 1 𝐻𝑒𝑟𝑒, 𝑛 = 4
𝐹𝑉 = 𝐶 × [ ]
𝑟 𝐶 = $1,000
4
(1 + 0.1) − 1 𝑖 = 10% = 0.1
= 1,000 × [ ] = $𝟒, 𝟔𝟒𝟏
0.1

Activity 10 (Slide 20)

Suppose you are going to receive $1000 at the beginning of each year for 4 years. What is the present value
if the discount rate is 10%?

Solution:
(1 + 𝑟)𝑛 − 1 𝐻𝑒𝑟𝑒, 𝑛 = 4
𝑃𝑉 = 𝐶 × [ ] × (1 + 𝑟)
𝑟 × (1 + 𝑟)𝑛 𝐶 = $1,000
4
(1 + 0.1) − 1 𝑖 = 10% = 0.10
= 1,000 × [ ] × (1 + 0.1) = $𝟑, 𝟒𝟖𝟔. 𝟖𝟔
0.1 × (1 + 0.1)4

Activity 11 (Slide 20)

If you invest $1,000 at the beginning of each year for four years and your funds grow at the rate of 10%. What
will be the future value of your investment at the end of year 4?

Solution:
(1 + 𝑟)𝑛 − 1 𝐻𝑒𝑟𝑒, 𝑛 = 4
𝐹𝑉 = 𝐶 × [ ] × (1 + 𝑟)
𝑟 𝐶 = $1,000
4
(1 + 0.1) − 1
= 1,000 × [ ] × (1 + 0.1) = $𝟓, 𝟏𝟎𝟓. 𝟏𝟎 𝑖 = 10% = 0.10
0.1
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Class Practice 01 (Slide 21)
Ramesh wishes to choose the better of two equally costly cash flow streams: annuity X and annuity Y. X is an
annuity due with a cash inflow of $9,000 for each of 6 years. Y is an ordinary annuity with a cash inflow of
$10,000 for each of 6 years. Assume that Ramesh can earn 15% on his investments. Find the future value at
the end of year 6 for both annuities.

Solution:
𝐹𝑜𝑟 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑋,
𝐻𝑒𝑟𝑒, 𝑛 = 6
(1 + 𝑟)𝑛 − 1
𝐹𝑉𝑥 = 𝐶𝑥 × [ ] × (1 + 𝑟) 𝑟 = 15% = 0.15
𝑟
(1 + 0.15)6 − 1 𝐶𝑥 = $9,000
= 9,000 × [ ] × (1 + 0.15) = $𝟗𝟎, 𝟔𝟎𝟏. 𝟐𝟎 𝐶𝑦 = $10,000
0.15

𝐹𝑜𝑟 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑌,
(1 + 𝑟)𝑛 − 1
𝐹𝑉𝑦 = 𝐶𝑦 × [ ]
𝑟
(1 + 0.15)6 − 1
= 10,000 × [ ] = $𝟖𝟕, 𝟓𝟑𝟕. 𝟒𝟎
0.15

𝑆𝑜, 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑋 𝑖𝑠 𝑏𝑒𝑡𝑡𝑒𝑟 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡ℎ𝑒 𝑡𝑤𝑜.

Class Practice 02 (Slide 22)

Marian Kirk wishes to select the better of two 10-year annuities, C and D. Annuity C is an ordinary annuity of
$2,500 per year for 10 years. Annuity D is an annuity due of $2,200 per year for 10 years.

a) Find the future value of both annuities at the end of year 10, assuming that Marian can earn 20%
annual interest.
b) Find the present value of both annuities, assuming that Marian can earn 20% annual interest.

Solution:
𝒂)
𝐻𝑒𝑟𝑒, 𝑛 = 10
(1 + 𝑟)𝑛 − 1
𝐹𝑉𝐶 = 𝐶𝐶 × [ ] 𝑟 = 20% = 0.2
𝑟
(1 + 0.2)10 − 1 𝐶𝐶 = $2,500
= 2,500 × [ ] = $𝟔𝟒, 𝟖𝟗𝟔. 𝟕𝟏 𝐶𝐷 = $2,200
0.2
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 (1 + 𝑟)𝑛 − 1
𝐹𝑉𝐷 = 𝐶𝐷 × [ ] × (1 + 𝑟)
𝑟
(1 + 0.2)10 − 1
= 2,200 × [ ] × (1 + 0.2) = $𝟔𝟖, 𝟓𝟑𝟎. 𝟗𝟐
0.2
𝑆𝑜, 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷 𝑖𝑠 𝑏𝑒𝑡𝑡𝑒𝑟 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡ℎ𝑒 𝑡𝑤𝑜.

𝒃)
(1 + 𝑟)𝑛 − 1
𝑃𝑉𝐶 = 𝐶𝐶 × [ ]
𝑟 × (1 + 𝑟)𝑛
(1 + 0.2)10 − 1
= 2,500 × [ ] = $𝟏𝟎, 𝟒𝟖𝟏. 𝟏𝟖
0.2 × (1 + 0.2)10
(1 + 𝑟)𝑛 − 1
𝑃𝑉𝐷 = 𝐶𝐷 × [ ] × (1 + 𝑟)
𝑟 × (1 + 𝑟)𝑛
(1 + 0.2)10 − 1
= 2,500 × [ ] × (1 + 0.2) = $𝟏𝟏, 𝟎𝟔𝟖. 𝟏𝟑
0.2 × (1 + 0.2)10

𝑆𝑜, 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷 𝑖𝑠 𝑏𝑒𝑡𝑡𝑒𝑟 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡ℎ𝑒 𝑡𝑤𝑜.

Slide 24:
Suppose a bank will provide you at end of each year $100 that will continue forever. The interest rate is 10%.
What is the present value of your deposit?

Solution:
𝐻𝑒𝑟𝑒, 𝐶𝐹 = $100, 𝑖 = 10% = 0.10

𝐶𝐹 100
𝑃𝑉 = = = $𝟏, 𝟎𝟎𝟎
𝑖 0.10

Slide 26:
A company is going to receive the following cash flows from the customer. The company can return 12% on
investment. What is the present value of the receipts?

End of Year Cash Flows

1 $34,432
2 39,530
3 39,359
4 32,219
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Solution:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐻𝑒𝑟𝑒,
𝑃𝑉 = + + +
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)3 (1 + 𝑖)4 𝑖 = 12% = 0.12

34,432 39,530 39,359 32,219

= + + +
(1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4

= $𝟏𝟏𝟎, 𝟕𝟒𝟔. 𝟔𝟓

Slide 27:
Suppose you receive the following cash flow at the end of each period. What will be the future amount if the
interest rate is 10%?

End of Year Cash Flows

1 $11,500
2 14,000
3 12,900
4 16,000
5 18,000

Solution:
𝐹𝑉 = 𝐶𝐹1 × (1 + 𝑖)𝑛−1 + 𝐶𝐹2 × (1 + 𝑖)𝑛−2 + 𝐶𝐹3 × (1 + 𝑖)𝑛−3 𝐻𝑒𝑟𝑒,
+𝐶𝐹4 × (1 + 𝑖)𝑛−4 + 𝐶𝐹5 × (1 + 𝑖)𝑛−5 𝑖 = 10% = 0.1
𝑛=5
= 11,500 × (1 + 0.1)5−1 + 14,000 × (1 + 0.1)5−2 + 12,900 × (1 + 0.1)5−3
+16,000 × (1 + 0.1)5−4 + 18,000 × (1 + 0.1)5−5

= $𝟖𝟔, 𝟔𝟖𝟎. 𝟏𝟓

Slide 29:
A company is going to receive the following cash flows from the customer. The company can return 12% on
investment. What is the present value of the receipts?

Beginning of Year Cash Flows

1 $34,432
2 39,530
3 39,359
4 32,219
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Solution:
𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐻𝑒𝑟𝑒,
𝑃𝑉 = 𝐶𝐹1 + + +
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)3 𝑖 = 12% = 0.12

39,530 39,359 32,219

= 34,432 + + +
(1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3

= $𝟏𝟐𝟒, 𝟎𝟑𝟔. 𝟐𝟒

Slide 30:
Suppose you receive the following cash flow at the beginning of each period. What will be the future amount
if the interest rate is 10%?

Beginning of Year Cash Flows

1 $11,500
2 14,000
3 12,900
4 16,000
5 18,000

Solution:
𝐹𝑉 = 𝐶𝐹1 × (1 + 𝑖)𝑛 + 𝐶𝐹2 × (1 + 𝑖)𝑛−1 + 𝐶𝐹3 × (1 + 𝑖)𝑛−2 𝐻𝑒𝑟𝑒,
+𝐶𝐹4 × (1 + 𝑖)𝑛−3 + 𝐶𝐹5 × (1 + 𝑖)𝑛−4 𝑖 = 10% = 0.1
𝑛=5
= 11,500 × (1 + 0.1)5 + 14,000 × (1 + 0.1)5−1 + 12,900 × (1 + 0.1)5−2
+16,000 × (1 + 0.1)5−3 + 18,000 × (1 + 0.1)5−4

= $𝟗𝟓, 𝟑𝟒𝟖. 𝟏𝟕

Slide 33:
Fred Moreno wishes to find the effective annual rate associated with an 8% nominal annual rate when
interest is compounded (1) annually; (2) semiannually; and (3) quarterly.

Solution:
(𝟏) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝐴𝑛𝑛𝑢𝑎𝑙𝑙𝑦, 𝑚=1 𝐻𝑒𝑟𝑒,
𝑖 𝑚 0.08 1 𝑖 = 8% = 0.08
𝐸𝐴𝑅 = (1 + ) − 1 = (1 + ) − 1 = 𝟎. 𝟎𝟖 = 𝟖%
𝑚 1
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 (𝟐) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑆𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦, 𝑚=2
𝑖 𝑚 0.08 2
𝐸𝐴𝑅 = (1 + ) − 1 = (1 + ) − 1 = 𝟎. 𝟎𝟖𝟏𝟔 = 𝟖. 𝟏𝟔%
𝑚 2

(𝟑) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑄𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦, 𝑚=4

𝑖 𝑚 0.08 4
𝐸𝐴𝑅 = (1 + ) − 1 = (1 + ) − 1 = 𝟎. 𝟎𝟖𝟐𝟒 = 𝟖. 𝟐𝟒%
𝑚 4

Slide 34:
We wish to accumulate Tk. 4,641 after 4 years at a 10% interest rate. How much must be set aside at the end
of each period?

Solution:
(1 + 𝑟)𝑛 − 1 𝐻𝑒𝑟𝑒, 𝑛 = 4
𝐹𝑉 = 𝐶 × [ ]
𝑟 𝐹𝑉 = $4,641
𝐹𝑉 × 𝑟 4,641 × 0.10 𝑖 = 10% = 0.10
⇒𝐶= = = $𝟏, 𝟎𝟎𝟎
(1 + 𝑟) − 1 (1 + 0.1)4 − 1
𝑛

Slide 35:
Judi Janson wishes to accumulate Tk. 8,000 by the end of 5 years by making equal, annual, end-of-year
deposits over the next 5 years. If Judi can earn 7% on her investments, how much must she deposit at the
end of each year to meet this goal?

Solution:
(1 + 𝑟)𝑛 − 1 𝐻𝑒𝑟𝑒, 𝑛 = 5
𝐹𝑉 = 𝐶 × [ ]
𝑟 𝐹𝑉 = 𝑇𝑘. 8,000
𝐹𝑉 × 𝑟 8,000 × 0.07 𝑖 = 7% = 0.07
⇒𝐶= = = 𝑻𝒌. 𝟏, 𝟑𝟗𝟏. 𝟏𝟑
(1 + 𝑟)𝑛 − 1 (1 + 0.07)5 − 1

Slide 35:
Jack and Jill have just had their first child. If college is expected to cost Tk.150,000 per year in 18 years, how
much should the couple begin depositing annually at the end of each year to accumulate enough funds to
pay the first year’s tuition at the beginning of the 19th year? Assume that they can earn a 6% annual rate of
return on their investment.
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Solution:
(1 + 𝑟)𝑛 − 1 𝐻𝑒𝑟𝑒, 𝑛 = 18
𝐹𝑉 = 𝐶 × [ ]
𝑟 𝐹𝑉 = 𝑇𝑘. 150,000
𝐹𝑉 × 𝑟 150,000 × 0.06 𝑖 = 6% = 0.06
⇒𝐶= = = 𝑻𝒌. 𝟒, 𝟖𝟓𝟑. 𝟒𝟖
(1 + 𝑟) − 1 (1 + 0.06)18 − 1
𝑛

Slide: 38
You can borrow Tk. 6000 at 10% with the agreement of making equal annual end-of-year payments over 4
years. What will be the size of the payment? Prepare the loan amortization schedule.

Solution:
𝐻𝑒𝑟𝑒, 𝑃𝑉 = 𝑇𝑘. 6,000, 𝑟 = 10% = 0.10, 𝑛=4

(1 + 𝑟)𝑛 − 1
𝑃𝑉 = 𝐶 × [ ]
𝑟 × (1 + 𝑟)𝑛
𝑃𝑉 × 𝑟 × (1 + 𝑟)𝑛
⇒𝐶=
(1 + 𝑟)𝑛 − 1
6,000 × 0.10 × (1 + 0.10)4
=
(1 + 0.10)4 − 1
= 𝑻𝒌. 𝟏, 𝟖𝟗𝟐. 𝟖𝟐

Principal End of Year

Beginning of the Interest Payment
Year Loan Payment Payment Principal
year Principal [(𝟏) × 𝒊]
[(𝟐) − (𝟑)] [(𝟏) − (𝟒)]

(1) (2) (3) (4) (5)

1 6,000 1,892.82 600 1,292.82 4,707.18

2 4,707.18 1,892.82 470.72 1,422.10 3,285.08

3 3,285.08 1,892.82 328.52 1,564.30 1,720.78

4 1,720.77 1,892.82 172.08 1,720.77 0

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Slide: 40
Jon borrowed $15,000 at a 14% annual rate of interest to be repaid over 3 years. The loan is amortized into
three equal, annual, end-of-year payments.

a) Calculate the annual, end-of-year loan payment.

b) Prepare a loan amortization schedule showing the interest and principal breakdown of each of the
three loan payments.
c) Explain why the interest portion of each payment declines with the passage of time.

Solution:
𝐻𝑒𝑟𝑒, 𝑃𝑉 = $15, ,000, 𝑟 = 14% = 0.14, 𝑛=3
(1 + 𝑟)𝑛 − 1
𝒂) 𝑃𝑉 = 𝐶 × [ ]
𝑟 × (1 + 𝑟)𝑛
𝑃𝑉 × 𝑟 × (1 + 𝑟)𝑛 15,000 × 0.14 × (1 + 0.14)3
⇒𝐶= = = $𝟔, 𝟒𝟔𝟏
(1 + 𝑟)𝑛 − 1 (1 + 0.14)3 − 1

𝒃)

Principal End of Year

Beginning of the Interest Payment
Year Loan Payment Payment Principal
year Principal [(𝟏) × 𝒊]
[(𝟐) − (𝟑)] [(𝟏) − (𝟒)]

(1) (2) (3) (4) (5)

1 15,000 6461 2,100 4,361 10,639

2 10,639 6461 1489.46 4,971.54 5,667.46

3 5,667.5 6461 793.45 5,667.5 0

𝒄) 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑠 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒𝑑 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 − 𝑤ℎ𝑖𝑐ℎ 𝑖𝑠 𝑒𝑠𝑠𝑒𝑛𝑡𝑖𝑎𝑙𝑙𝑦 𝑡ℎ𝑒 𝑒𝑛𝑑

𝑜𝑓 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑎𝑠𝑡 𝑦𝑒𝑎𝑟. 𝑇ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑑𝑒𝑐𝑙𝑖𝑛𝑒𝑠 𝑤𝑖𝑡ℎ 𝑒𝑎𝑐ℎ 𝑙𝑜𝑎𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡.

𝑎𝑠 𝑎 𝑟𝑒𝑠𝑢𝑙𝑡, 𝑡ℎ𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑒𝑎𝑐ℎ 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑎𝑙𝑠𝑜 𝑑𝑒𝑐𝑙𝑖𝑛𝑒𝑠 𝑤𝑖𝑡ℎ 𝑡ℎ𝑒 𝑝𝑎𝑠𝑠𝑎𝑔𝑒 𝑜𝑓 𝑡𝑖𝑚𝑒.
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P5–7 (Slide 41)
You can deposit $10,000 into an account paying 9% annual interest either today or exactly 10 years from
today. How much better off will you be at the end of 40 years if you decide to make the initial deposit today
rather than 10 years from today?

Solution:
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 𝐻𝑒𝑟𝑒,
𝐼𝑓 𝐼 𝐷𝑒𝑝𝑜𝑠𝑖𝑡 𝑁𝑜𝑤: 𝐹𝑉 = 10,000 × (1 + 0.09)40 = $314,094.20 𝑖 = 9% = 0.09
𝐼𝑓 𝐼 𝐷𝑒𝑝𝑜𝑠𝑖𝑡 10 𝑦𝑒𝑎𝑟𝑠 𝑙𝑎𝑡𝑒𝑟: 𝐹𝑉 = 10,000 × (1 + 0.09)40−10 = $132,676.78 𝑃𝑉 = $10,000
𝑆𝑜, 𝐼 𝑤𝑜𝑢𝑙𝑑 𝑏𝑒 𝑏𝑒𝑡𝑡𝑒𝑟 𝑜𝑓 𝑏𝑦 (314,094.20 − 132,676.78)
= $𝟏𝟖𝟏, 𝟒𝟏𝟕. 𝟒𝟐 𝑏𝑦 𝑖𝑛𝑣𝑒𝑠𝑡𝑖𝑛𝑔 𝑡𝑜𝑑𝑎𝑦 𝑟𝑎𝑡ℎ𝑒𝑟 𝑡ℎ𝑎𝑛 10 𝑦𝑒𝑎𝑟𝑠 𝑙𝑎𝑡𝑒𝑟.

P5–8 (Slide 42)

Misty needs to have $15,000 at the end of 5 years to fulfill her goal of purchasing a small sailboat. She is
willing to invest a lump sum today and leave the money untouched for 5 years until it grows to $15,000, but
she wonders what sort of investment return she will need to earn to reach her goal. Figure out the
approximate annually compounded rate of return needed in each of these cases:

a) Misty can invest $10,200 today.

b) Misty can invest $8,150 today.
c) Misty can invest $7,150 today.

Solution:
1
𝐹𝑉 𝑛
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ⇒𝑖 =( ) −1
𝑃𝑉 𝐻𝑒𝑟𝑒,
1
15,000 5 𝐹𝑉 = $15,000
𝒂) 𝑖 = ( ) − 1 = 0.0802 = 𝟖. 𝟎𝟐%
10,200 𝑛=5
1
15,000 5 𝑎) 𝑃𝑉 = $10,200
𝒃) 𝑖 = ( ) − 1 = 0.1298 = 𝟏𝟐. 𝟗𝟖%
8,150 𝑏) 𝑃𝑉 = $8,150
1 𝑐) 𝑃𝑉 = $7,150
15,000 5
𝒄) 𝑖 = ( ) − 1 = 0.1597 = 𝟏𝟓. 𝟗𝟕%
7,150
33
Page
P5-30 (Slide 43)
Find the present value of the streams of cash flows shown in the following table. Assume that the firm’s
opportunity cost is 12%.
A B C
Year Cash Flow Year Cash Flow Year Cash Flow
1 –$2,000 1 $10,000 1-5 $10,000/yr
2 3,000 2-5 5,000/yr 6-10 8,000/yr
3 4,000 6 7,000
4 6,000
5 8,000

Solution:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3
𝐹𝑜𝑟 𝑀𝑖𝑥𝑒𝑑 𝑆𝑡𝑟𝑒𝑎𝑚, 𝑃𝑉 = 1
+ 2
+ +⋯
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖)3
(1 + 𝑖)𝑛 − 1
𝐹𝑜𝑟 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦, 𝑃𝑉 = 𝐶 × [ ]
𝑖 × (1 + 𝑖)𝑛
𝑖 = 12% = 0.12

𝑭𝒐𝒓 (𝑨),
−2,000 3,000 4,000 6,000 8,000
𝑃𝑉 = 1
+ 2
+ 3
+ 4
+
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)5
= −1,785.71 + 2,391.58 + 2,847.12 + 3,813.11 + 4,539.41
= $𝟏𝟏, 𝟖𝟎𝟓. 𝟓𝟏

𝑭𝒐𝒓 (𝑩),
(1 + 0.12)4 − 1
10,000 5,000 × 7,000
0.12 × (1 + 0.12)4
𝑃𝑉 = ( )+( ) + ( )
(1 + 0.12)1 (1 + 0.12)1 (1 + 0.12)6

= 8,928.57 + 13,559.60 + 3,546.42

= $𝟐𝟔, 𝟎𝟑𝟒. 𝟓𝟗

𝐴𝑛𝑜𝑡ℎ𝑒𝑟 𝑆𝑜𝑙𝑢𝑡𝑖𝑜𝑛 (𝐵),

10,000 1 1 1 1 7,000
𝑃𝑉 = + (5,000 × ( + + + )) +
(1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4 (1 + 0.12)5 (1 + 0.12)6
= 8,928.57 + 13,559.60 + 3,546.42
= $𝟐𝟔, 𝟎𝟑𝟒. 𝟓𝟗
34
Page
 𝑭𝒐𝒓 (𝑪),
(1 + 0.12)5 − 1
(1 + 0.12) − 1 5 8,000 ×
0.12 × (1 + 0.12)5
𝑃𝑉 = (10,000 × ) + ( )
0.12 × (1 + 0.12)5 (1 + 0.12)5

= 36,047.76 + 16,363.57
= $𝟓𝟐, 𝟒𝟏𝟏. 𝟑𝟑

𝐴𝑛𝑜𝑡ℎ𝑒𝑟 𝑆𝑜𝑙𝑢𝑡𝑖𝑜𝑛 (𝐶),

1 1 1 1 1
𝑃𝑉 = 10,000 × ( 1
+ 2
+ 3
+ 4
+ )
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)5
1 1 1 1 1
+ 8,000 × ( + + + + )
(1 + 0.12)6 (1 + 0.12)7 (1 + 0.12)8 (1 + 0.12)9 (1 + 0.12)10
= 36,047.76 + 16,363.57
= $𝟓𝟐, 𝟒𝟏𝟏. 𝟑𝟑

P5-14 (Slide 44)

Suppose you want to save money to pay for a down payment on an apartment in 5 years’ time. One year
from now, you will invest your Tk. 30,000 year-end bonus for the down payment. If you can invest at 15% per
year, how much interest will you receive on your cash in 5 years? If you need Tk. 210,000 for the down
payment and you would like to top-up the remaining amount by investing lump sum today, what is the
amount you should invest?

Solution:
𝐹𝑉1 = 𝑃𝑉1 (1 + 𝑖)𝑛 = 30,000 × (1 + 0.15)4 = $52,470.19 𝐻𝑒𝑟𝑒,

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑚𝑜𝑢𝑛𝑡, 𝐼 = 𝐹𝑉1 − 𝑃𝑉1 = 52,470.19 − 30,000 = $𝟐𝟐, 𝟒𝟕𝟎. 𝟏𝟗 𝑖 = 15% = 0.15
𝑃𝑉1 = $30,000
𝑁𝑜𝑤, 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑑𝑜𝑤𝑛𝑝𝑎𝑦𝑚𝑒𝑛𝑡,

𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡, 𝐹𝑉2 = 210,000 − 52,470.19 = $157,529.81

𝐹𝑉2 157,529.81
𝐴𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 𝑏𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑡𝑜𝑑𝑎𝑦, 𝑃𝑉2 = 𝑛
= = $𝟕𝟖, 𝟑𝟐𝟎. 𝟏𝟔
(1 + 𝑖) (1 + 0.15)5

P5–15 (Slide 45)

You just won a lottery that promises to pay you $1,000,000 exactly 10 years from today. Because the
$1,000,000 payment is guaranteed by the state in which you live, opportunities exist to sell the claim today
35

for an immediate single cash payment. What is the least you will sell your claim for if you can earn 6%, 9%,
Page

12% rates of return on similar-risk investments during the 10-year period?

Solution:
𝐹𝑉 𝐻𝑒𝑟𝑒,
𝑃𝑉 =
(1 + 𝑖)𝑛
𝐹𝑉 = $1,000,000
𝐹𝑜𝑟 𝑖 = 6% = 0.06,
𝑛 = 10
1,000,000
𝑃𝑉 = = $𝟓𝟓𝟖, 𝟑𝟗𝟒. 𝟕𝟖
(1 + 0.06)10

𝐹𝑜𝑟 𝑖 = 9% = 0.09,
1,000,000
𝑃𝑉 = = $𝟒𝟐𝟐, 𝟒𝟏𝟎. 𝟖𝟏
(1 + 0.09)10

𝐹𝑜𝑟 𝑖 = 12% = 0.12,

1,000,000
𝑃𝑉 = = $𝟑𝟐𝟏, 𝟗𝟕𝟑. 𝟐𝟒
(1 + 0.12)10

P5–18 (Slide 46)

You put $10,000 in an account earning 5%. After 3 years, you make another deposit into the same account.
Four years later (that is, 7 years after your original $10,000 deposit), the account balance is $20,000. What
was the amount of the deposit at the end of year 3?

Solution:
𝐹𝑜𝑟 𝑡ℎ𝑒 $10,000 𝑑𝑒𝑝𝑜𝑠𝑖𝑡, 𝑓𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 7 𝑦𝑒𝑎𝑟𝑠, 𝐻𝑒𝑟𝑒,
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 = 10,000 × (1 + 0.05)7 = $14,071 𝑖 = 5% = 0.05

𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡 = 20,000 − 14,071 = $5,929

𝐹𝑜𝑟 𝑡ℎ𝑒 2𝑛𝑑 𝑑𝑒𝑝𝑜𝑠𝑖𝑡, 𝐹𝑉 = $5,929, 𝑛 = 4

𝐹𝑉 5,929
𝑃𝑉 = = = $𝟒, 𝟖𝟕𝟕. 𝟖𝟎
(1 + 𝑖)𝑛 (1 + 0.05)4

P5–24 (Slide 47)

You plan to retire in exactly 20 years. Your goal is to create a fund that will allow you to receive $20,000 at
the end of each year for the 30 years between retirement and death (a psychic told you would die exactly 30
years after you retire). You know that you will be able to earn 11% per year during the 30-year retirement
period.
a) How large a fund will you need when you retire in 20 years to provide the 30-year, $20,000 retirement
annuity?
36

b) How much will you need today as a single amount to provide the fund calculated in part (a) if you earn
Page

only 9% per year during the 20 years preceding retirement?

Solution:
(1 + 𝑟)𝑛 − 1
𝒂) 𝑃𝑉 = 𝐶 × [ ] 𝒂) 𝐻𝑒𝑟𝑒,
𝑟 × (1 + 𝑟)𝑛
𝐶 = $20,000
(1 + 0.11)30 − 1
= 20,000 × [ ] = $𝟏𝟕𝟑, 𝟖𝟕𝟓. 𝟖𝟓 𝑛 = 30, 𝑟 = 11% = 0.11
0.11 × (1 + 0.11)30

𝐹𝑉 𝒃) 𝐻𝑒𝑟𝑒,
𝒃) 𝑃𝑉 =
(1 + 𝑟)𝑛
𝑛 = 20, 𝑟 = 9% = 0.09
𝟏𝟕𝟑, 𝟖𝟕𝟓. 𝟖𝟓
= = $𝟑𝟏, 𝟎𝟐𝟒. 𝟖𝟐 𝐹𝑉 = $173,875.85
(1 + 0.09)20

P5–39 (Slide 48)

You plan to invest $2,000 in an individual retirement arrangement (IRA) today at a nominal annual rate of
8%, which is expected to apply to all future years.

a) How much will you have in the account at the end of 10 years if interest is compounded (1) annually, (2)
semiannually, (3) daily (assume a 365-day year), and (4) continuously?
b) What is the effective annual rate, EAR, for each compounding period in part a?
c) How much greater will your IRA balance be at the end of 10 years if interest is compounded continuously
rather than annually?
d) How does the compounding frequency affect the future value and effective annual rate for a given
deposit? Explain in terms of your findings in parts a through c.

Solution:
𝐻𝑒𝑟𝑒, 𝑃𝑉 = $2,000, 𝑖 = 8% = 0.08, 𝑛 = 10

𝑖 𝑚𝑛
𝒂) 𝐹𝑉 = 𝑃𝑉 (1 + )
𝑚
(𝟏) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝐴𝑛𝑛𝑢𝑎𝑙𝑙𝑦, 𝑚 = 1
0.08 1×10
𝐹𝑉 = 2,000 × (1 + ) = $𝟒, 𝟑𝟏𝟕. 𝟖𝟓
1
(𝟐) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑆𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦, 𝑚 = 2
0.08 2×10
𝐹𝑉 = 2,000 × (1 + ) = $𝟒, 𝟑𝟖𝟐. 𝟐𝟓
2
(𝟑) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝐷𝑎𝑖𝑙𝑦, 𝑚 = 365
0.08 365×10
𝐹𝑉 = 2,000 × (1 + ) = $𝟒, 𝟒𝟓𝟎. 𝟔𝟗
365
(𝟒) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠𝑙𝑦,
37

𝐹𝑉 = 𝑃𝑉 × 𝑒 (𝑖×𝑛) = 2,000 × 𝑒 (0.08×10) = $𝟒, 𝟒𝟓𝟏. 𝟎𝟖

Page
 𝑖 𝑚
𝒃) 𝐸𝐴𝑅 = (1 + ) −1
𝑚
(𝟏) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝐴𝑛𝑛𝑢𝑎𝑙𝑙𝑦, 𝑚 = 1
0.08 1
𝐸𝐴𝑅 = (1 + ) − 1 = 0.08 = 𝟖%
1
(𝟐) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑆𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦, 𝑚 = 2
0.08 2
𝐸𝐴𝑅 = (1 + ) − 1 = 0.0816 = 𝟖. 𝟏𝟔%
2
(𝟑) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝐷𝑎𝑖𝑙𝑦, 𝑚 = 365
0.08 365
𝐸𝐴𝑅 = (1 + ) − 1 = 0.0833 = 𝟖. 𝟑𝟑%
365
(𝟒) 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠𝑙𝑦,
𝐸𝐴𝑅 = 𝑒 𝑖 − 1 = 1.0833 − 1 = 0.0833 = 𝟖. 𝟑𝟑%

𝒄) 𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡ℎ𝑒 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠𝑙𝑦 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑎𝑛𝑑 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝐼𝑅𝐴

= 4,451.08 − 4,317.85 = $𝟏𝟑𝟑. 𝟐𝟑

𝒅) As shown in part (a), the larger the compounding frequency (m), the larger the future value. The
effective annual rate (EAR) also increases as the frequency of compounding increases, as shown in
part (b). Part (c) shows that the IRA increased by $133.23 as the EAR moved from 8% to 8.33% as
compounding frequency moved from annually to continuously.

P5–52 (Slide 49)

Rishi Singh has $1,500 to invest. His investment counselor suggests an investment that pays no stated interest
but will return $2,000 at the end of 3 years.
a) What annual rate of return will Rishi earn with this investment?
b) Rishi is considering another investment, of equal risk, that earns an annual return of 8%. Which
investment should he make, and why?

Solution:
𝒂) 𝐻𝑒𝑟𝑒, 𝑃𝑉 = $1,500, 𝐹𝑉 = $2,000, 𝑛=3
1
𝐹𝑉 𝑛
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ⇒𝑖 =( ) −1
𝑃𝑉
1
2,000 3
⇒𝑖=( ) − 1 = 0.1006 = 𝟏𝟎. 𝟎𝟔%
1,500

𝒃) 𝐻𝑒𝑟𝑒, 𝑃𝑉 = $1,500, 𝑖 = 8% = 0.08, 𝑛=3

38

𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 = 1,500 × (1 + 0.08)3 = $𝟏, 𝟖𝟖𝟗. 𝟓𝟕

Page
4-19 (Slide 50)
While Steve Bouchard was a student at the University of Florida, he borrowed $12,000 in student loans at an
annual interest rate of 9 percent. If Steve repays $1,500 per year, how long, to the nearest year, will it take
him to repay the loan?

Solution:
(1 + 𝑟)𝑛 − 1 𝐻𝑒𝑟𝑒,
𝑃𝑉 = 𝐶 × [ ]
𝑟 × (1 + 𝑟)𝑛 𝑃𝑉 = $12,000
(1 + 0.09) − 1 𝑛
⇒ 12,000 = 1,500 × [ ] 𝐶 = $1,500
0.09 × (1 + 0.09)𝑛
𝑟 = 9% = 0.09
12,000 1
⇒ × 0.09 = 1 −
1,500 (1.09)𝑛
1
⇒ = 1 − 0.72 = 0.28
(1.09)𝑛
1
⇒ 𝑛 × 𝑙𝑛 ( ) = 𝑙𝑛(0.28)
1.09
∴ 𝑛 = 14.77 𝑦𝑒𝑎𝑟𝑠 ≈ 𝟏𝟒 𝒚𝒆𝒂𝒓𝒔 𝟗 𝒎𝒐𝒏𝒕𝒉𝒔 ≈ 𝟏𝟓 𝒚𝒆𝒂𝒓𝒔 (𝑎𝑝𝑝𝑟𝑜𝑥)

4-21 (Slide 51)

Jack just discovered that he holds the winning ticket for the $87 million mega lottery in Missouri. Now he
needs to decide which alternative to choose: (1) a $44 million lump-sum payment today or (2) a payment of
$2.9 million per year for 30 years; the first payment will be made today. If Jack's opportunity cost is 5 percent,
which alternative should he choose?

Solution:
𝐹𝑜𝑟 𝑜𝑝𝑡𝑖𝑜𝑛 (1),
𝐹𝑉 = 𝑃𝑉 × (1 + 𝑟)𝑛 = 44,000,000 × (1 + 0.05)30 = $𝟏𝟗𝟎, 𝟏𝟔𝟓, 𝟒𝟔𝟒. 𝟓

𝐹𝑜𝑟 𝑜𝑝𝑡𝑖𝑜𝑛 (2),

(1 + 𝑟)𝑛 − 1
𝐹𝑉 = 𝐶 × [ ] × (1 + 𝑟)
𝑟
(1 + 0.05)30 − 1
= 2,900,000 × [ ] × (1 + 0.05) = $𝟐𝟎𝟐, 𝟑𝟎𝟔, 𝟐𝟗𝟎. 𝟔
0.05

𝑱𝒂𝒄𝒌 𝒔𝒉𝒐𝒖𝒍𝒅 𝒄𝒉𝒐𝒐𝒔𝒆 𝒕𝒉𝒆 𝒐𝒑𝒕𝒊𝒐𝒏 (𝟐), 𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑡ℎ𝑒 𝑓𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 2𝑛𝑑 𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑎𝑦𝑠 𝑚𝑜𝑟𝑒 𝑡ℎ𝑎𝑛
𝑡ℎ𝑒 1𝑠𝑡 𝑜𝑝𝑡𝑖𝑜𝑛.
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 𝐴𝑛𝑜𝑡ℎ𝑒𝑟 𝑆𝑜𝑙𝑢𝑡𝑖𝑜𝑛,
𝐹𝑜𝑟 𝑜𝑝𝑡𝑖𝑜𝑛 (1), 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = $𝟒𝟒, 𝟎𝟎𝟎, 𝟎𝟎𝟎

𝐹𝑜𝑟 𝑜𝑝𝑡𝑖𝑜𝑛 (2),

(1 + 𝑟)𝑛 − 1
𝑃𝑉 = 𝐶 × [ ] × (1 + 𝑟)
𝑟 × (1 + 𝑟)𝑛
(1 + 0.05)30 − 1
= 2,900,000 × [ ] × (1 + 0.05) = $𝟒𝟔, 𝟖𝟎𝟗, 𝟏𝟏𝟑. 𝟒
0.05 × (1 + 0.05)30

𝑱𝒂𝒄𝒌 𝒔𝒉𝒐𝒖𝒍𝒅 𝒄𝒉𝒐𝒐𝒔𝒆 𝒕𝒉𝒆 𝒐𝒑𝒕𝒊𝒐𝒏 (𝟐), 𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑡ℎ𝑒 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 2𝑛𝑑 𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑎𝑦𝑠 𝑚𝑜𝑟𝑒
𝑡ℎ𝑎𝑛 𝑡ℎ𝑒 1𝑠𝑡 𝑜𝑝𝑡𝑖𝑜𝑛.

4-35 (Slide 52)

Brandon just graduated from college. Unfortunately, Brandon's education was fairly costly; the student loans
he took out to pay for his education total $95,000. The provisions of the student loans require Brandon to
pay interest equal to the prime rate, which is 8 percent, plus a 1 percent margin—that is, the interest rate on
the loans is 9 percent. Payments will be made monthly, and the loans must be repaid within 20 years. Brandon
wants to determine how he is going to repay his student loans. His first payment is due in one month.

a) If Brandon decides to repay the loans over the maximum period—that is, 20 years—how much must he
pay each month?
b) If Brandon wants to repay the loans in 10 years, how much must he pay each month?
c) If Brandon pays $985 per month, how long will it take him to repay the loans?

Solution:
𝑖 0.09
𝐻𝑒𝑟𝑒, 𝑃𝑉 = $95,000, 𝑖 = 9% = 0.09, 𝑚 = 12, 𝑟= = = 0.0075
𝑚 12
𝒂) 𝑛 = 20
(1 + 𝑟)𝑚𝑛 − 1 𝑃𝑉 95,000
𝑃𝑉 = 𝐶 × [ ] ⇒𝐶= = = $𝟖𝟓𝟒. 𝟕𝟒
𝑟 × (1 + 𝑟)𝑚𝑛 (1 + 𝑟)𝑚𝑛 − 1 (1 + 0.0075)12×20 − 1
[ ] [ ]
𝑟 × (1 + 𝑟)𝑚𝑛 0.0075 × (1 + 0.0075)12×20

𝒃) 𝑛 = 20
(1 + 𝑟)𝑚𝑛 − 1 𝑃𝑉 95,000
𝑃𝑉 = 𝐶 × [ ] ⇒𝐶= 𝑚𝑛 = = $𝟏𝟐𝟎𝟑. 𝟒𝟐
𝑟 × (1 + 𝑟)𝑚𝑛 (1 + 𝑟) − 1 (1 + 0.0075)12×10 − 1
[ ] [ ]
40

𝑟 × (1 + 𝑟)𝑚𝑛 0.0075 × (1 + 0.0075)12×10

Page
𝒄) 𝐶 = $985
(1 + 𝑟)𝑚𝑛 − 1 𝑃𝑉 × 𝑟 𝑃𝑉 × 𝑟
𝑃𝑉 = 𝐶 × [ ] ⇒ = 1 − (1 + 𝑟)−𝑚𝑛 ⇒ (1 + 𝑟)−𝑚𝑛 = 1 −
𝑟 × (1 + 𝑟)𝑚𝑛 𝐶 𝐶
95,000 × 0.0075
⇒ (1 + 0.0075)−12𝑛 = 1 − ⇒ 𝑙𝑛(1.0075)−12𝑛 = 𝑙𝑛(0.277)
985
𝑙𝑛(0.277)
⇒𝑛= = 𝟏𝟒. 𝟑𝟑 𝒚𝒆𝒂𝒓𝒔
−12 × 𝑙𝑛(1.0075)

∴ 𝑛 ≈ 𝟏𝟒 𝒚𝒆𝒂𝒓𝒔 𝟒 𝒎𝒐𝒏𝒕𝒉𝒔 ≈ 𝟏𝟓 𝒚𝒆𝒂𝒓𝒔

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Chapter 04 – Capital Budgeting

Capital Budgeting:
o Capital: Fixed assets used in production.
o Budget: A plan that details projected cash inflows and outflows during some future periods.
o Capital Budget: Outline of planned investments in the firm’s fixed assets.
o Capital Budgeting: The whole process of analyzing the project and deciding which project should be
included in the capital budget.

 Definition of Capital Budgeting:

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent
with the firm’s goal of maximizing owners’ wealth.

Classifications of Projects:

Capital budgeting projects are often classified into:

1. Replacement decisions: Replacement decisions involve determining whether to purchase capital assets
to replace the existing assets to maintain or improve existing operations.
2. Expansion decisions: Expansion decisions involve whether to purchase capital projects and add them to
existing assets, to increase existing operations.
3. Safety or/and Environmental projects: Projects that improve safety or the environment or comply with

regulations.
4. Others: Projects that maintain, improve, or expand operations, such as office buildings, parking lot,
executive aircraft etc.

Importance of Capital Budgeting:

A number of factors combine to make capital budgeting decisions among the most important decisions
financial managers must make. Such as –

 Influence on the firm’s growth: By investing in new or improved assets, the firm can increase its
production capacity, improve its efficiency, and develop new products or services. This can lead to
increased sales and profits, and ultimately, faster growth. Capital budgeting decisions can also have a
negative impact on the firm's growth if they are not made carefully.
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 Influence on risk: An error in the forecast of asset requirements can have serious consequences. If the
firm invests too much in assets, it will incur unnecessarily heavy expenses. But if it does not spend enough
on fixed assets, it might find that inefficient production and inadequate capacity lead to lost sales that
are difficult, if not impossible, to recover.

 Commitment of large amount of funds: Capital budgeting is important because the acquisition of fixed
assets typically involves substantial expenditures, and before a firm can spend a large amount of money,
it must have the funds available. Therefore, a firm contemplating a major capital expenditure program
must arrange its financing well in advance to be sure the required funds are available.

 Irreversible or reversible at substantial loss: The impact of capital budgeting is long term and involves
large investments; thus, the firm loses some decision-making flexibility when capital projects are
purchased.

 Complexity: Capital budgeting decisions can be complex because they involve a number of factors,
including the cost of the investment, the expected cash flows, the risk of the investment, and the firm's
strategic goals. Financial managers need to carefully consider all of these factors before making a capital
budgeting decision.

Steps in Capital Budgeting Process:

The capital budgeting process consists of five distinct but interrelated steps:

1. Proposal generation: Proposals for new investment projects are made at all levels within a business
organization and are reviewed by finance personnel. Proposals that require large outlays are more
carefully scrutinized than less costly ones.

2. Review and analysis: Financial managers perform formal review and analysis to assess the merits of
investment proposals.

3. Decision making: Firms typically delegate capital expenditure decision making on the basis of dollar
limits. Generally, the board of directors must authorize expenditures beyond a certain amount. Often,
plant managers are given authority to make decisions necessary to keep the production line moving.

4. Implementation: Following approval, expenditures are made, and projects are implemented.
Expenditures for a large project often occur in phases.

5. Follow-up: Results are monitored, and actual costs and benefits are compared with those that were
expected. Action may be required if actual outcomes differ from the projected ones.
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Basic Terminology:

 Independent Projects vs Mutually Exclusive Projects:

❑ Independent Projects: Projects whose cash flows are unrelated to (or independent of) one another;
that is, the acceptance of one does not eliminate the others from further consideration.
❑ Mutually Exclusive Projects: Projects that compete with one another, so that the acceptance of one
eliminates all other projects that serve a similar function from further consideration.

 Unlimited Funds vs Capital Rationing:

❑ Unlimited Funds: The financial situation in which a firm is able to accept all independent projects that
provide an acceptable return.
❑ Capital Rationing: The financial situation in which a firm has only a fixed number of dollars available
for capital expenditures, and numerous projects compete for these dollars.

 Accept–Reject vs Ranking Approaches:

❑ Accept–Reject Approach: The evaluation of capital expenditure proposals to determine whether they
meet the firm’s minimum acceptance criterion.
❑ Ranking Approach: The ranking of capital expenditure projects on the basis of some predetermined
measure, such as the rate of return.

 Conventional and Non-conventional Cash Flows:

❑ Conventional Cash Flows: One change in the direction of cash flows during a period.
❑ Non-conventional Cash Flows: More than one change in the direction of cash flows during a period.

Capital Budgeting Techniques:

❑ Traditional Approach:
1. Payback Period (PP)
2. Discounted Payback Period (DPP)
3. Accounting Rate of Return (ARR)

❑ Modern Approach:
1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
44

3. Profitability Index (PI)

Page
Payback Period (PP):

The amount of time required for a firm to recover its initial investment in a project as calculated from cash
inflows.
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 (𝑷𝑷) = 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒚𝒆𝒂𝒓𝒔 𝒑𝒓𝒊𝒐𝒓 𝒕𝒐 𝒇𝒖𝒍𝒍 𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒚
𝑼𝒏𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒆𝒅 𝒄𝒐𝒔𝒕 𝒂𝒕 𝒔𝒕𝒂𝒓𝒕 𝒐𝒇 𝒇𝒖𝒍𝒍 𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒚 𝒚𝒆𝒂𝒓
+
𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝒅𝒖𝒓𝒊𝒏𝒈 𝒇𝒖𝒍𝒍 𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒚 𝒚𝒆𝒂𝒓

Decision:
 If the 𝑃𝑃 < 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐴𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒 𝑃𝑃, then accept the project.
 If the 𝑃𝑃 > 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐴𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒 𝑃𝑃, then, reject the project.

Example (Slide 13):

Project A Project B
Initial Investment -25,000 Initial Investment -25,000
Year Cash Flow Year Cash Flow
1 $12,000 1 $15,000
2 10,000 2 9,000
3 8,000 3 25,000
4 5,000 4 17,000
5 3,000 5 3,000

Determine the payback periods of each project.

Solution:
3,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐴: 𝑃𝑃 = 2 + = 𝟐. 𝟒 𝒚𝒆𝒂𝒓𝒔
8,000
4,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐴: 𝑃𝑃 = 3 + = 𝟑. 𝟐 𝒚𝒆𝒂𝒓𝒔
17,000

Strengths:
✓ Simplicity: Payback Period is simple to understand and easy to calculate.
✓ Risk Exposure: The longer the firm must wait to recover its invested funds, the greater the possibility
of a calamity. Hence, the shorter the payback period, the lower the firm’s risk exposure.

Weaknesses:
✓ Payment period does not take into account the time value of money.
✓ It ignores the cash flows after the payback period.
45

✓ It doesn’t recommend an acceptable payback period for the projects. The appropriate payback period
Page

is merely a subjectively determined number.

Discounted Payback Period (DPP)

The length of time it takes for the cumulative discounted cash flows to equal the initial outlay.

𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕𝒆𝒅 𝑷𝒂𝒚𝒎𝒆𝒏𝒕 𝑷𝒆𝒓𝒊𝒐𝒅 (𝑫𝑷𝑷) = 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒚𝒆𝒂𝒓𝒔 𝒑𝒓𝒊𝒐𝒓 𝒕𝒐 𝒇𝒖𝒍𝒍 𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒚

𝑼𝒏𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒆𝒅 𝒄𝒐𝒔𝒕 𝒂𝒕 𝒔𝒕𝒂𝒓𝒕 𝒐𝒇 𝒇𝒖𝒍𝒍 𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒚 𝒚𝒆𝒂𝒓
+
𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕𝒆𝒅 𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝒅𝒖𝒓𝒊𝒏𝒈 𝒇𝒖𝒍𝒍 𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒚 𝒚𝒆𝒂𝒓

Decision:
 If the 𝐷𝑃𝑃 < 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐴𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒 𝐷𝑃𝑃, then accept the project.
 If the 𝐷𝑃𝑃 > 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐴𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒 𝐷𝑃𝑃, then, reject the project.

Example (Slide 16):

Initial Investment: – $25,000 Initial Investment: – $53,000

Discount Rate, K = 10% Discount Rate, K = 10%

CFt CFt
Present Value = Present Value =
(1 + k)t (1 + k)t
Cash Present Accumulated Cash Present Accumulated
Year Year
Flow Value PV Flow Value PV
1 $12,000 $10,909.1 $10,909.1 1 $15,000 $13,636.4 $13,636.4
2 10,000 8,264.5 19,173.6 2 9,000 7,438.0 21,074.4
3 8,000 6,010.5 25,184.1 3 25,000 18,782.9 39,857.3
4 5,000 3,415.1 28,599.2 4 17,000 11,611.2 51,468.5
5 3,000 1,862.8 30,462 5 3,000 1,862.8 53,331.3

5,826.4 1,531.5
𝑃𝑃 = 2 + = 𝟐. 𝟗𝟕 𝒚𝒆𝒂𝒓𝒔 𝑃𝑃 = 4 + = 𝟒. 𝟖𝟐 𝒚𝒆𝒂𝒓𝒔
6,010.5 1,862.8

Strengths:
✓ It considers time value of money.
✓ It provides a more accurate estimate of the time frame for the recovery of initial investment.

Weaknesses:
✓ It ignores cash flows after the recovery of initial investment.
✓ It doesn’t recommend an acceptable payback period for the projects. The appropriate payback period
is merely a subjectively determined number.
✓ It is more difficult to calculate than Payback Period.
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Accounting Rate of Return (ARR):

Accounting Rate of Return (ARR), also known as “Return on Investment” is the ratio of the average net income
to the average investment.

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆

𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒊𝒏𝒈 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏 (𝑨𝑹𝑹) =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 𝒐𝒗𝒆𝒓 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑷𝒆𝒓𝒊𝒐𝒅

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 =
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒀𝒆𝒂𝒓𝒔

𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 𝒂𝒕 𝒀𝒆𝒂𝒓 𝟏 + 𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 𝒂𝒕 𝒕𝒉𝒆 𝑬𝒏𝒅 𝒐𝒇 𝑼𝒔𝒆𝒇𝒖𝒍 𝑳𝒊𝒇𝒆

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 =
𝟐

Decision:
 If the 𝐴𝑅𝑅 ≥ 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐴𝑅𝑅, then accept the project.

Example (Slide 19):

A project will cost Tk. 40,000. Its stream of earnings before depreciation, interest, and taxes (EBIDT) during
the first year through five years is expected to be Tk. 10,000, Tk. 12,000, Tk. 14,000, Tk. 16,000, and Tk.
20,000. Assume a 50 percent tax rate and depreciation on straight-line basis. What is the ARR?

Solution:
𝑇𝑘. 40,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = 𝑇𝑘. 8,000/𝑦𝑒𝑎𝑟
5 𝑦𝑒𝑎𝑟𝑠

Year: 1 2 3 4 5

EBIDT: Tk. 10,000 12,000 14,000 16,000 20,000

(–) Depreciation: 8,000 8,000 8,000 8,000 8,000
EBIT: 2,000 4,000 6,000 8,000 12,000
(–) Tax (50%): 1,000 2,000 3,000 4,000 6,000
Net Income: 1,000 2,000 3,000 4,000 6,000

1,000 + 2,000 + 3,000 + 4,000 + 6,000

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = = 𝑇𝑘. 3,200
5

40,000 + 0
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = 𝑇𝑘. 20,000
2

3,200
∴ 𝐴𝑅𝑅 = × 100% = 𝟏𝟔%
47

20,000
Page
Example (Slide 20):
A project will cost Tk. 100,000. Its stream of earnings before depreciation, interest, and taxes (EBIDT) during
the first year through five years is expected to be Tk. 25,000, Tk. 45,000, Tk. 37,000, Tk. 30,000, and Tk.
23,000. Assume a 35 percent tax rate and depreciation on straight-line basis. What is the ARR?

Solution:
𝑇𝑘. 100,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = 𝑇𝑘. 20,000/𝑦𝑒𝑎𝑟
5 𝑦𝑒𝑎𝑟𝑠

Year: 1 2 3 4 5

EBIDT: Tk. 25,000 45,000 37,000 30,000 23,000

(–) Depreciation: 20,000 20,000 20,000 20,000 20,000
EBIT: 5,000 25,000 17,000 10,000 3,000
(–) Tax (35%): 1,750 8,750 5,950 3,500 1,050
Net Income: 3,250 16,250 11,050 6,500 1,950

3,250 + 16,250 + 11,050 + 6,500 + 1,950

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = = 𝑇𝑘. 7,800
5

100,000 + 0
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = 𝑇𝑘. 50,000
2

7,800
∴ 𝐴𝑅𝑅 = × 100% = 𝟏𝟓. 𝟔%
50,000

Strengths:
✓ ARR is simple and easy to calculate and use.
✓ It relies on familiar accounting profits, facilitating communication with stakeholders accustomed to
traditional accounting measures.
✓ It considers the whole life of the project.

Weaknesses:
✓ It uses profits, not cash flows.
✓ It ignores the time value of money.
✓ ARR does not consider the size of the investment. Two projects with the same ARR may have
48

significantly different initial investments, which is a crucial factor in decision-making.

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Net Present Value (NPV):
Net Present Value (NPV) is found by subtracting a project’s initial investment (initial outlay) from the present
value of its cash inflows discounted at a rate equal to the firm’s cost of capital.

Net Present Value = Present Value of Cash Inflows – Initial Investment

𝒏
𝑪𝑭𝒕
𝑵𝑷𝑽 = ∑ − 𝑪𝑭𝟎
(𝟏 + 𝒓)𝒕
𝒕=𝟏

Decision:
 If 𝑁𝑃𝑉 > 0, then accept the project.
 Otherwise, reject the project.

Example (Slide 23):

Project A and B are two independent projects. Project A will cost Tk. 25,000 and its stream of earnings during
the first year through five years is expected to be Tk. 12,000, Tk. 10,000, Tk. 8,000, Tk. 5,000, and Tk. 3,000.
Project B will cost Tk. 53,000 and its stream of earnings is expected to be Tk. 15,000, Tk. 9,000, Tk. 25,000,
Tk. 17,000, and Tk. 3,000. Assuming a 10% discount rate, determine using NPV whether to accept or reject
each project.

Solution:
Discount Rate, 𝑘 = 10% = 0.1
Investment Outlay, 𝐶𝐹0 = −25,000 Investment Outlay, 𝐶𝐹0 = −53,000
Year Cash Flow 𝑪𝑭𝒕 Year Cash Flow 𝑪𝑭𝒕
𝐏𝐕 = 𝐏𝐕 =
(t) (CF) (𝟏 + 𝒌)𝒕 (t) (CF) (𝟏 + 𝒌)𝒕
12,000 15,000
1 Tk. 12,000 = 10,909.1 1 Tk. 15,000 = 13,636.4
(1 + 0.1)1 (1 + 0.1)1
10,000 9,000
2 10,000 = 8,264.5 2 9,000 = 7,438.0
(1 + 0.1)2 (1 + 0.1)2
8,000 25,000
3 8,000 = 6,010.5 3 25,000 = 18,782.9
(1 + 0.1)3 (1 + 0.1)3
5,000 17,000
4 5,000 = 3,415.1 4 17,000 = 11,611.2
(1 + 0.1)4 (1 + 0.1)4
3,000 3,000
5 3,000 = 1,862.8 5 3,000 = 1,862.8
(1 + 0.1)5 (1 + 0.1)5
5 5
𝐶𝐹𝑡 𝐶𝐹𝑡
∑ = 30,462 ∑ = 53,331.3
(1 + 𝑟)𝑡 (1 + 𝑟)𝑡
𝑡=1 𝑡=1

𝑁𝑃𝑉 = 30,462 − 25,000 = 𝑻𝒌. 𝟓, 𝟒𝟔𝟐 𝑁𝑃𝑉 = 53,331.3 − 53,000 = 𝑻𝒌. 𝟑𝟑𝟏. 𝟑
49

Since 𝑁𝑃𝑉 > 0, the project should be accepted. Since 𝑁𝑃𝑉 > 0, the project should be accepted.
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Strengths:
✓ NPV considers the time value of money.
✓ It takes account of risk.
✓ It considers total benefits over the entire life of the project.

Weaknesses:
✓ NPV estimates future cash inflows, which may not always be correctly predicted.
✓ It requires estimation of the discount rate, which may not always be accurate in practice.
✓ When comparing projects of different investment sizes, NPV may favor larger projects, as it does not
account for the scale of the investment and the lifetime of the project.

Internal Rate of Return (IRR):

Internal Rate of Return (IRR) is defined as the rate of return at which NPV of a project is zero.
n
CFt
That is, at IRR, NPV = ∑ − CF0 = 0
(1 + IRR)t
t=1

Here, 𝑅𝐿 = Lower Discount Rate

𝑵𝑷𝑽𝑳 𝑅𝐻 = Higher Discount Rate
Formula: 𝑰𝑹𝑹 = 𝑹𝑳 + × (𝑹𝑯 − 𝑹𝑳 )
𝑵𝑷𝑽𝑳 − 𝑵𝑷𝑽𝑯 𝑁𝑃𝑉𝐿 = NPV at lower discount rate
𝑁𝑃𝑉𝐻 = NPV at higher discount rate

Decision:
 If 𝐼𝑅𝑅 > 𝑟 (Opportunity Cost of Capital), then accept the project.
 If 𝐼𝑅𝑅 < 𝑟 (Opportunity Cost of Capital), then reject the project.

Example (Slide 27):

Think of a project where initial investment is 45,000BDT. Cashflows from the project are 27,000 (year1) and
33,000 (year2). Cost of Capital is 10%. What is the IRR of this project?

Solution:
Here,
Initial Outlay, 𝐶𝐹0 = 45,000 𝐵𝐷𝑇
𝐶𝐹1 = 27,000 𝐵𝐷𝑇
𝐶𝐹2 = 33,000 𝐵𝐷𝑇
50

Cost of Capital, 𝑟 = 10%

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 2
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑ − 𝐶𝐹0
(1 + 𝑅)𝑡
𝑡=1

Trial and Error Method:

Let, 𝑅𝐿 = 8% = 0.08,
27,000 33,000
𝑁𝑃𝑉𝐿 = 1
+ − 45,000 = 8,292.18 𝐵𝐷𝑇
(1 + 0.08) (1 + 0.08)2

Let, 𝑅𝐿 = 15% = 0.15,

27,000 33,000
𝑁𝑃𝑉𝐿 = + − 45,000 = 3,431 𝐵𝐷𝑇
(1 + 0.15)1 (1 + 0.15)2

Let, 𝑅𝐿 = 20% = 0.20,

27,000 33,000
𝑁𝑃𝑉𝐿 = 1
+ − 45,000 = 416.67 𝐵𝐷𝑇
(1 + 0.20) (1 + 0.20)2

Let, 𝑅𝐻 = 21% = 0.21,

27,000 33,000
𝑁𝑃𝑉𝐻 = 1
+ − 45,000 = −146.51 𝐵𝐷𝑇
(1 + 0.21) (1 + 0.21)2

𝑁𝑃𝑉𝐿
∴ 𝐼𝑅𝑅 = 𝑅𝐿 + × (𝑅𝐻 − 𝑅𝐿 )
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻
416.67
= 0.20 + × (0.21 − 0.20) = 0.2074 = 𝟐𝟎. 𝟕𝟒%
416.67 + 146.51

Example (Slide 28):

For project A, the initial investment is 25,000. Cash inflow for the next five years is as follows:
Year 1 2 3 4 5
Cash Flow 12,000 10,000 8,000 5,000 3,000

For project B, the initial investment is 53,000. Cash inflow for the next five years is as follows:
Year 1 2 3 4 5
Cash Flow 15,000 9,000 25,000 17,000 3,000
Determine the IRR of each project.

Solution:
5
𝑁𝑃𝑉𝐿 𝐶𝐹𝑡
51

𝐼𝑅𝑅 = 𝑅𝐿 + × (𝑅𝐻 − 𝑅𝐿 ) 𝑎𝑛𝑑 𝑁𝑃𝑉 = ∑ − 𝐶𝐹0

𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻 (1 + 𝑅)𝑡
Page

𝑡=1
For Project A,
Initial Investment, 𝐶𝐹0 = 25,000 𝐵𝐷𝑇
𝐶𝐹1 = 12,000, 𝐶𝐹2 = 10,000, 𝐶𝐹3 = 8,000, 𝐶𝐹4 = 5,000, 𝐶𝐹5 = 3,000

Let, 𝑅𝐿 = 10% = 0.10,

12,000 10,000 8,000 5,000 3,000
𝑁𝑃𝑉𝐿 = 1
+ 2
+ 3
+ 4
+ − 25,000 = 5,461.90
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)5

Let, 𝑅𝐿 = 15% = 0.15,

12,000 10,000 8,000 5,000 3,000
𝑁𝑃𝑉𝐿 = 1
+ 2
+ 3
+ 4
+ − 25,000 = 2,606.65
(1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15)5

Let, 𝑅𝐿 = 20% = 0.20,

12,000 10,000 8,000 5,000 3,000
𝑁𝑃𝑉𝐿 = 1
+ 2
+ 3
+ 4
+ − 25,000 = 190.97
(1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20)5

Let, 𝑅𝐻 = 21% = 0.21,

12,000 10,000 8,000 5,000 3,000
𝑁𝑃𝑉𝐻 = 1
+ 2
+ 3
+ 4
+ − 25,000 = −247.55
(1 + 0.21) (1 + 0.21) (1 + 0.21) (1 + 0.21) (1 + 0.21)5

190.97
∴ 𝐼𝑅𝑅 = 0.20 + × (0.21 − 0.20) = 0.2044 = 𝟐𝟎. 𝟒𝟒%
190.97 + 247.55

For Project B,
Initial Investment, 𝐶𝐹0 = 53,000 𝐵𝐷𝑇
𝐶𝐹1 = 15,000, 𝐶𝐹2 = 9,000, 𝐶𝐹3 = 25,000, 𝐶𝐹4 = 17,000, 𝐶𝐹5 = 3,000

Let, 𝑅𝐿 = 10% = 0.10,

15,000 9,000 25,000 17,000 3,000

𝑁𝑃𝑉𝐿 = + + + + − 53,000 = 331.24
(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3 (1 + 0.10)4 (1 + 0.10)5

Let, 𝑅𝐻 = 11% = 0.11,

15,000 9,000 25,000 17,000 3,000

𝑁𝑃𝑉𝐻 = + + + + − 53,000 = −923.32
(1 + 0.11)1 (1 + 0.11)2 (1 + 0.11)3 (1 + 0.11)4 (1 + 0.11)5

331.24
∴ 𝐼𝑅𝑅 = 0.10 + × (0.11 − 0.10) = 0.1026 = 𝟏𝟎. 𝟐𝟔%
331.24 + 923.32
52
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Strengths:
✓ IRR takes account of the time value of money.
✓ It is easy to be understood by managers.
✓ It considers both the cash inflows and outflows over the entire life of the project.

Weaknesses:
✓ IRR involves tedious calculations; it can involve time-consuming trial-and-error calculations.
✓ It is difficult to use in choosing projects of varying sizes.
✓ It is difficult to choose when projects have the same IRR.

Profitability Index (PI)

The Profitability Index (PI) is the ratio of the present value of future cash inflows to the initial outlay.

Present Value of the future cash flows

That is, Profitability Index (PI) =
Initial Investment

𝑵𝑷𝑽
Formula: 𝑷𝑰 = 𝟏 + Here, 𝐶𝐹0 = Initial Investment
𝑪𝑭𝟎

Decision:
 If 𝑃𝐼 > 1, accept the project.
 For multiple projects with 𝑃𝐼 > 1, accept the project with higher 𝑃𝐼 value.

Example (Slide 31):

For project A, the initial investment is 25,000. Cash inflow for the next five years is as follows:
Year 1 2 3 4 5
Cash Flow 12,000 10,000 8,000 5,000 3,000

For project B, the initial investment is 53,000. Cash inflow for the next five years is as follows:
Year 1 2 3 4 5
Cash Flow 15,000 9,000 25,000 17,000 3,000

Determine the PI of each project assuming a discount rate of 10%.

53
Page
Solution:
For Project A,
Initial Investment, 𝐶𝐹0 = 25,000 𝐵𝐷𝑇, Discount Rate, 𝑟 = 10% = 0.10
𝐶𝐹1 = 12,000, 𝐶𝐹2 = 10,000, 𝐶𝐹3 = 8,000, 𝐶𝐹4 = 5,000, 𝐶𝐹5 = 3,000

12,000 10,000 8,000 5,000 3,000

𝑁𝑃𝑉 = 1
+ 2
+ 3
+ 4
+ − 25,000 = 5,461.90
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)5

𝑁𝑃𝑉 5,461.90
∴ 𝑃𝐼 = 1 + =1+ = 𝟏. 𝟐𝟐
𝐶𝐹0 25,000

For Project B,
Initial Investment, 𝐶𝐹0 = 53,000 𝐵𝐷𝑇, Discount Rate, 𝑟 = 10% = 0.10
𝐶𝐹1 = 15,000, 𝐶𝐹2 = 9,000, 𝐶𝐹3 = 25,000, 𝐶𝐹4 = 17,000, 𝐶𝐹5 = 3,000

15,000 9,000 25,000 17,000 3,000

𝑁𝑃𝑉 = 1
+ 2
+ 3
+ 4
+ − 53,000 = 331.24
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)5

𝑁𝑃𝑉 331.24
∴ 𝑃𝐼 = 1 + =1+ = 𝟏. 𝟎𝟏
𝐶𝐹0 53,000

Strengths:
✓ PI considers the time value of money.
✓ Relative profitability: PI provides a measure of relative profitability by comparing the present value of
cash inflows to the present value of cash outflows. This allows decision-makers to assess the
attractiveness of an investment in relation to the costs associated with it.
✓ It allows for the comparison of projects of different sizes.

Weaknesses:
✓ The accuracy of the Profitability Index is contingent on the precision of the cash flow and discount
rate calculations. If there are errors or uncertainties in estimating cash flows or determining the
appropriate discount rate, it can impact the reliability of the PI.
54
Page
NPV Profiles:
NPV Profiles are graphs that depict project NPVs for various discount rates and provide an excellent means
of making comparisons between projects.
❑ Crossover Rate: The discount rate at which the NPV profiles of two projects cross and, thus, at which the
projects' NPVs are equal.

Figure: NPV Profiles for Project S and Project L

Which Capital Budgeting Technique/Approach is Better?

❑ On a purely theoretical basis, NPV is the better approach because:

✓ NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes
they are reinvested at the IRR.
✓ Certain mathematical properties may cause a project with non-conventional cash flows to have zero
or more than one real IRR.
55

❑ Despite the theoretical superiority of NPV, however, financial managers prefer to use the IRR because of
Page

the preference for rates of return.

Formulas:

𝑃𝑃 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑝𝑟𝑖𝑜𝑟 𝑡𝑜 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦

𝑈𝑛𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟
+
Payback Period 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟
(PP)
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑃𝑃 =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

𝐷𝑃𝑃 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑝𝑟𝑖𝑜𝑟 𝑡𝑜 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦

Discounted Payment Period
𝑈𝑛𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟
(DPP) +
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝐴𝑅𝑅 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Accounting Rate of Return 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑜𝑣𝑒𝑟 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠
(ARR)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝑌𝑒𝑎𝑟 1 + 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡ℎ𝑒 𝐸𝑛𝑑 𝑜𝑓 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒
=
2
𝑛
Net Present Value 𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑ − 𝐶𝐹0
(NPV) (1 + 𝑟)𝑡
𝑡=1

Internal Rate of Return 𝑁𝑃𝑉𝐿

𝐼𝑅𝑅 = 𝑅𝐿 + × (𝑅𝐻 − 𝑅𝐿 )
(IRR) 𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

Profitability Index 𝑁𝑃𝑉

𝑃𝐼 = 1 +
(PI) 𝐶𝐹0

Additional Formula from Time Value of Money

(1 + 𝑟)𝑛 − 1
Present Value of an Annuity 𝑃𝑉 = 𝐶𝐹 × [ ]
𝑟 × (1 + 𝑟)𝑛

𝐶𝐹
Present Value of Perpetuity 𝑃𝑉 =
𝑟
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Page
Mathematical Problems

ST10–1 (Slide 35)

Fitch Industries is in the process of choosing the better of two equal-risk, mutually exclusive capital
expenditure projects—M and N. The relevant cash flows for each project are shown in the following table.
The firm’s cost of capital is 14%.

a) Calculate each project’s payback period.

b) Calculate the net present value (NPV) for each project.
c) Calculate the internal rate of return (IRR) for each project.
d) Summarize the preferences dictated by each measure you calculated and indicate which project
you would recommend. Explain why.

Solution:

a)
For project M, Initial Investment, 𝐶𝐹0 = $28,500
8,500
Payback Period of Project M, 𝑃𝑃 = 2 + = 𝟐. 𝟖𝟓 𝒚𝒆𝒂𝒓𝒔
10,000

For project N, Initial Investment, 𝐶𝐹0 = $27,000

6,000
Payback Period of Project N, 𝑃𝑃 = 2 + = 𝟐. 𝟔𝟕 𝒚𝒆𝒂𝒓𝒔
9,000

b)
𝑛
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑ − 𝐶𝐹0
(1 + 𝑟)𝑡
𝑡=1
𝑛
𝐶𝐹𝑡 (1 + 𝑟)𝑛 − 1
For Annuity, ∑ = 𝐶𝐹𝑡 × [ ]
(1 + 𝑟)𝑡 𝑟 × (1 + 𝑟)𝑛
𝑡=1
57

Cost of Capital, 𝑟 = 14% = 0.14

Page
For project M, 𝐶𝐹0 = $28,500, 𝑛 = 4, Cash Flow of the Annuity, 𝐶𝐹𝑡 = $10,000

(1 + 0.14)4 − 1
𝑁𝑃𝑉 = 10,000 × [ ] − 28,500 = $𝟔𝟑𝟕. 𝟏𝟐
0.14 × (1 + 0.14)4

For project N, 𝐶𝐹0 = $27,000

11,000 10,000 9,000 8,000

𝑁𝑃𝑉 = 1
+ 2
+ 3
+ − 27,000 = $𝟏, 𝟏𝟓𝟓. 𝟏𝟖
(1 + 0.14) (1 + 0.14) (1 + 0.14) (1 + 0.14)4

c)
𝑁𝑃𝑉𝐿
𝐼𝑅𝑅 = 𝑅𝐿 + × (𝑅𝐻 − 𝑅𝐿 )
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

For Project M,

Let, 𝑅𝐿 = 15% = 0.15

(1 + 0.15)4 − 1
𝑁𝑃𝑉𝐿 = 10,000 × [ ] − 28,500 = $49.78
0.15 × (1 + 0.15)4

Let, 𝑅𝐻 = 16% = 0.16

(1 + 0.16)4 − 1
𝑁𝑃𝑉𝐻 = 10,000 × [ ] − 28,500 = −$518.19
0.16 × (1 + 0.16)4

49.78
∴ 𝐼𝑅𝑅 = 0.15 + × (0.16 − 0.15) = 0.1509 = 𝟏𝟓. 𝟎𝟗%
49.78 + 518.19

For Project N,

Let, 𝑅𝐿 = 16% = 0.16

11,000 10,000 9,000 8,000

𝑁𝑃𝑉𝐿 = + + + − 27,000 = $98.64
(1 + 0.16)1 (1 + 0.16)2 (1 + 0.16)3 (1 + 0.16)4

Let, 𝑅𝐻 = 17% = 0.17

11,000 10,000 9,000 8,000

𝑁𝑃𝑉𝐻 = 1
+ 2
+ 3
+ − 27,000 = −$404.62
(1 + 0.17) (1 + 0.17) (1 + 0.17) (1 + 0.17)4

98.64
∴ 𝐼𝑅𝑅 = 0.16 + × (0.17 − 0.16) = 0.162 = 𝟏𝟔. 𝟐𝟎%
98.64 + 404.62
58
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d)
Summary of the preferences dictated by each measure:

Approach Project M Project N Preferred Project

Payback Period (PP) 2.85 years 2.67 years Project N
Net Present Value (NPV) $637.12 $1,155.18 Project N
Internal Rate of Return (IRR) 15.09% 16.20% Project N

Project N is recommended because it has the shorter payback period, the higher NPV and the larger IRR.

E10–1 (Slide 36)

Elysian Fields, Inc., uses a maximum payback period of 6 years and currently must choose between two
mutually exclusive projects. Project Hydrogen requires an initial outlay of $25,000; project Helium requires
an initial outlay of $35,000. Using the expected cash inflows given for each project in the following table,
calculate each project’s payback period. Which project meets Elysian’s standards?

Solution:
For project Hydrogen, Initial Investment = $25,000
1,000
Payback Period of Project Hydrogen, 𝑃𝑃 = 4 + = 𝟒. 𝟐𝟗 𝒚𝒆𝒂𝒓𝒔
3,500

For project Helium, Initial Investment = $35,000

3,000
Payback Period of Project Helium, 𝑃𝑃 = 5 + = 𝟓. 𝟕𝟓 𝒚𝒆𝒂𝒓𝒔
4,000

The maximum payback period is 6 years. So, both projects meet Elysian’s standards, but, however,
project Hydrogen is preferable for its shorter payback period.
59
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E10–3 (Slide 37)
Axis Corp. is considering investment in the best of two mutually exclusive projects. Project Kelvin involves an
overhaul of the existing system; it will cost $45,000 and generate cash inflows of $20,000 per year for the
next 3 years. Project Thompson involves replacement of the existing system; it will cost $275,000 and
generate cash inflows of $60,000 per year for 6 years. Using an 8% cost of capital, calculate each project’s
NPV, and make a recommendation based on your findings.

Solution:
For Project Kelvin, Here,
(1 + 𝑟)𝑛 − 1 Initial Investment, 𝐶𝐹0 = $45,000
𝑁𝑃𝑉 = 𝐶𝐹 × [ ] − 𝐶𝐹0
𝑟 × (1 + 𝑟 )𝑛 Cash Inflows, 𝐶𝐹 = $20,000
3
(1 + 0.08) − 1 𝑛 = 3 𝑦𝑒𝑎𝑟𝑠
= 20,000 × − 45,000
0.08 × (1 + 0.08)3
Cost of Capital, 𝑟 = 8% = 0.08
= $𝟔, 𝟓𝟒𝟏. 𝟗𝟒

For Project Thompson, Here,

(1 + 𝑟)𝑛 − 1 Initial Investment, 𝐶𝐹0 = $275,000
𝑁𝑃𝑉 = 𝐶𝐹 × [ ] − 𝐶𝐹0
𝑟 × (1 + 𝑟)𝑛 Cash Inflows, 𝐶𝐹 = $60,000
3
(1 + 0.08) − 1 𝑛 = 6 𝑦𝑒𝑎𝑟𝑠
= 60,000 × − 275,000
0.08 × (1 + 0.08)3
Cost of Capital, 𝑟 = 8% = 0.08
= $𝟐, 𝟑𝟕𝟐. 𝟕𝟖

The NPV of project Kelvin is more than that of project Thompson. So, project Kelvin is recommended.

E10–4 (Slide 38)

Billabong Tech uses the internal rate of return (IRR) to select projects. Calculate the IRR for each of the
following projects and recommend the best project based on this measure. Project T-Shirt requires an initial
investment of $15,000 and generates cash inflows of $8,000 per year for 4 years. Project Board Shorts
requires an initial investment of $25,000 and produces cash inflows of $12,000 per year for 5 years.

Solution:
(1 + 𝑟)𝑛 − 1
𝑁𝑃𝑉 = 𝐶𝐹 × [ ] − 𝐶𝐹0
𝑟 × (1 + 𝑟)𝑛

𝑁𝑃𝑉𝐿
𝐼𝑅𝑅 = 𝑅𝐿 + × (𝑅𝐻 − 𝑅𝐿 )
60

𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻
Page
For project T-Shirt, Here,
Initial Outlay, 𝐶𝐹0 = $15,000
Let, 𝑅𝐿 = 39% = 0.39
Cash Inflows, 𝐶𝐹 = $8,000
(1 + 0.39)4 − 1
𝑁𝑃𝑉𝐿 = 8,000 × − 15,000 = $17.84 𝑛 = 4 𝑦𝑒𝑎𝑟𝑠
0.39 × (1 + 0.39)4

Let, 𝑅𝐻 = 40% = 0.40

(1 + 0.40)4 − 1
𝑁𝑃𝑉𝐻 = 8,000 × − 15,000 = −$206.16
0.40 × (1 + 0.40)4

17.84
∴ 𝐼𝑅𝑅 = 0.39 + × (0.40 − 0.39) = 0.3908 = 𝟑𝟗. 𝟎𝟖%
17.84 + 206.16

For project Board Shorts, Here,

Initial Outlay, 𝐶𝐹0 = $25,000
Let, 𝑅𝐿 = 38% = 0.38
Cash Inflows, 𝐶𝐹 = $12,000
(1 + 0.38)5 − 1
𝑁𝑃𝑉𝐿 = 12,000 × − 25,000 = $269.34 𝑛 = 5 𝑦𝑒𝑎𝑟𝑠
0.38 × (1 + 0.38)5

Let, 𝑅𝐻 = 39% = 0.39

(1 + 0.39)5 − 1
𝑁𝑃𝑉𝐻 = 12,000 × − 25,000 = −$160.60
0.39 × (1 + 0.39)5

269.34
∴ 𝐼𝑅𝑅 = 0.38 + × (0.39 − 0.38) = 0.3863 = 𝟑𝟖. 𝟔𝟑%
269.34 + 160.60

The IRR of project T-Shirt is higher than that of project Board Shorts.
So, project T-Shirt is recommended.

P10–2 (Slide 39)

Nova Products has a 5-year maximum acceptable payback period. The firm is considering the purchase of a
new machine and must choose between two alternative ones. The first machine requires an initial
investment of $14,000 and generates annual after-tax cash inflows of $3,000 for each of the next 7 years.
The second machine requires an initial investment of $21,000 and provides an annual cash inflow after taxes
of $4,000 for 20 years.

1. Determine the payback period for each machine.

2. Comment on the acceptability of the machines, assuming that they are independent projects.
3. Which machine should the firm accept? Why?
61

4. Do the machines in this problem illustrate any of the weaknesses of using payback? Discuss.
Page
Solution:
a)
For the first machine, 𝐶𝐹0 = $14,000, Annual Cash Inflow, 𝐶𝐹 = $3,000
14,000
Payback Period, 𝑃𝑃 = = 𝟒. 𝟔𝟕 𝒚𝒆𝒂𝒓𝒔
3,000

For the second machine, 𝐶𝐹0 = $21,000, Annual Cash Inflow, 𝐶𝐹 = $4,000
21,000
Payback Period, 𝑃𝑃 = = 𝟓. 𝟐𝟓 𝒚𝒆𝒂𝒓𝒔
4,000

b)
Here, the maximum acceptable payback period is 5 years. Only the first machine has a payback period
of less than 5 years, and thus, the first machine is acceptable.

c)

The firm should accept the first machine, because the payback period of this project is 4.67 years which
is less than the maximum acceptable payback period of 5 years as required by the firm.

d)

The machines in this problem clearly illustrate the weaknesses of the Payback Period technique. Here,
the first machine project is accepted solely based on the maximum payback time required while
ignoring all the cash inflows that are generated beyond the payback period. The second machine
generates a cash inflow for 20 years which is almost 3 times as much as the first machine’s 7 years of
cash inflow. Also, the total cash inflow from the first machine is less than that of the second machine.

P10–6 (Slide 40)

Dane Cosmetics is evaluating a new fragrance-mixing machine. The machine requires an initial investment of
$24,000 and will generate after-tax cash inflows of $5,000 per year for 8 years. For each of the costs of capital
listed, (1) calculate the net present value (NPV), (2) indicate whether to accept or reject the machine, and (3)
explain your decision.

a. The cost of capital is 10%.

b. The cost of capital is 12%.
c. The cost of capital is 14%.
62
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Solution:
Here, Initial Investment, 𝐶𝐹0 = $24,000, Annual Cash Inflow, 𝐶𝐹 = $5,000, 𝑛 = 8 𝑦𝑒𝑎𝑟𝑠

❑ Cost of Capital, 𝑟 = 10% = 0.10

1. The Net Present Value,

(1 + 𝑟)𝑛 − 1 (1 + 0.10)8 − 1
𝑁𝑃𝑉 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 5,000 × [ ] − 24,000 = $𝟐, 𝟔𝟕𝟒. 𝟔𝟑
𝑟 × (1 + 𝑟)𝑛 0.10 × (1 + 0.10)8
2. Accept the machine.
3. Accept the machine, because we have a positive NPV for the machine, which indicates an
economic wellbeing for the firm.

❑ Cost of Capital, 𝑟 = 12% = 0.12

a. The Net Present Value,

(1 + 𝑟)𝑛 − 1 (1 + 0.12)8 − 1
𝑁𝑃𝑉 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 5,000 × [ ] − 24,000 = $𝟖𝟑𝟖. 𝟐
𝑟 × (1 + 𝑟)𝑛 0.12 × (1 + 0.12)8
b. Accept the machine.
c. Accept the machine, because we have a positive NPV for the machine, which indicates an
economic wellbeing for the firm.

❑ Cost of Capital, 𝑟 = 14% = 0.14

1. The Net Present Value,

(1 + 𝑟)𝑛 − 1 (1 + 0.14)8 − 1
𝑁𝑃𝑉 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 5,000 × [ ] − 24,000 = −$𝟖𝟎𝟓. 𝟔𝟖
𝑟 × (1 + 𝑟)𝑛 0.14 × (1 + 0.14)8
2. Reject the machine.
3. Reject the machine, because we have a negative NPV for the machine, which indicates that the
project is expected to generate less value than the cost of its investment.

P10–9 (Slide 41)

A firm can purchase a fixed asset for a $150,000 initial investment. The asset generates an annual after-tax
cash inflow of $44,400 for 4 years.

a. Determine the net present value (NPV) of the asset, assuming that the firm has a 10% cost of capital.
Is the project acceptable?
63

b. Determine the maximum required rate of return (closest whole percentage rate) that the firm can
Page

have and still accept the asset. Discuss this finding in light of your response in part a.
Solution:

Here, Initial Investment, 𝐶𝐹0 = $150,000, Annual Cash Inflow, 𝐶𝐹 = $44,400, 𝑛 = 4 𝑦𝑒𝑎𝑟𝑠

a) Cost of Capital, 𝑟 = 10% = 0.10

The Net Present Value,

(1 + 𝑟)𝑛 − 1 (1 + 0.10)4 − 1
𝑁𝑃𝑉 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 44,400 × [ ] − 150,000 = −$𝟗, 𝟐𝟓𝟕. 𝟗𝟕
𝑟 × (1 + 𝑟)𝑛 0.10 × (1 + 0.10)4

The project is not acceptable, because we have a negative NPV for the machine, which indicates that
the project is expected to generate less value than the cost of its investment.

b) Let, 𝑅𝐿 = 7% = 0.07,
(1 + 𝑟)𝑛 − 1 (1 + 0.07)4 − 1
𝑁𝑃𝑉𝐿 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 44,400 × [ ] − 150,000 = $392.18
𝑟 × (1 + 𝑟)𝑛 0.07 × (1 + 0.07)4

Let, 𝑅𝐻 = 8% = 0.08,
(1 + 𝑟)𝑛 − 1 (1 + 0.08)4 − 1
𝑁𝑃𝑉𝐻 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 44,400 × [ ] − 150,000 = −$2,941.57
𝑟 × (1 + 𝑟)𝑛 0.08 × (1 + 0.08)4

𝑁𝑃𝑉𝐿
∴ 𝐼𝑅𝑅 = 𝑅𝐿 + × (𝑅𝐻 − 𝑅𝐿 )
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

392.18
= 0.07 + × (0.08 − 0.07) = 0.0712 = 𝟕. 𝟏𝟐%
392.18 + 2,941.57

The Internal Rate of Return is the rate at which the NPV of a project equals its initial investment,
which, in this case is 7.12%. Any required rate greater than the IRR would result in a negative NPV,
as we have found in part a. So, the maximum required rate of return should be 7% (taken to the
closest whole percentage rate).
64
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P10–10 (Slide 42)
Hook Industries is considering the replacement of one of its old drill presses. Three alternative replacement
presses are under consideration. The relevant cash flows associated with each are shown in the following
table. The firm’s cost of capital is 15%.

a. Calculate the net present value (NPV) of each press.

b. Using NPV, evaluate the acceptability of each press.
c. Rank the presses from best to worst using NPV.
d. Calculate the profitability index (PI).
e. Rank the presses from best to worst using PI.

Solution:
The Cost of Capital, 𝑟 = 15% = 0.15

a) For Press A, Initial Investment, 𝐶𝐹0 = $85,000, 𝑛 = 8 𝑦𝑒𝑎𝑟𝑠, Cash Flow, 𝐶𝐹 = $18,000

The Net Present Value of Press A,

(1 + 𝑟)𝑛 − 1 (1 + 0.15)8 − 1
𝑁𝑃𝑉 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 18,000 × [ ] − 85,000 = −$𝟒, 𝟐𝟐𝟖. 𝟐𝟏
𝑟 × (1 + 𝑟)𝑛 0.15 × (1 + 0.15)8

For Press B, Initial Investment, 𝐶𝐹0 = $60,000, 𝑛 = 6 𝑦𝑒𝑎𝑟𝑠

The Net Present Value of Press B,

𝑛
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑ − 𝐶𝐹0
(1 + 𝑟)𝑡
𝑡=1

12,000 14,000 16,000 18,000 20,000 25,000

= 1
+ 2
+ 3
+ 4
+ 5
+ − 60,000
(1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15)6
65

= $𝟐, 𝟓𝟖𝟒. 𝟑𝟒
Page
 For Press C, Initial Investment, 𝐶𝐹0 = $130,000, 𝑛 = 8 𝑦𝑒𝑎𝑟𝑠

The Net Present Value of Press C,

𝑛
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑ − 𝐶𝐹0
(1 + 𝑟)𝑡
𝑡=1

50,000 30,000 20,000 20,000 20,000 30,000

= + + + + +
(1 + 0.15)1 (1 + 0.15)2 (1 + 0.15)3 (1 + 0.15)4 (1 + 0.15)5 (1 + 0.15)6
40,000 50,000
+ + − 130,000
(1 + 0.15)7 (1 + 0.15)8
= $𝟏𝟓, 𝟎𝟒𝟑. 𝟖𝟗

b) In part a, we found that the NPV of Press A is negative, so Press A should be rejected. However, the
NPV of Press B and C are positive. So, Press B and C are acceptable.

c) Using NPV, we have the following ranking –

Rank Press NPV

1 C $15,043.89
2 B $2,584.34
3 A – $4,228.21

d) For Press A,
𝑁𝑃𝑉 −4,228.21
Profitability Index, 𝑃𝐼 = 1 + =1+ = 𝟎. 𝟗𝟓
𝐶𝐹0 85,000

For Press B,
𝑁𝑃𝑉 2,584.34
Profitability Index, 𝑃𝐼 = 1 + =1+ = 𝟏. 𝟎𝟒
𝐶𝐹0 60,000

For Press C,
𝑁𝑃𝑉 15,043.89
Profitability Index, 𝑃𝐼 = 1 + =1+ = 𝟏. 𝟏𝟐
𝐶𝐹0 130,000

e) Using PI, we have the following ranking –

Rank Press PI
1 C 1.12
2 B 1.04
3 A 0.95
66
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P10–13 (Slide 43)
A project costs $2.5 million up front and will generate cash flows in perpetuity of $240,000. The firm’s cost
of capital is 9%. Calculate the project’s NPV.

Solution:
Here, Initial Investment, 𝐶𝐹0 = $2,500,000
Inflow, 𝐶𝐹 = $240,000
Cost of Capital, 𝑟 = 9% = 0.09

𝐶𝐹 240,000
For Perpetuity, 𝑃𝑉 = = = $2,666,667
𝑟 0.09

∴ 𝑁𝑃𝑉 = 2,666,667 − 2,500,000 = $𝟏𝟔𝟔, 𝟔𝟔𝟕

P10–19 (Slide 44)

Benson Designs has prepared the following estimates for a long-term project it is considering. The initial
investment is $18,250, and the project is expected to yield after-tax cash inflows of $4,000 per year for 7
years. The firm has a 10% cost of capital.

a. Determine the net present value (NPV) for the project.

b. Determine the internal rate of return (IRR) for the project.
c. Would you recommend that the firm accept or reject the project? Explain your answer.

Solution:
Here, Initial Investment, 𝐶𝐹0 = $18,250
Inflow, 𝐶𝐹 = $4,000, 𝑛 = 7 𝑦𝑒𝑎𝑟𝑠
Cost of Capital, 𝑟 = 10% = 0.10

a) The Net Present Value,

(1 + 𝑟)𝑛 − 1 (1 + 0.10)7 − 1
𝑁𝑃𝑉 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 4,000 × [ ] − 18,250 = $𝟏, 𝟐𝟐𝟑. 𝟔𝟖
𝑟 × (1 + 𝑟)𝑛 0.10 × (1 + 0.10)7

b) Let, 𝑅𝐿 = 12% = 0.12

(1 + 𝑟)𝑛 − 1 (1 + 0.12)7 − 1
𝑁𝑃𝑉𝐿 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 4,000 × [ ] − 18,250 = $5.03
𝑟 × (1 + 𝑟)𝑛 0.12 × (1 + 0.12)7

Let, 𝑅𝐻 = 13% = 0.13

67

(1 + 𝑟)𝑛 − 1 (1 + 0.13)7 − 1
𝑁𝑃𝑉𝐻 = 𝐶𝐹 × [ ] − 𝐶𝐹0 = 4,000 × [ ] − 18,250 = −$559.56
𝑟 × (1 + 𝑟)𝑛 0.13 × (1 + 0.13)7
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 𝑁𝑃𝑉𝐿
∴ 𝐼𝑅𝑅 = 𝑅𝐿 + × (𝑅𝐻 − 𝑅𝐿 )
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

5.03
= 0.12 + × (0.13 − 0.12) = 0.1201 = 𝟏𝟐. 𝟎𝟏%
5.03 + 559.56

c) We found that, in part a, the NPV of the project is greater than zero, and in part b, the IRR (12.01%)
is greater than the cost of capital (10%). So, the project should be accepted.

P10–22
Rieger International is attempting to evaluate the feasibility of investing $95,000 in a piece of equipment that
has a 5-year life. The firm has estimated the cash inflows associated with the proposal as shown in the
following table. The firm has a 12% cost of capital.

a. Calculate the payback period for the proposed investment.

b. Calculate the net present value (NPV) for the proposed investment.
c. Calculate the internal rate of return (IRR),
d. Evaluate the acceptability of the proposed investment using NPV and IRR. What recommendation
would you make relative to implementation of the project? Why?

Solution:

Here, Initial Investment, 𝐶𝐹0 = $95,000

Cost of Capital, 𝑟 = 12% = 0.12, 𝑛 = 5 𝑦𝑒𝑎𝑟𝑠

a) The Payback Period,

20,000
𝑃𝑃 = 3 + = 𝟑. 𝟓𝟕 𝒚𝒆𝒂𝒓𝒔
35,000
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b) The Net Present Value,
𝑛
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑ − 𝐶𝐹0
(1 + 𝑟)𝑡
𝑡=1

20,000 25,000 30,000 35,000 40,000

= 1
+ 2
+ 3
+ 4
+ − 95,000
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)5

= $𝟗, 𝟎𝟖𝟎. 𝟔𝟎

c) Let, 𝑅𝐿 = 15% = 0.15

20,000 25,000 30,000 35,000 40,000

𝑁𝑃𝑉𝐿 = 1
+ 2
+ 3
+ 4
+ − 95,000
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)5

= $918.82

Let, 𝑅𝐻 = 16% = 0.16

20,000 25,000 30,000 35,000 40,000

𝑁𝑃𝑉𝐻 = + + + + − 95,000
(1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4 (1 + 0.12)5

= $1,585.11

𝑁𝑃𝑉𝐿
∴ 𝐼𝑅𝑅 = 𝑅𝐿 + × (𝑅𝐻 − 𝑅𝐿 )
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

918.82
= 0.15 + × (0.16 − 0.15) = 0.1537 = 𝟏𝟓. 𝟑𝟕%
918.82 + 1,585.11

d) We see that the project’s NPV > 0, and the IRR > 12% (cost of capital). Both NPV and IRR, as
decision criterion, indicate that the project should be implemented. 69
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Chapter 05 – Bond Valuation

Fundamentals of Interest Rate:

❑ The interest rate or required return represents the price or cost of money.
❑ Interest rates act as a regulating device that controls the flow of money between suppliers and
demanders of funds.
❑ When funds are raised, the cost the company must pay is called the required return which reflects the
supplier’s expected level of return.

𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏 = 𝑹𝒊𝒔𝒌-𝒇𝒓𝒆𝒆 𝑹𝒂𝒕𝒆 + 𝑹𝒊𝒔𝒌 𝑷𝒓𝒆𝒎𝒊𝒖𝒎

𝒓 = 𝒓𝑹𝑭 + 𝑹𝑷

Here, 𝐫 = Quoted or nominal rate of interest on a given security.

𝐫𝐑𝐅 = Quoted risk-free rate of return. Theoretically this rate is the return associated with an
investment that has a guaranteed outcome in the future – that is, it has no risk. We generally use the
return on Government securities as the risk-free rate because Government securities represent the
short-term debt of the Bangladesh government that is very liquid and free of most risks. In other
words, Government securities are considered very close to pure risk-free assets.

𝐑𝐏 = Risk premium, which is the return that exceeds the risk-free rate of return, rRF , and thus
represents payment for the risk associated with an investment.

Term Structure:
The term structure of interest rates is the relationship between the rate of return and maturities of securities.

Yield Curve:
A graphic depiction of the term structure of interest rates, that is – a graph showing the relationship between
yields and maturities of securities.

Types of Yield Curve:

• Normal Yield Curve: An upward-sloping yield curve indicates that long-term interest rates are
generally higher than short-term interest rates.
• Inverted Yield Curve: A downward-sloping yield curve indicates that short-term interest rates are
generally higher than long-term interest rates.
• Flat Yield Curve: A yield curve that indicates that interest rates do not vary much at different
70

maturities.
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Concept of Debt:
Debt refers to a loan to an entity i.e., firm, government, or individual.

General Features or Characteristics of Debt:

1. Principal Value: The principal value of debt represents the amount owed to the lender, which must be
repaid at some point during the life of the debt. When a company takes out a loan or issues a bond, the
principal value is the initial amount they receive from the lender or bondholder. For much of the debt
issued by corporations, the principal amount is repaid at maturity.

2. Interest Payments: Owners of debt instruments receive periodic payments of interest, which are
computed as a percentage of the principal amount. Interest is the cost of borrowing and is typically paid
periodically (annually or semi-annually).

3. Maturity Date: The maturity date represents the date on which the principal amount of a debt is due.
Maturity date is the date by which the borrowed amount must be repaid in full.

4. Priority in Assets and Earnings: Debt holders have priority over stockholders with regard to distribution
of earnings and liquidation of assets. That is, debt holders must be paid before stockholders can be paid.
Interest on debt is paid before stock dividends are distributed, and any outstanding debt must be repaid
before stockholders can receive any proceeds from liquidation of the company.

5. Control of the Firm: Debt doesn't grant ownership rights in the company. Unlike equity (stocks), lenders
71

or bondholders don't have voting rights or control over the operations or decision-making of the firm.
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Bonds:
A long-term debt instrument issued by a business or government unit under which the borrower agrees to
make payments of interest and principal on specific future dates to the bondholders over the life of the
instruments. [individuals cannot issue bond]

Related Terms:
❑ Par Value or Face Value: This refers to the nominal or stated value of a bond, which is the amount that
the issuer promises to repay to the bondholder at the bond's maturity date.
✓ It's the value at which the bond is initially issued.
✓ Bonds may trade above or below their par value in the secondary market.
✓ For most debt, the terms – par value, face value, maturity value, and principal value are used
interchangeably to designate the amount that must be repaid by the borrower.

❑ Coupon Rate and Payment: The coupon rate is the fixed annual interest rate that the bond issuer agrees
to pay to the bondholder, expressed as a percentage of the bond's par value.
✓ For instance, if a bond has a face value of $1,000 and a coupon rate of 5%, the issuer will pay
(1,000 × 5% =) $50 in interest annually.
✓ This interest payment is made periodically (usually semi-annually or annually) depending on the
terms of the bond.

❑ Maturity Period: This refers to the length of time until the bond's principal amount is repaid to the
bondholder.
✓ It's the duration for which the bond is issued.
✓ When the bond reaches its maturity date, the issuer repays the bondholder the face value of the
bond.

Bond Contract Features:

1. Bond Indenture: An indenture is a legal document that spells out any legal restrictions associated with
the bond as well as the rights of the bondholders (lenders) and the corporation (bond issuer).
Included in the indenture are descriptions of the amount and timing of all interest and principal
payments, various standard and restrictive provisions, and, frequently, sinking-fund requirements and
security interest provisions.

 Standard Provisions: The standard debt provisions in the bond indenture specify certain record-
72

keeping and general business practices that the bond issuer must follow.
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  Restrictive Covenants: Bond indentures also normally include certain restrictive covenants which
place operating and financial constraints on the borrower.
It refers to a provision in a debt contract that constrains the action of the borrower. These
provisions help protect the bondholder against increases in borrower risk. Without them, the
borrower could increase the firm’s risk but not have to pay increased interest to compensate for
the increased risk.

2. Call Provision: A feature included in nearly all corporate bond issues that gives the issuer the opportunity
to repurchase bonds at a stated call price prior to maturity.

 Call Price: The stated price at which a bond may be repurchased, by use of a call feature, prior to
maturity.
As a rule, the call price exceeds the par value of a bond by an amount equal to 1 year’s interest.
For example, a $1,000 bond with a 10% coupon interest rate would be callable for around $1,100
[$1,000 + (10% × $1,000)]. The amount by which the call price ($1,100) exceeds the bond’s
par value of $1,000 is commonly referred to as the call premium [here, call premium = $100].

 Call Premium: The amount by which a bond’s call price exceeds its par value. This premium
compensates bondholders for having the bond called away from them; to the issuer, it is the cost
of calling the bonds.

3. Sinking Fund Provision: A sinking fund is a provision that facilitates the systematic withdrawal/retirement
of a bond issue.

→ Typically, the sinking fund provision requires the firm to retire a portion of the bond issue each
year.
→ On rare occasions, the firm might be required to deposit money with a trustee, which invests the
funds and then uses the accumulated sum to retire the bonds when they mature.

4. Convertible Feature: A conversion feature permits the bondholder (investor) to exchange or convert the
bond into shares of common stock at a fixed price.

→ Investors have greater flexibility with convertible bond than with straight bonds because they can
choose whether to hold the company’s bond or convert into its stock.
→ When the conversion takes place, the firm has effectively issued stock.
→ Once the conversion is made, investors cannot convert back to bonds.
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Cost of Bonds to the Issuer:
The major factors that affect the cost:
1. Impact of Bond Maturity: The longer the maturity of a bond, the less accuracy there is in predicting
future interest rates and therefore the greater the bondholders’ risk. In addition, the longer the term, the
greater the chance that the issuer might default.
2. Impact of Offering Size: The size of the bond offering also affects the interest cost of borrowing but in an
inverse manner: Bond flotation and administration costs per dollar borrowed are likely to decrease with
increasing offering size. On the other hand, the risk to the bondholders may increase, because larger
offerings result in greater risk of default.
3. Impact of Issuer's Risk: The greater the issuer’s default risk and/or liquidity risk, the higher the interest
rate. Some of this risk can be reduced through inclusion of appropriate restrictive provisions in the bond
indenture. Clearly, bondholders must be compensated with higher returns for taking greater risks.
4. Impact of Cost of Money: The cost of money in the capital market is the basis for determining a bond’s
coupon interest rate. That is, if the general cost of money in an economy is higher, the coupon interest
rate should also be higher.

Common Types of Bonds:

1. Government Bonds: The bonds which are issued by the government to raise funds are called Government
Bonds.

i. Treasury Bond: On behalf of the Government of Bangladesh, the Bangladesh Bank issues bonds to
raise fund from the market which are referred to as Treasury Bonds. On a regular basis Bangladesh
Bank issues treasury bonds and raise funds from the banking sector. This fund directly contributes
to the treasury of Bangladesh government and the government uses the fund. Bangladesh Bank is
only responsible for the issuing and management of the bond.

ii. Municipal Bond: The bonds issued by the local government of a country (i.e., the Union Parishad,
Upazila Parishad etc.) to raise funds from the market.

a. Revenue Bond: A revenue bond is a type of municipal bond issued to finance a specific project
that is expected to generate revenue. The revenue generated by the specific project will be used
to repay the bond obligations.

b. General Obligation Bonds: General Obligation Bonds are a type of municipal bond issued to fund
various public projects and initiatives. General obligation bonds are backed by the credit and
74

taxing power of the issuing local government, or the financial support they receive from the
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central government.
2. Corporate Bonds: The bonds which are issued by the business corporations to raise funds are called
Corporate Bonds.

i. Mortgage Bond: The bond which is secured by a real estate property. In case the issuer defaults,
bondholders have a priority claim on the assets used as collateral.

ii. Debenture: A debenture is an unsecured bond issued by corporations or governments, not

backed by any specific collateral. These bonds rely solely on the creditworthiness and reputation
of the issuer. In case of default, debenture holders are considered general creditors and do not
have a claim on any specific assets.

iii. Subordinated Debenture: When a company, which has already issued debentures previously,
subsequently issues new debentures, then the new debentures are called subordinated
debentures. It ranks lower in the priority of payment in the event of bankruptcy or liquidation.
The subordinated nature of these bonds implies higher risk for investors, which is reflected in the
higher interest rates typically offered compared to senior debt.

iv. Income Bond: Income bonds are debt instruments that pay interest to bondholders only when
the issuer generates enough income to cover the interest payment. If the issuer doesn't make a
profit or generate the necessary income, it might skip interest payments to bondholders.

v. Zero Coupon Bond: A zero coupon bond is a type of bond that doesn't make periodic interest
payments like traditional bonds, instead, it is issued at a discount rate to its face value. That is,
investors purchase these bonds at a discounted price and receive a known lump-sum payout (the
full face value) of the bond at maturity.

vi. Junk Bond: Junk bonds are bonds issued by companies or entities with lower credit ratings. These
ratings are typically below investment grade, implying a higher risk of default compared to
investment-grade bonds. Because of their higher risk, junk bonds offer higher yields or interest
rates to attract investors.

vii. Convertible Bond: Convertible bonds are hybrid securities that give bondholders the option to
convert their bonds into a specified number of shares of the issuer's common stock at a
predetermined price. These bonds offer the benefits of both debt and equity. Bondholders receive
fixed interest payments like traditional bonds, but they also have the potential to convert their
bonds into equity.
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 viii. Putable Bond: Putable bonds, also known as puttable or retractable bonds, grant the bondholder
the right to sell the bond back to the issuer at a predetermined price before maturity. This feature
provides investors with an option to sell the bond back to the issuer and receive the face value of
the bond (or a specified price) before the maturity date.

ix. Callable Bond: Callable bonds give the issuer the right to redeem or "call back" the bonds before
the stated maturity date. When called, bondholders receive the face value of the bond plus any
accrued interest up to the call date.

x. Floating Rate Bond: A floating rate bond is a type of bond that has a variable or floating interest
rate, which adjusts periodically based on changes in a reference interest rate (typically a
benchmark such as LIBOR (London Interbank Offered Rate) or a government bond yield).

Valuation:
Valuation is the process that links risk and return to determine the worth of an asset.

There are three key inputs to the valuation process:

1. Cash Flows (returns)
2. Timing, and
3. A Measure of Risk

The value of any asset is the present value of all future cash flows it is expected to provide over the relevant
time period.
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛
Value of an Asset, 𝑉0 = 1
+ 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑛

Here, 𝑉0 = Value of an asset at time zero

𝐶𝐹𝑡 = Cash flow expected at the end of year t
𝑟 = Required return (discount rate)
𝑛 = Relevant time period

Valuation of Bonds:
𝐼𝑁𝑇 𝐼𝑁𝑇 𝐼𝑁𝑇 𝑀
𝑉0 = 1
+ 2
+⋯+ 𝑛
+
(1 + 𝑟𝑑 ) (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 )𝑛

(𝟏 + 𝒓𝒅 )𝒏 − 𝟏 𝑴
𝑽𝟎 = 𝑰𝑵𝑻 × [ 𝒏
]+
𝒓𝒅 × (𝟏 + 𝒓𝒅 ) (𝟏 + 𝒓𝒅 )𝒏
76

Here, INT = Annual Interest Payment, M = Par Value of the Bond, rd = Required Rate (Discount Rate)
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Example (Slide 15):
Mills Company, a large defense contractor, issued a 10% coupon interest rate, 3-year bond with a $1,000 par
value that pays interest annually. Tim wishes to determine the current value of the Mills Company bond
assuming that the required return is 15%.

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 10%, 𝑟𝑑 = 15% = 0.15, 𝑛 = 3 𝑦𝑒𝑎𝑟𝑠

Annual Interest Payment, 𝐼𝑁𝑇 = $1,000 × 10% = $100

(1 + 𝑟𝑑 )𝑛 − 1 𝑀
Current value of the bond, 𝑉0 = 𝐼𝑁𝑇 × [ 𝑛
]+
𝑟𝑑 × (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 )𝑛

(1 + 0.15)3 − 1 1,000
= 100 × [ 3
]+ = $𝟖𝟖𝟓. 𝟖𝟒
0.15 × (1 + 0.15) (1 + 0.15)3

Discount & Premium:

❑ Discount Bond: A bond that sells below its par value (V0 < M). This occurs whenever the going rate
of interest rises above the coupon rate. The amount by which a bond sells below its par value is
called discount (M − V0 ).
❑ Premium Bond: A bond that sells above its par value (V0 > M). This occurs whenever the going
rate of interest falls below the coupon rate. The amount by which a bond sells above its par value
is called premium (V0 − M).

Example (Slide 17):

Lahey Industries has outstanding a $1,000 par-value bond with an 8% coupon interest rate. The bond has 12
years remaining to its maturity date.
a. If interest is paid annually, find the value of the bond when the required return is – (1) 7%, (2) 8%,
and (3) 10%.
b. Indicate for each case in part a whether the bond is selling at a discount, at a premium, or at its par
value.
c. Using the 10% required return, find the bond’s value when interest is paid semiannually.

Solution:

Here, 𝑀 = $1,000, Coupon Interest Rate = 8%, 𝑛 = 12 𝑦𝑒𝑎𝑟𝑠

77

Annual Interest Payment, 𝐼𝑁𝑇 = $1,000 × 8% = $80

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 (1 + 𝑟𝑑 )𝑛 − 1 𝑀
𝒂) Value of the Bond, 𝑉0 = 𝐼𝑁𝑇 × [ 𝑛
]+
𝑟𝑑 × (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 )𝑛

1) When required return, 𝑟𝑑 = 7%,

(1 + 0.07)12 − 1 1,000
𝑉0 = 80 × [ 12
]+ = $𝟏, 𝟎𝟕𝟗. 𝟒𝟑
0.07 × (1 + 0.07) (1 + 0.07)12

2) When required return, 𝑟𝑑 = 8%,

(1 + 0.08)12 − 1 1,000
𝑉0 = 80 × [ ] + = $𝟏, 𝟎𝟎𝟎
0.08 × (1 + 0.08)12 (1 + 0.08)12

3) When required return, 𝑟𝑑 = 10%,

(1 + 0.10)12 − 1 1,000
𝑉0 = 80 × [ ] + = $𝟖𝟔𝟑. 𝟕𝟑
0.10 × (1 + 0.10)12 (1 + 0.10)12

𝒃)
1) When the required rate is 7%, V0 > M,
so, the bond is selling at a premium.

2) When the required rate is 8%, V0 = M,

so, the bond is selling at its par value.

3) When the required rate is 10%, V0 < M,

so, the bond is selling at a discount.

𝒄) Compounding Frequency, 𝑚 = 2, 𝑟𝑑 = 10% = 0.10

8%
Interest Amount, 𝐼𝑁𝑇 = $1,000 × = $40
2

𝑟𝑑 𝑚×𝑛
(1 + ) −1 𝑀
The Value of the Bond, 𝑉0 = 𝐼𝑁𝑇 × [ 𝑚 ]+
𝑟𝑑 𝑟𝑑 𝑚×𝑛 𝑟𝑑 𝑚×𝑛
× (1 + ) (1 +
𝑚 𝑚 𝑚)

0.10 2×12
(1 + 2 ) −1 1,000
= 40 × [ ] +
0.10 0.10 2×12 0.10 2×12
× (1 + ) (1 +
2 2 2 )

= $𝟖𝟔𝟐. 𝟎𝟏
78
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Bond Yield:
The amount of return an investor realizes on a bond.

Types of Bond Yield:

1. Yield To Maturity (YTM): The average rate of return earned on a bond if it is held to maturity. That is,
if you buy a bond and hold it until it matures, the average rate of return you will earn per year is called
the bond's yield to maturity (YTM).

2. Yield To Call (YTC): The average rate of return earned on a bond if it is held until the first call date.
Bonds that contain call provisions (callable bonds) often are called by the firm prior to maturity. In
cases in which a bond issue is called, investors do not have the opportunity to earn the yield to
maturity (YTM) because the bond issue is retired before the maturity date arrives.
Call Price: The price a firm has to pay to recall a bond; generally equal to the principal amount plus
some interest.

3. Current Yield: A bond's annual return based on its annual coupon payments and current price (as
opposed to its original price or face). This measure looks at the current price of a bond instead of its
face value.

Yield To Maturity (YTM):

Calculation of YTM (Trial and Error Method) –

1. Calculate the net present value (NPVL ) at low interest rate (L).
(𝟏 + 𝑳)𝒏 − 𝟏 𝑴
𝑵𝑷𝑽𝑳 = 𝑰𝑵𝑻 × [ 𝒏
]+ − 𝑴𝒂𝒓𝒌𝒆𝒕 𝑽𝒂𝒍𝒖𝒆
𝑳 × (𝟏 + 𝑳) (𝟏 + 𝑳)𝒏

2. Calculate the net present value (NPVL ) at high interest rate (H).
(𝟏 + 𝑯)𝒏 − 𝟏 𝑴
𝑵𝑷𝑽𝑯 = 𝑰𝑵𝑻 × [ ] + − 𝑴𝒂𝒓𝒌𝒆𝒕 𝑽𝒂𝒍𝒖𝒆
𝑯 × (𝟏 + 𝑯)𝒏 (𝟏 + 𝑯)𝒏

3. Apply YTM formula.

𝑵𝑷𝑽𝑳
𝒀𝑻𝑴 = 𝑳 + × (𝑯 − 𝑳)
𝑵𝑷𝑽𝑳 − 𝑵𝑷𝑽𝑯
79

This method is the same as calculating IRR in Capital Budgeting chapter.

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Shortcut for calculating YTM:
𝑴−𝑷
𝑰𝑵𝑻 + 𝒏
Approximate 𝒀𝑻𝑴 =
𝑴+𝑷
𝟐

Here, P = Market Value of the Bond, M = Face Value, n = Time Period, INT = Annual Interest Payment.

Use this formula to gain an idea about the bond’s approximate YTM value, then use the “Trial and Error
Method” to calculate the actual YTM value.

Example (Slide 21):

Elliot Enterprises’ bonds currently sell for $1,150, have an 11% coupon interest rate and a $1,000 par value,
pay interest annually, and have 18 years to maturity. Calculate the bonds’ yield to maturity (YTM).

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 11%, 𝑛 = 18 𝑦𝑒𝑎𝑟𝑠, Market Value = $1,150

Annual Interest Payment, 𝐼𝑁𝑇 = $1,000 × 11% = $110

Let, 𝐿 = 9% = 0.09,
(1 + 𝐿)𝑛 − 1 𝑀
𝑁𝑃𝑉𝐿 = 𝐼𝑁𝑇 × [ ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐿 × (1 + 𝐿)𝑛 (1 + 𝐿)𝑛

(1 + 0.09)18 − 1 1,000
= 110 × [ 18
]+ − 1,150 = $25.11
0.09 × (1 + 0.09) (1 + 0.09)18

Let, 𝐻 = 10% = 0.10,

(1 + 𝐻)𝑛 − 1 𝑀
𝑁𝑃𝑉𝐻 = 𝐼𝑁𝑇 × [ 𝑛
]+ − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐻 × (1 + 𝐻) (1 + 𝐻)𝑛

(1 + 0.10)18 − 1 1,000
= 110 × [ 18
]+ − 1,150 = −$67.99
0.10 × (1 + 0.10) (1 + 0.10)18

𝑁𝑃𝑉𝐿
𝑆𝑜, 𝑌𝑇𝑀 = 𝐿 + × (𝐻 − 𝐿)
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

25.11
= 9% + × (10% − 9%) = 𝟗. 𝟐𝟕%
25.11 + 67.99
80
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Practice (Slide 24):
The Salem Company bond currently sells for $955, has a 12% coupon interest rate and a $1,000 par value,
pays interest annually, and has 15 years to maturity. Calculate the yield to maturity (YTM) on this bond.

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 12%, 𝑛 = 15 𝑦𝑒𝑎𝑟𝑠, Market Value = $955
Annual Interest Payment, 𝐼𝑁𝑇 = $1,000 × 12% = $120

Let, 𝐿 = 12% = 0.12,

(1 + 𝐿)𝑛 − 1 𝑀
𝑁𝑃𝑉𝐿 = 𝐼𝑁𝑇 × [ 𝑛
]+ − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐿 × (1 + 𝐿) (1 + 𝐿)𝑛

(1 + 0.12)15 − 1 1,000
= 120 × [ ] + − 955 = $45
0.12 × (1 + 0.12)15 (1 + 0.12)15
Let, 𝐻 = 13% = 0.13,
(1 + 𝐻)𝑛 − 1 𝑀
𝑁𝑃𝑉𝐻 = 𝐼𝑁𝑇 × [ ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐻 × (1 + 𝐻)𝑛 (1 + 𝐻)𝑛

(1 + 0.13)15 − 1 1,000
= 120 × [ ] + − 955 = −$19.62
0.13 × (1 + 0.13)15 (1 + 0.13)15

𝑁𝑃𝑉𝐿
𝑆𝑜, 𝑌𝑇𝑀 = 𝐿 + × (𝐻 − 𝐿)
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

45
= 12% + × (13% − 12%) = 𝟏𝟐. 𝟕%
45 + 19.62

Yield To Call (YTC):

The computation for the 𝑌𝑇𝐶 is the same as that for the 𝑌𝑇𝑀, except that we substitute the call price (𝐶𝑃)
of the bond for the maturity (par) value (𝑀), and the number of years until the bond can be called (𝑁𝑐 ) for
the years to maturity (𝑛). That is, replace 𝑀 with 𝐶𝑃 and 𝑛 with 𝑁𝑐 .

𝑪𝑷 − 𝑷
𝑰𝑵𝑻 + 𝑵𝒄
Use the shortcut formula for Approximate 𝒀𝑻𝑪 =
𝑪𝑷 + 𝑷
𝟐

Here, P = Market Value of the Bond, CP = Call Price, 𝐍𝐜 = Number of Years until the bond can be called,
INT = Annual Interest Payment.
81

Use this formula to gain an idea about the bond’s approximate YTC value, then use the “Trial and Error
Page

Method” to calculate the actual YTC value.

Calculation of YTC (Trial and Error Method) –

1. Calculate the net present value (NPVL ) at low interest rate (L).
(𝟏 + 𝑳)𝑵𝒄 − 𝟏 𝑪𝑷
𝑵𝑷𝑽𝑳 = 𝑰𝑵𝑻 × [ 𝑵
]+ − 𝑴𝒂𝒓𝒌𝒆𝒕 𝑽𝒂𝒍𝒖𝒆
𝑳 × (𝟏 + 𝑳) 𝒄 (𝟏 + 𝑳)𝑵𝒄

2. Calculate the net present value (NPVL ) at high interest rate (H).
(𝟏 + 𝑯)𝑵𝒄 − 𝟏 𝑪𝑷
𝑵𝑷𝑽𝑯 = 𝑰𝑵𝑻 × [ 𝑵
]+ − 𝑴𝒂𝒓𝒌𝒆𝒕 𝑽𝒂𝒍𝒖𝒆
𝑯 × (𝟏 + 𝑯) 𝒄 (𝟏 + 𝑯)𝑵𝒄

3. Apply YTC formula.

𝑵𝑷𝑽𝑳
𝒀𝑻𝑪 = 𝑳 + × (𝑯 − 𝑳)
𝑵𝑷𝑽𝑳 − 𝑵𝑷𝑽𝑯

Example (Slide 28):

Jon Company’ bonds currently sell for $1,150, have an 11% coupon interest rate and a $1,000 par value, pay
interest annually, and have 18 years to maturity. The company may call the bond in 10 years at a call price of
$1,100. Calculate the bonds’ yield to call (YTC).

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 11%, 𝑛 = 18 𝑦𝑒𝑎𝑟𝑠, Market Value = $1,150,
Call Price, 𝐶𝑃 = $1,100, 𝑁𝑐 = 10 𝑦𝑒𝑎𝑟𝑠

Annual Interest Payment, 𝐼𝑁𝑇 = $1,000 × 11% = $110

Let, 𝐿 = 9% = 0.09,
(1 + 𝐿)𝑁𝑐 − 1 𝐶𝑃
𝑁𝑃𝑉𝐿 = 𝐼𝑁𝑇 × [ 𝑁
]+ − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐿 × (1 + 𝐿) 𝑐 (1 + 𝐿)𝑁𝑐

(1 + 0.09)10 − 1 1,100
= 110 × [ ] + − 1,150 = $20.6
0.09 × (1 + 0.09)10 (1 + 0.09)10

Let, 𝐻 = 10% = 0.10,

(1 + 𝐻)𝑁𝑐 − 1 𝐶𝑃
𝑁𝑃𝑉𝐻 = 𝐼𝑁𝑇 × [ 𝑁
]+ − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐻 × (1 + 𝐻) 𝑐 (1 + 𝐻)𝑁𝑐

(1 + 0.10)10 − 1 1,100
= 110 × [ ] + − 1,150 = −$50
0.10 × (1 + 0.10)10 (1 + 0.10)10

𝑁𝑃𝑉𝐿 20.6
82

𝑆𝑜, 𝑌𝑇𝐶 = 𝐿 + × (𝐻 − 𝐿) = 9% + × (10% − 9%) = 𝟗. 𝟐𝟗%

𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻 20.6 + 50
Page
Practice (Slide 31):
The Brook Company bond currently sells for $900, has a 10% coupon interest rate and a $1,000 par value,
pays interest annually, and has 13 years to maturity. The company may call the bond in 10 years at a call price
of $1,150. Based on the available information, calculate the yield to call (YTC) on this bond.

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 10%, 𝑛 = 13 𝑦𝑒𝑎𝑟𝑠, Market Value = $900,
Call Price, 𝐶𝑃 = $1,150, 𝑁𝑐 = 10 𝑦𝑒𝑎𝑟𝑠

Annual Interest Payment, 𝐼𝑁𝑇 = $1,000 × 10% = $100

Let, 𝐿 = 12% = 0.12,

(1 + 𝐿)𝑁𝑐 − 1 𝐶𝑃
𝑁𝑃𝑉𝐿 = 𝐼𝑁𝑇 × [ 𝑁
]+ − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐿 × (1 + 𝐿) 𝑐 (1 + 𝐿)𝑁𝑐

(1 + 0.12)10 − 1 1,150
= 100 × [ ] + − 900 = $35.29
0.12 × (1 + 0.12)10 (1 + 0.12)10

Let, 𝐻 = 13% = 0.13,

(1 + 𝐻)𝑁𝑐 − 1 𝐶𝑃
𝑁𝑃𝑉𝐻 = 𝐼𝑁𝑇 × [ ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐻 × (1 + 𝐻)𝑁𝑐 (1 + 𝐻)𝑁𝑐

(1 + 0.13)10 − 1 1,150
= 100 × [ 10
]+ − 900 = −$18.6
0.13 × (1 + 0.13) (1 + 0.13)10

𝑁𝑃𝑉𝐿 35.29
𝑆𝑜, 𝑌𝑇𝐶 = 𝐿 + × (𝐻 − 𝐿) = 12% + × (13% − 12%) = 𝟏𝟐. 𝟔𝟓%
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻 35.29 + 18.6

Current Yield (CY):

Current Yield refers to the bond's annual return based on its annual coupon payments and current price. This
measure looks at the current price of a bond instead of its face value.

𝑨𝒏𝒏𝒖𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑷𝒂𝒚𝒎𝒆𝒏𝒕

𝑪𝒀 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆

Example (Slide 34):

Rebeca Enterprises’ bonds currently sell for $1,150, have an 11% coupon interest rate and a $1,000 par value,
pay interest annually, and have 18 years to maturity. Calculate the bonds’ current yield (CY).

Solution:
83

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 $1,000 × 11%

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 = = = 𝟗. 𝟓𝟕%
Page

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 $1,150

Formulas:

(1 + 𝑟𝑑 )𝑛 − 1 𝑀
Bond Valuation 𝑉0 = 𝐼𝑁𝑇 × [ 𝑛
]+
𝑟𝑑 × (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 )𝑛

Premium Bond (𝐕𝟎 > 𝐌) 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = V0 − M

Discount Bond (𝐕𝟎 < 𝐌) 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = M − V0

(1 + 𝐿)𝑛 − 1 𝑀
𝑁𝑃𝑉𝐿 = 𝐼𝑁𝑇 × [ ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐿 × (1 + 𝐿)𝑛 (1 + 𝐿)𝑛

(1 + 𝐻)𝑛 − 1 𝑀
𝑁𝑃𝑉𝐻 = 𝐼𝑁𝑇 × [ 𝑛
]+ − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐻 × (1 + 𝐻) (1 + 𝐻)𝑛
Yield To Maturity (YTM)
𝑁𝑃𝑉𝐿
𝑌𝑇𝑀 = 𝐿 + × (𝐻 − 𝐿)
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

𝑀−𝑃
𝐼𝑁𝑇 + 𝑛
Approximate 𝑌𝑇𝑀 =
𝑀+𝑃
2

(1 + 𝐿)𝑁𝑐 − 1 𝐶𝑃
𝑁𝑃𝑉𝐿 = 𝐼𝑁𝑇 × [ 𝑁
]+ − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐿 × (1 + 𝐿) 𝑐 (1 + 𝐿)𝑁𝑐

(1 + 𝐻)𝑁𝑐 − 1 𝐶𝑃
𝑁𝑃𝑉𝐻 = 𝐼𝑁𝑇 × [ 𝑁
]+ − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐻 × (1 + 𝐻) 𝑐 (1 + 𝐻)𝑁𝑐
Yield To Call (YTC)
𝑁𝑃𝑉𝐿
𝑌𝑇𝐶 = 𝐿 + × (𝐻 − 𝐿)
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

𝐶𝑃 − 𝑃
𝐼𝑁𝑇 + 𝑁𝑐
Approximate 𝑌𝑇𝐶 =
𝐶𝑃 + 𝑃
2

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡

Current Yield (CY) 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
84
Page
Mathematical Problems

P6–15 (Slide 35):

Complex Systems has an outstanding issue of $1,000-par-value bonds with a 12% coupon interest rate. The
issue pays interest annually and has 16 years remaining to its maturity date. If bonds of similar risk are
currently earning a 10% rate of return, how much should the Complex Systems bond sell for today?

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 12%, 𝑟𝑑 = 10% = 0.10, 𝑛 = 16 𝑦𝑒𝑎𝑟𝑠

Annual Interest Payment, 𝐼𝑁𝑇 = $1,000 × 12% = $120

(1 + 𝑟𝑑 )𝑛 − 1 𝑀
Current value of the bond, 𝑉0 = 𝐼𝑁𝑇 × [ ] +
𝑟𝑑 × (1 + 𝑟𝑑 )𝑛 (1 + 𝑟𝑑 )𝑛

(1 + 0.10)16 − 1 1,000
= 120 × [ ] + = $𝟏, 𝟏𝟓𝟔. 𝟒𝟕
0.10 × (1 + 0.10)16 (1 + 0.10)16

P6–17 (Slide 36):

Midland Utilities has outstanding a bond issue that will mature to its $1,000 par value in 12 years. The bond
has a coupon interest rate of 11% and pays interest annually. Find the value of the bond if the required return
is (1) 11%, (2) 15%, and (3) 8%.

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 11%, 𝑛 = 12 𝑦𝑒𝑎𝑟𝑠

Annual Interest Payment, 𝐼𝑁𝑇 = $1,000 × 11% = $110

(1 + 𝑟𝑑 )𝑛 − 1 𝑀
Value of the Bond, 𝑉0 = 𝐼𝑁𝑇 × [ 𝑛
]+
𝑟𝑑 × (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 )𝑛

1) When required return, 𝑟𝑑 = 11%,

(1 + 0.11)12 − 1 1,000
𝑉0 = 110 × [ 12
]+ = $𝟏, 𝟎𝟎𝟎
0.11 × (1 + 0.11) (1 + 0.11)12

2) When required return, 𝑟𝑑 = 15%,

(1 + 0.15)12 − 1 1,000
𝑉0 = 110 × [ 12
]+ = $𝟕𝟖𝟑. 𝟏𝟖
0.15 × (1 + 0.15) (1 + 0.15)12

3) When required return, 𝑟𝑑 = 8%,

85

(1 + 0.08)12 − 1 1,000
𝑉0 = 110 × [ ]+ = $𝟏, 𝟐𝟐𝟔. 𝟎𝟖
Page

0.08 × (1 + 0.08)12 (1 + 0.08)12

6-1 (Slide 37):
Filkins Farm Equipment needs to raise $4.5 million for expansion, and it expects that five-year zero coupon
bonds can be sold at a price of $567.44 for each $1,000 bond.

a. How many $1,000 par value zero coupon bonds would Filkins have to sell to raise the needed $4.5
million?
b. What will be the burden of this bond issue on the future cash flows generated by Filkins? What will
be the annual debt service costs?
c. What is the yield to maturity (YTM) on the bonds?

Solution: (Doubtful)
𝒂) Here, Required Amount = $4,500,000, Market Price = $567.44
4,500,000
Number of bonds that must be sold = = 7,930.35 ≈ 𝟕, 𝟗𝟑𝟏
567.44

𝒃) The burden of this bond issue on the future cash flows generated by Filkins is the total amount
of principal that needs to be repaid at maturity, which is 7,931 × $1,000 = $7,931,000. The
difference between the amount raised and the amount owed, which is $7,931,000 −
$4,500,000 = $3,431,000. This is the total interest expense that Filkins incurs after the five
years. The annual debt service costs are zero, since there are no coupon payments.

𝒄) Here, 𝑀 = $1,000, 𝑛 = 5 𝑦𝑒𝑎𝑟𝑠, Market Price = $567.44

For the bond's Yield to Maturity,

𝑀
− 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 = 0
(1 + 𝑌𝑇𝑀)𝑛

1,000
⇒ − 567.44 = 0
(1 + 𝑌𝑇𝑀)5

1,000
⇒ (1 + 𝑌𝑇𝑀)5 =
567.44
1
1,000 5
⇒ 𝑌𝑇𝑀 = ( ) −1
567.44

∴ 𝑌𝑇𝑀 = 0.11999 ≈ 𝟏𝟐%

86
Page
6-3 (Slide 38):
Buner Corporation's outstanding bond has the following characteristics:

Years to maturity 6.0

Coupon rate of interest 8.0%
Face value $1,000

If investors require a rate of return equal to 12 percent on similar-risk bonds and interest is paid semiannually,
what should be the market price of Buner’s bond?

Solution:
Here, 𝑛 = 6 𝑦𝑒𝑎𝑟𝑠, Coupon Rate = 8%, 𝑀 = $1,000, 𝑟𝑑 = 12%, 𝑚=2

8%
Interest Payment = $1,000 × = $40
2
𝑟 𝑚×𝑛
(1 + 𝑚𝑑 ) −1 𝑀
Value of the Bond, 𝑉0 = 𝐼𝑁𝑇 × [ 𝑚×𝑛 ] +
𝑟𝑑 𝑟𝑑 𝑟 𝑚×𝑛
(1 + 𝑚𝑑 )
𝑚 × (1 + 𝑚 )

0.12 2×6
(1 + 2 ) −1 1,000
= 40 × [ 2×6 ] + = $𝟖𝟑𝟐. 𝟑𝟐
0.12 0.12 0.12 2×6
2 × (1 + 2 ) (1 + 2 )

6-4 (Slide 39):

Intercontinental Baseball Manufacturers (IBM) has an outstanding bond that matures in 10 years. The bond,
which pays $25 interest every six months ($50 per year), is currently selling for $598.55. What is the bond’s
yield to maturity?

Solution:
Here, 𝑀 = $1,000, 𝑛 = 10 𝑦𝑒𝑎𝑟𝑠, Market Value = $598.55, 𝑚=2

Coupon Interest Payment, 𝐼𝑁𝑇 = $25

Let, 𝐿 = 11% = 0.11,

𝐿 𝑚×𝑛
(1 + 𝑚) −1 𝑀
𝑁𝑃𝑉𝐿 = 𝐼𝑁𝑇 × [ 𝑚×𝑛 ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐿 𝐿 𝐿 𝑚×𝑛
𝑚 × (1 + 𝑚) (1 + 𝑚)

0.11 2×10
(1 + 2 ) −1 1,000
87

= 25 × [ 2×10 ] + − 598.55 = $42.94

0.11 0.11 0.11 2×10
2 × (1 + 2 ) (1 + 2 )
Page
Let, 𝐻 = 13% = 0.13,
𝐻 𝑚×𝑛
(1 + 𝑚) −1 𝑀
𝑁𝑃𝑉𝐻 = 𝐼𝑁𝑇 × [ 𝑚×𝑛 ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐻 𝐻 𝐻 𝑚×𝑛
× (1 + 𝑚) (1 + 𝑚)
𝑚

0.13 2×10
(1 + 2 ) −1 1,000
= 25 × [ 2×10 ] + − 598.55 = −$39.29
0.13 0.13 0.13 2×10
2 × (1 + 2 ) (1 + 2 )

𝑁𝑃𝑉𝐿
𝑆𝑜, 𝑌𝑇𝑀 = 𝐿 + × (𝐻 − 𝐿)
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

42.94
= 11% + × (13% − 11%) = 𝟏𝟐. 𝟎𝟒%
42.94 + 39.29

6-5 (Slide 40):

A corporation has an outstanding bond with the following characteristics:

Coupon rate of interest 6.0%

Interest Payment Semiannually
Face value $1,000.00
Years to maturity 8
Current market value $902.81

What is the yield to maturity (YTM) for this bond?

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 6%, 𝑛 = 8 𝑦𝑒𝑎𝑟𝑠, Market Value = $902.81, 𝑚=2

6%
Interest Payment, 𝐼𝑁𝑇 = $1,000 × = $30
2

Let, 𝐿 = 7% = 0.07,
𝐿 𝑚×𝑛
(1 + 𝑚) −1 𝑀
𝑁𝑃𝑉𝐿 = 𝐼𝑁𝑇 × [ 𝑚×𝑛 ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐿 𝐿 𝐿 𝑚×𝑛
𝑚 × (1 + 𝑚) (1 + 𝑚)

0.07 2×8
(1 + 2 ) −1 1,000
= 30 × [ 2×8 ] + − 902.81 = $36.72
0.07 0.07 0.07 2×8
2 × (1 + 2 ) (1 + 2 )
88
Page
Let, 𝐻 = 8% = 0.08,
𝐻 𝑚×𝑛
(1 + 𝑚) −1 𝑀
𝑁𝑃𝑉𝐻 = 𝐼𝑁𝑇 × [ 𝑚×𝑛 ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐻 𝐻 𝐻 𝑚×𝑛
× (1 + 𝑚) (1 + 𝑚)
𝑚

0.08 2×8
(1 + 2 ) −1 1,000
= 30 × [ 2×8 ] + − 902.81 = −$19.33
0.08 0.08 0.08 2×8
2 × (1 + 2 ) (1 + 2 )

𝑁𝑃𝑉𝐿
𝑆𝑜, 𝑌𝑇𝑀 = 𝐿 + × (𝐻 − 𝐿)
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

36.72
= 7% + × (8% − 7%) = 𝟕. 𝟔𝟔%
36.72 + 19.33

6-15 (Slide 41):

What will be the rate of return on a perpetual bond with a $1,000 par value, an 8 percent coupon rate, and
a current market price of (a) $600, (b) $800, (c) $1,000, and (d) $1,5OO? Assume that interest is paid annually.

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 8%

Interest Payment, 𝐼𝑁𝑇 = $1,000 × 8% = $80

𝒂) Current Market Value = $600

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 80

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 = = = 0.1333 = 𝟏𝟑. 𝟑𝟑%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 600

𝒃) Current Market Value = $800

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 80

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 = = = 0.1 = 𝟏𝟎%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 800

𝒄) Current Market Value = $1,000

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 80

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 = = = 0.08 = 𝟖%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 1,000

𝒅) Current Market Value = $1,500

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 80

89

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 = = = 0.0533 = 𝟓. 𝟑𝟑%

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 1,500
Page
P6–18 (Slide 42):
Pecos Manufacturing has just issued a 15-year, 12% coupon interest rate, $1,000-par bond that pays interest
annually. The required return is currently 14%, and the company is certain it will remain at 14% until the
bond matures in 15 years.

a. Assuming that the required return does remain at 14% until maturity, find the value of the bond with
(1) 15 years, (2) 12 years, (3) 9 years, (4) 6 years, (5) 3 years, and (6) 1 year to maturity.
b. Construct a graph by plotting your findings on a set of “time to maturity (x axis)–market value of bond
(y axis)”
c. All else remaining the same, when the required return differs from the coupon interest rate and is
assumed to be constant to maturity, what happens to the bond value as time moves toward maturity?
Explain in light of the graph in part b.

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 12%, 𝑟𝑑 = 14% = 0.14

Interest Payment, 𝐼𝑁𝑇 = $1,000 × 12% = $120

(1 + 𝑟𝑑 )𝑛 − 1 𝑀
𝒂) Value of the bond, 𝑉0 = 𝐼𝑁𝑇 × [ ] +
𝑟𝑑 × (1 + 𝑟𝑑 )𝑛 (1 + 𝑟𝑑 )𝑛

(1 + 0.14)15 − 1 1,000
𝟏) When 𝑛 = 15 𝑦𝑒𝑎𝑟𝑠, 𝑉0 = 120 × [ ] + = $𝟖𝟕𝟕. 𝟏𝟔
0.14 × (1 + 0.14)15 (1 + 0.14)15

(1 + 0.14)12 − 1 1,000
𝟐) When 𝑛 = 12 𝑦𝑒𝑎𝑟𝑠, 𝑉0 = 120 × [ ] + = $𝟖𝟖𝟔. 𝟕𝟗
0.14 × (1 + 0.14)12 (1 + 0.14)12

(1 + 0.14)9 − 1 1,000
𝟑) When 𝑛 = 9 𝑦𝑒𝑎𝑟𝑠, 𝑉0 = 120 × [ 9
]+ = $𝟗𝟎𝟏. 𝟎𝟕
0.14 × (1 + 0.14) (1 + 0.14)9

(1 + 0.14)6 − 1 1,000
𝟒) When 𝑛 = 6 𝑦𝑒𝑎𝑟𝑠, 𝑉0 = 120 × [ 6
]+ = $𝟗𝟐𝟐. 𝟐𝟑
0.14 × (1 + 0.14) (1 + 0.14)6

(1 + 0.14)3 − 1 1,000
𝟓) When 𝑛 = 3 𝑦𝑒𝑎𝑟𝑠, 𝑉0 = 120 × [ 3
]+ = $𝟗𝟓𝟑. 𝟓𝟕
0.14 × (1 + 0.14) (1 + 0.14)3

(1 + 0.14)1 − 1 1,000
𝟔) When 𝑛 = 1 𝑦𝑒𝑎𝑟𝑠, 𝑉0 = 120 × [ 1
]+ = $𝟗𝟖𝟐. 𝟒𝟔
0.14 × (1 + 0.14) (1 + 0.14)1
90
Page
𝒃)

Bond Value vs Time to Maturity

$1,000.00
$982.46
$980.00
$953.57
$960.00
Market Value of Bond

$940.00
$922.23
$920.00
$901.07
$900.00 $886.79
$877.16
$880.00

$860.00

$840.00

$820.00
15 Years to 12 Years to 9 Years to 6 Years to 3 Years to 1 Year to
Maturity Maturity Maturity Maturity Maturity Maturity
Time to Maturity

𝒄)
The value of the bond differs from its face value when the required rate of return differs from the
coupon interest rate. As we can see in part a, if the required rate of return is higher than the coupon
rate, then the bond value is lower than its face (par) value. In the graph of part b, we can see that
with a constant required return of 14%, the bond value increases as time moves toward maturity.

P6-21 (Slide 43):

Three years ago, ABC company issued 10-years bonds that pay 5% semiannually. If the bond currently sells
from $1,045, what is the YTM on this bond?

Solution:
Here, 𝑀 = $1,000, Coupon Interest Rate = 5%, 𝑛 = 10 − 3 = 7 𝑦𝑒𝑎𝑟𝑠, 𝑚 = 2, Market Value = $1,045
5%
Interest Payment, 𝐼𝑁𝑇 = $1,000 × = $25
2
Let, 𝐿 = 4% = 0.04,
𝐿 𝑚×𝑛
(1 + 𝑚) −1 𝑀
𝑁𝑃𝑉𝐿 = 𝐼𝑁𝑇 × [ 𝑚×𝑛 ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐿 𝐿 𝐿 𝑚×𝑛
𝑚 × (1 + 𝑚) (1 + 𝑚)

0.04 2×7
(1 + 2 ) −1 1,000
= 25 × [ 2×7 ] + − 1,045 = $15.53
0.04 2×7
91

0.04 0.04
2 × (1 + 2 ) (1 + 2 )
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Let, 𝐻 = 5% = 0.05,
𝐻 𝑚×𝑛
(1 + 𝑚) −1 𝑀
𝑁𝑃𝑉𝐻 = 𝐼𝑁𝑇 × [ 𝑚×𝑛 ] + − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐻 𝐻 𝐻 𝑚×𝑛
× (1 + 𝑚) (1 + 𝑚)
𝑚

0.05 2×7
(1 + 2 ) −1 1,000
= 25 × [ 2×7 ] + − 1,045 = −$45
0.05 0.05 0.05 2×7
2 × (1 + 2 ) (1 + 2 )

𝑁𝑃𝑉𝐿
𝑆𝑜, 𝑌𝑇𝑀 = 𝐿 + × (𝐻 − 𝐿)
𝑁𝑃𝑉𝐿 − 𝑁𝑃𝑉𝐻

15.53
= 4% + × (5% − 4%) = 𝟒. 𝟐𝟔%
15.53 + 45

P6–23 (Slide 44):

Mark Goldsmith’s broker has shown him two bonds. Each has a maturity of 5 years, a par value of $1,000,
and a yield to maturity of 12%. Bond A has a coupon interest rate of 6% paid annually. Bond B has a coupon
interest rate of 14% paid annually.
a. Calculate the selling price for each of the bonds.
b. Mark has $20,000 to invest. Judging on the basis of the price of the bonds, how many of either one
could Mark purchase if he were to choose it over the other? (Mark cannot really purchase a fraction
of a bond, but for purposes of this question, pretend that he can.)
c. Calculate the yearly interest income of each bond on the basis of its coupon rate and the number of
bonds that Mark could buy with his $20,000.

Solution:
Here, 𝑀 = $1,000, 𝑛 = 5 𝑦𝑒𝑎𝑟𝑠, 𝑌𝑇𝑀 = 12% = 0.12

Coupon Interest Rate of Bond A = 6%

Interest Payment of Bond A, 𝐼𝑁𝑇𝐴 = $1,000 × 6% = $60

Coupon Interest Rate of Bond B = 14%

Interest Payment of Bond B, 𝐼𝑁𝑇𝐵 = $1,000 × 14% = $140

(1 + 𝑌𝑇𝑀)𝑛 − 1 𝑀
𝒂) Market Value of Bond A, 𝑉𝐴 = 𝐼𝑁𝑇𝐴 × [ 𝑛
]+
𝑌𝑇𝑀 × (1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)𝑛

(1 + 0.12)5 − 1
92

1,000
= 60 × [ ] + = $𝟕𝟖𝟑. 𝟕
0.12 × (1 + 0.12)5 (1 + 0.12)5
Page
 (1 + 𝑌𝑇𝑀)𝑛 − 1 𝑀
Market Value of Bond B, 𝑉𝐵 = 𝐼𝑁𝑇𝐵 × [ 𝑛
]+
𝑌𝑇𝑀 × (1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)𝑛

(1 + 0.12)5 − 1 1,000
= 140 × [ 5
]+ = $𝟏, 𝟎𝟕𝟐. 𝟏
0.12 × (1 + 0.12) (1 + 0.12)5

𝒃) By investing $20,000, Mark can buy either:

20,000
= 𝟐𝟓. 𝟓𝟐 𝐛𝐨𝐧𝐝 𝐀, or
783.7

20,000
= 𝟏𝟖. 𝟔𝟓 𝐛𝐨𝐧𝐝 𝐁
1,072.1

𝒄) Yearly Interest Income of −

Bond A: 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐵𝑜𝑛𝑑𝑠 × 𝐼𝑁𝑇𝐴 = 25.52 × $60 = $𝟏, 𝟓𝟑𝟏. 𝟐

Bond B: 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐵𝑜𝑛𝑑𝑠 × 𝐼𝑁𝑇𝐵 = 18.65 × $140 = $𝟐, 𝟔𝟏𝟏

93
Page
Chapter 06 – Stock Valuation

Stock or Share:
A stock or share is a financial instrument that indicates the holders’ ownership in the issuing entity. A firm
can obtain equity either internally, by retaining earnings, or externally, by selling stocks.

Differences Between Debt & Equity:

❑ Definition: Debt refers to all borrowings incurred by a firm and is repaid according to a fixed schedule of
payments. Equity refers to the funds provided by the firm’s owners (investors or stockholders) that are
repaid subject to the firm’s performance. [A firm can obtain equity either internally, by retaining earnings,
or externally, by selling stocks]

❑ Voice in management: Stockholders generally have voting rights that permit them to select the firm’s
directors and vote on special issues. Debtholders do not receive voting privileges but instead rely on the
firm’s contractual obligations to them to be their voice.

❑ Claims on income and assets: Equity holders’ claims on income and assets are secondary to the claims
of creditors. Their claims on income cannot be paid until the claims of all creditors, including both interest
and scheduled principal payments, have been satisfied. After satisfying creditor’s claims, the firm’s board
of directors decides whether to distribute dividends to the owners.

❑ Maturity: Maturity date is the date by which the borrowed amount must be repaid in full. Unlike debt,
equity is a permanent form of financing for the firm. It does not “mature”, so repayment is not required.

❑ Tax treatment: Interest payments to debtholders are treated as tax-deductible expenses by the issuing
firm, whereas dividend payments to a firm’s stockholders are not tax deductible. The tax deductibility of
interest lowers the corporation’s cost of debt financing, which is yet another reason the cost of debt
financing is lower than the cost of equity financing.

Type of Stocks:
1. Common Stock: Common stock represents ownership in a corporation.
2. Preferred Stock: Preferred stock is a type of ownership in a company that sits between common stock
and bonds. It is a hybrid type of stock.
94
Page
Common Stock:
Common stockholders, who are sometimes referred to as residual owners or residual claimants, are the true
owners of the firm.

✓ As residual owners, common stockholders receive what is left—the residual—after all other claims on
the firm’s income and assets have been satisfied.
✓ Because of this uncertain position, common stockholders expect to be compensated with adequate
dividends and ultimately, capital gains.
✓ That is, in case of residual owners, there are two major ways to be benefited –
1. Dividend: Payments that a company makes to its shareholders from its profits.
2. Capital Gain: The profit realized from selling an asset for more than what was initially paid to acquire
it.

❑ Ownership:
The common stock of a firm can be privately owned by private investors or publicly owned by public
investors.

1. Privately Owned (stock): The common stock of a firm is owned by private investors; this stock is not
publicly traded.
2. Publicly Owned (stock): The common stock of a firm is owned by public investors; this stock is publicly
traded.

Two related terms:

▪ Closely Owned (stock): The common stock of a firm is owned by an individual or a small group of
investors (such as a family); they are usually privately owned companies.
▪ Widely Owned (stock): The common stock of a firm is owned by many unrelated individual or
institutional investors.

❑ Par Value:
An arbitrary value established for legal purposes in the firm’s corporate charter, and which can be used
to find the total number of shares outstanding by dividing it into the book value of common stock. For
publicly owned shares in Bangladesh, the par value is 10 Taka per share.

❑ Preemptive Rights:
Allows common stockholders to maintain their proportionate ownership in the corporation when new
shares are issued, thus protecting them from dilution of their ownership.

▪ Dilution of Ownership: A reduction in each previous shareholder’s fractional ownership resulting

95

from the issuance of additional shares of common stock.

Page
 ▪ Dilution of Earnings: A reduction in each previous shareholder’s fractional claim on the firm’s
earnings resulting from the issuance of additional shares of common stock.
▪ Rights Offering: Financial instruments that allow stockholders to purchase additional shares at a price
below the market price, in direct proportion to their number of owned shares.

❑ Authorized Shares, Issued Shares, Outstanding Shares, and Treasury Stock:

▪ Authorized Shares: Shares of common stock that a firm’s corporate charter allows it to issue.
▪ Issued Shares: Shares of common stock that have been put into circulation. It is the sum of the
outstanding shares and the treasury stock.
o Outstanding Shares: Issued shares of common stock held by investors, including both private and
public investors.
o Treasury Stock: Issued shares of common stock held by the firm; often these shares have been
repurchased by the firm.

❑ Voting Rights:
Each share of common stock entitles its holder to one vote in the election of directors and on special
issues. Votes are generally assignable and may be cast at the annual stockholders meeting.
✓ Because most shareholders do not attend the annual meeting to vote, they may sign a proxy
statement giving their votes to another party.
✓ Occasionally, when the firm is widely owned, outsiders may wage a proxy battle to unseat existing
management and gain control.

❑ Dividends:
Payment of dividends is at the discretion of the board of directors, that is, a company isn't obligated to
pay dividends, and the amount can vary based on the company's performance and decisions by its board
of directors.
✓ Dividends may be made in cash or shares.
✓ Because stockholders are residual claimants—they receive dividend payments only after all claims
have been settled with the government, creditors, and preferred stockholders.
✓ Dividends are calculated based on the par value of the share.

Preferred Stock:
Preferred stock is an equity instrument that usually pays a fixed dividend and has a prior claim on the firm’s
earnings and assets in case of liquidation.
▪ The dividend is expressed as either a dollar amount or as a percentage of its par value.
96

▪ If a firm fails to pay a preferred stock dividend, the dividend is said to be in arrears.
Page
 ▪ Preferred stocks are also called “Quasi-debt” or hybrid securities because they possess the
characteristics of both common stocks and bonds.
o Preferred stocks are like common stock because they are perpetual securities with no maturity
date.
o Preferred stocks are like bonds because they are fixed income securities, that is, dividends never
change.

❑ Restrictive Covenants:
The restrictive covenants in a preferred stock issue focus on ensuring the firm’s continued existence and
regular payment of the dividend. These covenants include provisions about passing dividends, the sale
of senior securities, mergers, sales of assets, minimum liquidity requirements, and repurchases of
common stock. The violation of preferred stock covenants usually permits preferred stockholders either
to obtain representation on the firm’s board of directors or to force the retirement of their stock at or
above its par or stated value.

❑ Cumulation:
▪ Cumulative (preferred stock): Preferred stock for which all passed (unpaid) dividends in arrears, along
with the current dividend, must be paid before dividends can be paid to common stockholders.
▪ Noncumulative (preferred stock): Preferred stock for which passed (unpaid) dividends do not
accumulate.

❑ Callable feature (preferred stock):

A feature of callable preferred stock that allows the issuer to retire the shares within a certain period of
time and at a specified price.

❑ Conversion feature (preferred stock):

A feature of convertible preferred stock that allows holders to change each share into a stated number
of shares of common stock.

Types of Stock Market Transactions:

1. Primary Market: The primary market is where newly issued stocks are sold for the first time by issuers to
investors.
 Newly issued shares or IPO are traded.
 The only market in which the issuer is directly involved in the transaction.
2. Secondary Markets: The secondary market is where previously issued shares are bought and sold among
97

investors.
Page

 Preowned securities (those that are not new issues) are traded.
Basic Stock Valuation Equation:
Here,
∞
𝐷1 𝐷2 𝐷𝑛 𝐷𝑛 𝑃0 = Value of common stock today
𝑃0 = + + ⋯ + = ∑ 𝐷𝑛 = Per share expected dividend at the
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑛 (1 + 𝑟)𝑛
𝑛=1
end of time n
𝑟 = Required return on common stock

Example (Slide 18):

ABC Company is expected to pay annual dividend of Tk. 5, Tk. 10 Tk. 15, Tk. 20, Tk. 25, Tk. 30, Tk. 35, Tk. 40,
Tk. 45, Tk. 50 per share for next 10 years. If the appropriate discount rate is 10%, what is the value of the
common stock?

Solution:
Here, 𝑟 = 10% = 0.10
10
𝐷𝑛
Current value of the common stock, 𝑃0 = ∑
(1 + 𝑟)𝑛
𝑛=1

5 10 15 20 25 30
= 1
+ 2
+ 3
+ 4
+ 5
+
(1 + 0.1) (1 + 0.1) (1 + 0.1) (1 + 0.1) (1 + 0.1) (1 + 0.1)6
35 40 45 50
+ 7
+ 8
+ 9
+
(1 + 0.1) (1 + 0.1) (1 + 0.1) (1 + 0.1)10
= 𝑻𝒌. 𝟏𝟒𝟓. 𝟏𝟖

Stock Valuation Models:

1. Zero Growth Model: An approach to dividend valuation that assumes a constant, nongrowing dividend
stream.
2. Constant Growth Model: A widely cited dividend valuation approach that assumes that dividends will
grow at a constant rate, but a rate that is less than the required return.
3. Variable Growth Model: A dividend valuation approach that allows for a change in the dividend growth
rate.

Zero Growth Model:

𝐷 𝐷 𝐷 Here,
𝑃0 = 1
+ 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑛 𝑃0 = Value of common stock today
𝑫 𝐷 = Constant per share dividend
𝑜𝑟, 𝑷𝟎 =
98

𝒓 𝑟 = Required return on common stock

Page
Example (Slide 22):
ABC Company is expected to provide an annual constant dividend of Tk. 10 per share indefinitely. If the
appropriate discount rate is 10%, what is the value of the common stock?

Solution:
Here, 𝐷 = 𝑇𝑘. 10, 𝑟 = 10% = 0.10
𝐷 10
Value of the common stock, 𝑃0 = = = 𝑻𝒌. 𝟏𝟎𝟎
𝑟 0.10

Constant Growth Model:

Here,
𝐷1 𝐷2 𝐷∞
𝑃0 = 1
+ 2
+ ⋯+ 𝑃0 = Value of common stock today
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)∞
𝐷0 = Dividend paid this year or the last
𝐷0 (1 + 𝑔)1 𝐷0 (1 + 𝑔)2 𝐷0 (1 + 𝑔)∞ dividend or the most recent dividend
𝑜𝑟, 𝑃0 = + + ⋯+
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)∞ 𝐷0 = Expected dividend to be paid at
𝑫𝟎 (𝟏 + 𝒈) 𝑫𝟏 the end of year or in next year
𝑜𝑟, 𝑷𝟎 = =
𝒓−𝒈 𝒓−𝒈 𝑔 = Constant dividend growth rate
𝑟 = Required return on common stock

Assumptions:
▪ Stable Growth Rate
▪ Stable Required Rate of Return
▪ Required Rate of Return > Growth Rate

Example (Slide 24):

ABC Company has recently paid Tk. 10 dividend per share. The company has an expected constant dividend
growth rate of 5%. The appropriate discount rate is 15%. What is the value of the common stock?

Solution:
Here, 𝐷0 = 𝑇𝑘. 10, 𝑔 = 5% = 0.05, 𝑟 = 15% = 0.15

𝐷0 (1 + 𝑔) 10(1 + 0.05)
Value of the common stock, 𝑃0 = = = 𝑻𝒌. 𝟏𝟎𝟓
𝑟−𝑔 0.15 − 0.05

Example (Slide 26, 27 & 28):

If 𝐷0 = $2, 𝑔 is a constant 6%, and required rate is 13%, then (a) find the expected dividend stream for the
next 3 years, and their PVs. (b) What is the stock’s present value? (c) What is the expected value of the stock
99

one year from now?

Page
Solution:
Here, 𝐷0 = $2, 𝑔 = 6% = 0.06, 𝑟 = 13% = 0.13

(a) The expected dividends and their PVs for the next 3 years:
2.12
Year 1: 𝐷1 = 𝐷0 (1 + 𝑔)1 = 2 × (1 + 0.06)1 = $𝟐. 𝟏𝟐 𝑃𝑉1 = = $𝟏. 𝟖𝟕𝟔𝟏
(1 + 0.13)1
2.2472
Year 2: 𝐷2 = 𝐷0 (1 + 𝑔)2 = 2 × (1 + 0.06)2 = $𝟐. 𝟐𝟒𝟕𝟐 𝑃𝑉2 = = $𝟏. 𝟕𝟓𝟗𝟗
(1 + 0.13)2
2.3820
Year 3: 𝐷3 = 𝐷0 (1 + 𝑔)3 = 2 × (1 + 0.06)3 = $𝟐. 𝟑𝟖𝟐𝟎 𝑃𝑉3 = = $𝟏. 𝟔𝟓𝟎𝟖
(1 + 0.13)3

(b) Present value of the stock,

𝐷1 2.12
𝑃0 = = = $𝟑𝟎. 𝟐𝟗
𝑟 − 𝑔 0.13 − 0.06

(c) Expected value of the stock one year later,

𝐷2 2.2472
𝑃1 = = = $𝟑𝟎. 𝟏𝟎
𝑟 − 𝑔 0.13 − 0.06

Variable Growth Model:

Assuming that a single shift in growth rates occurs at the end of year 𝑁, and 𝑔1 represents the initial growth
rate, 𝑔2 represents growth rate after the shift (after year N). To determine the value of a share of stock in the
case of variable growth, we use a four-step procedure:

Step 1: Find the value of the cash dividends at the end of each year, 𝐷𝑡 , during the initial growth period, years
1 through 𝑁.
𝐷𝑡 = 𝐷0 (1 + 𝑔1 )𝑡 here, 𝑡 = 1 𝑡𝑜 𝑁

Step 2: Find the value of the cash dividend, 𝐷𝑁+1 at the end of year 𝑁.
𝐷𝑁+1 = 𝐷0 (1 + 𝑔1 )𝑁 × (1 + 𝑔2 )

Step 3: Find the value of the stock at the end of year 𝑁.

𝐷𝑁+1
𝑃𝑁 =
𝑟 − 𝑔2

Step 4: Add the present value of the dividends found in step 1 and the present value of the value of the stock
at the end of year 𝑁 found in step 3, to find the current value of the stock, 𝑃0 .
𝑁
𝐷0 (1 + 𝑔1 )𝑡 𝑃𝑁
100

𝑃0 = ∑ ( 𝑡
)+
(1 + 𝑟) (1 + 𝑟)𝑁
𝑡=1
Page
Example (Slide 30):
ABC Company has an expected dividend growth rate of 10% for the first 3 years and 5% thereafter. The
company has recently paid Tk. 5 dividend per share. The appropriate discount rate is 15%. What is the value
of the common stock?

Solution:
Here, 𝐷0 = 𝑇𝑘. 5, 𝑔1 = 10% = 0.10, 𝑔2 = 5% = 0.05, 𝑟 = 15% = 0.15

The expected dividends,

𝐷1 = 𝐷0 (1 + 𝑔1 )1 = 5 × (1 + 0.1)1 = 𝑇𝑘. 5.50

𝐷2 = 𝐷0 (1 + 𝑔1 )2 = 5 × (1 + 0.1)2 = 𝑇𝑘. 6.05

𝐷3 = 𝐷0 (1 + 𝑔1 )3 = 5 × (1 + 0.1)3 = 𝑇𝑘. 6.655

𝐷4 = 𝐷0 (1 + 𝑔1 )3 × (1 + 𝑔2 ) = 5 × (1 + 0.1)3 × (1 + 0.05) = 𝑇𝑘. 6.9878

𝐷4 6.9878
Now, 𝑃3 = = = 𝑇𝑘. 69.8775
𝑟 − 𝑔2 0.15 − 0.05

𝐷1 𝐷2 𝐷3 𝑃3
∴ 𝑃0 = 1
+ 2
+ 3
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)3

5.5 6.05 6.655 69.8775

= 1
+ 2
+ 3
+ = 𝑻𝒌. 𝟓𝟗. 𝟔𝟖
(1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15)3

Example (Slide 32):

If the growth rate is 30% for 3 years before achieving long-run growth of 6%, what should be the present
value of this stock? The appropriate discount rate is 13% and the company has recently paid a $2 dividend
per share.

Solution:
Here, 𝐷0 = $2, 𝑔1 = 30% = 0.30, 𝑔2 = 6% = 0.06, 𝑟 = 13% = 0.13

The expected dividends,

𝐷1 = 𝐷0 (1 + 𝑔1 )1 = 2 × (1 + 0.30)1 = $2.60

𝐷2 = 𝐷0 (1 + 𝑔1 )2 = 2 × (1 + 0.30)2 = $3.38

𝐷3 = 𝐷0 (1 + 𝑔1 )3 = 2 × (1 + 0.30)3 = $4.394
101

𝐷4 = 𝐷0 (1 + 𝑔1 )3 × (1 + 𝑔2 ) = 2 × (1 + 0.30)3 × (1 + 0.06) = $4.6576

Page
 𝐷4 4.6576
Now, 𝑃3 = = = $66.5377
𝑟 − 𝑔2 0.13 − 0.06

𝐷1 𝐷2 𝐷3 𝑃3
∴ 𝑃0 = 1
+ 2
+ 3
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)3

2.60 3.38 4.394 66.5377

= 1
+ 2
+ 3
+ = $𝟓𝟒. 𝟏𝟏
(1 + 0.13) (1 + 0.13) (1 + 0.13) (1 + 0.13)3

Formulas:

𝐷1 𝐷2 𝐷𝑛
Basic Stock Valuation 𝑃0 = 1
+ 2
+ ⋯+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑛

𝐷
Zero Growth Model 𝑃0 =
𝑟

𝐷0 (1 + 𝑔) 𝐷1
Constant Growth Model 𝑃0 = =
𝑟−𝑔 𝑟−𝑔

Step 1: Find the value of the cash dividends at the end of each year, 𝐷𝑡 ,
during the initial growth period, years 1 through 𝑁.
𝐷𝑡 = 𝐷0 (1 + 𝑔1 )𝑡 here, 𝑡 = 1 𝑡𝑜 𝑁

Step 2: Find the value of the cash dividend, 𝐷𝑁+1 at the end of year 𝑁.
𝐷𝑁+1 = 𝐷0 (1 + 𝑔1 )𝑁 × (1 + 𝑔2 )

Step 3: Find the value of the stock at the end of year 𝑁.

Variable Growth Model
𝐷𝑁+1
𝑃𝑁 =
𝑟 − 𝑔2

Step 4: Add the present value of the dividends found in step 1 and the
present value of the value of the stock at the end of year 𝑁 found in step
3, to find the current value of the stock, 𝑃0 .
𝑁
𝐷0 (1 + 𝑔1 )𝑡 𝑃𝑁
𝑃0 = ∑ ( ) +
(1 + 𝑟)𝑡 (1 + 𝑟)𝑁
𝑡=1
102
Page
Mathematical Problems

ST7–1 (Slide 34):

Perry Motors’ common stock just paid its annual dividend of $1.80 per share. The required return on the
common stock is 12%. Estimate the value of the common stock under each of the following assumptions
about the dividend:

a. Dividends are expected to grow at an annual rate of 0% to infinity.

b. Dividends are expected to grow at a constant annual rate of 5% to infinity.
c. Dividends are expected to grow at an annual rate of 5% for each of the next 3 years, followed by a
constant annual growth rate of 4% in years 4 to infinity.

Solution:
Here, 𝐷0 = $1.80 and 𝑟 = 12% = 0.12

(a) For Zero Growth Rate,

𝐷0 1.80
𝑃0 = = = $𝟏𝟓
𝑟 0.12

(b) Growth Rate, 𝑔 = 5% = 0.05,

𝐷0 (1 + 𝑔) 1.80 × (1 + 0.05)
𝑃0 = = = $𝟐𝟕
𝑟−𝑔 0.12 − 0.05

(c) Here, 𝑔1 = 5% = 0.05 𝑎𝑛𝑑 𝑔2 = 4% = 0.04

Expected dividends for next four years:

𝐷1 = 𝐷0 (1 + 𝑔1 )1 = 1.80 × (1 + 0.05)1 = $1.89

𝐷2 = 𝐷0 (1 + 𝑔1 )2 = 1.80 × (1 + 0.05)2 = $1.9845

𝐷3 = 𝐷0 (1 + 𝑔1 )3 = 1.80 × (1 + 0.05)3 = $2.0837

𝐷4 = 𝐷0 (1 + 𝑔1 )3 × (1 + 𝑔2 ) = 1.80 × (1 + 0.05)3 × (1 + 0.04) = $2.2754

𝐷4 2.2754
Now, 𝑃3 = = = $28.4425
𝑟 − 𝑔2 0.12 − 0.04

𝐷1 𝐷2 𝐷3 𝑃3
∴ 𝑃0 = 1
+ 2
+ 3
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)3

1.89 1.9845 2.0837 28.4425

= 1
+ 2
+ 3
+
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)3
103

= $𝟐𝟒. 𝟗𝟗𝟕𝟓
Page
E7–5 (Slide 35):
Stacker Weight Loss currently pays an annual year-end dividend of $1.20 per share. It plans to increase this
dividend by 5% next year and maintain it at the new level for the foreseeable future. If the required return
on this firm’s stock is 8%, what is the value of Stacker’s stock?

Solution:
Here, 𝐷0 = $1.20, 𝑔 = 5% = 0.05, 𝑟 = 8% = 0.08

𝐷0 (1 + 𝑔) 1.20 × (1 + 0.05)
Value of the Stacker ′ s Stock, 𝑃0 = = = $𝟒𝟐
𝑟−𝑔 0.08 − 0.05

E7–6 (Slide 36):

Brash Corporation initiated a new corporate strategy that fixes its annual dividend at $2.25 per share forever.
If the risk-free rate is 4.5% and the risk premium on Brash’s stock is 10.8%, what is the value of Brash’s stock?

Solution:
Here, 𝐷 = $2.25, Risk-free rate = 4.5% = 0.045, Risk premium = 10.8% = 0.108

Rate of return = Risk-free rate + Risk premium

= 4.5% + 10.8% = 15.30% = 0.1530

𝐷 2.25
Value of the Stock, 𝑃0 = = = $𝟏𝟒. 𝟕𝟏
𝑟 0.1530

P7–1 (Slide 37):

Aspin Corporation’s charter authorizes issuance of 2,000,000 shares of common stock. Currently, 1,400,000
shares are outstanding, and 100,000 shares are being held as treasury stock. The firm wishes to raise
$48,000,000 for a plant expansion. Discussions with its investment bankers indicate that the sale of new
common stock will net the firm $60 per share.

a. What is the maximum number of new shares of common stock that the firm can sell without receiving
further authorization from shareholders?
b. Judging on the basis of the data given and your finding in part a, will the firm be able to raise the
needed funds without receiving further authorization?
c. What must the firm do to obtain authorization to issue more than the number of shares found in part
a?
104
Page
P7–2 (Slide 38):
Slater Lamp Manufacturing has an outstanding issue of preferred stock with an $80 par value and an 11%
annual dividend.

a. What is the annual dollar dividend? If it is paid quarterly, how much will be paid each quarter?
b. If the preferred stock is noncumulative and the board of directors has passed the preferred dividend
for the last 3 quarters, how much must be paid to preferred stockholders in the current quarter before
dividends are paid to common stockholders?
c. If the preferred stock is cumulative and the board of directors has passed the preferred dividend for
the last 3 quarters, how much must be paid to preferred stockholders in the current quarter before
dividends are paid to common stockholders?

Solution:
Here, Par value = $80

(a) Annual dividend, 𝐷 = $80 × 11% = $𝟖. 𝟖𝟎

8.80
Quarterly dividend = = $𝟐. 𝟐
4

(b) Passed (unpaid) dividends do not accumulate for noncumulative preferred stocks. So, the
company will only pay the dividend of the current quarter which is $2.2.
(c) For cumulative preferred stocks, all passed (unpaid) dividends in arrears, along with the current
dividend, must be paid before dividends can be paid to common stockholders.
So, the amount to be paid to the preferred stockholders in the current quarter = unpaid
dividends + current dividends = 2.2 + 2.2 + 2.2 + 2.2 = $8.8.

P7–4 (Slide 39):

Valerian Corp. convertible preferred stock has a fixed conversion ratio of 5 common shares per 1 share of
preferred stock. The preferred stock pays a dividend of $10.00 per share per year. The common stock
currently sells for $20.00 per share and pays a dividend of $1.00 per share per year.

a. Judging on the basis of the conversion ratio and the price of the common shares, what is the current
conversion value of each preferred share?
b. If the preferred shares are selling at $96.00 each, should an investor convert the preferred shares to
common shares?
105

c. What factors might cause an investor not to convert from preferred to common stock?
Page
P7-5 (Slide 40):
You are a financial analyst for Elite Investment Company, and you are looking for undervalued securities. After
searching the market, you identify Stock A and Stock B as potential purchases. Stock A is currently selling at
$100 with an expected dividend of $6 and constant growth rate of 5%, while Stock B is a preferred stock,
currently selling at $60 with a $5 dividend paid each year. Answer the following questions on the basis that
you believe the required rates of return for both stocks should be 10%:

a. How much would you pay for Stock A?

b. How much would you pay for Stock B?
c. Which security is undervalued? Why?

Solution:
Here, 𝐷𝐴 = $6, 𝑔𝐴 = 5% = 0.05, Selling Price of Stock A = $100
𝐷𝐵 = $5, Selling Price of Stock B = $60, 𝑟 = 10% = 0.10

(a) Value of Stock A,

𝐷𝐴 (1 + 𝑔𝐴 ) 6 × (1 + 0.05)
𝑃𝐴 = = = $𝟏𝟐𝟔
𝑟 − 𝑔𝐴 0.10 − 0.05

(b) Value of Stock B,

𝐷𝐵 5
𝑃𝐵 = = = $𝟓𝟎
𝑟 0.10

(c) Based on the calculations in part a and b, the value of Stock A is $126, whereas its selling price is
$100, and the value of Stock B is $50, whereas its selling price is $60. So, Stock A is undervalued,
because it is selling at a lower price than its value.

P7–10 (Slide 41):

The common stock of Denis and Denis Research, Inc., trades for $60 per share. Investors expect the company
to pay a $3.90 dividend next year, and they expect that dividend to grow at a constant rate forever. If investors
require a 10% return on this stock, what is the dividend growth rate that they are anticipating?

Solution:
Here, 𝐷1 = $3.90, 𝑃0 = $60, 𝑟 = 10% = 0.10

𝐷1
Now, 𝑃0 =
𝑟−𝑔
106

𝐷1 3.90
∴𝑔=𝑟− = 0.10 − = 0.035 = 𝟑. 𝟓%
𝑃0 60
Page
P7–12 (Slide 42):
You are analyzing the stock of First Health Company, a healthcare company with a current stock price of $78.
The company just paid an annual dividend of $5, and it is expected that the dividend will grow at 4% in the
coming two years and then increase by 5% per year thereafter. You estimate that the required return of the
stock is 12%. Estimate the stock price of First Health Company by using a two-stage dividend discount model.
Is the stock fairly priced, overpriced, or underpriced?

Solution:
Here, 𝐷0 = $5, 𝑃0 = $78, 𝑔1 = 4% = 0.04, 𝑔2 = 5% = 0.05, 𝑟 = 12% = 0.12

Expected dividends for next three years:

𝐷1 = 𝐷0 (1 + 𝑔1 )1 = 5 × (1 + 0.04)1 = $5.2

𝐷2 = 𝐷0 (1 + 𝑔1 )2 = 5 × (1 + 0.04)2 = $5.408

𝐷3 = 𝐷0 (1 + 𝑔1 )2 (1 + 𝑔2 ) = 5 × (1 + 0.04)2 × (1 + 0.05) = $5.6784

𝐷3 5.6784
Now, 𝑃2 = = = $81.12
𝑟 − 𝑔2 0.12 − 0.05

𝐷1 𝐷2 𝑃2
∴ 𝑃0 = 1
+ 2
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)2

5.2 5.408 81.12

= 1
+ 2
+ = $𝟕𝟑. 𝟔𝟐
(1 + 0.12) (1 + 0.12) (1 + 0.12)2

The stock is overpriced, because the current stock price is $78, which is higher than the fair value of the
stock is $73.62.

P7–13 (Slide 43):

Home Place Hotels, Inc., is entering into a 3-year remodeling and expansion project. The construction will
have a limiting effect on earnings during that time, but when it is complete, it should allow the company to
enjoy much improved growth in earnings and dividends. Last year, the company paid a dividend of $3.40. It
expects zero growth in the next year. In years 2 and 3, 5% growth is expected, and in year 4, 15% growth. In
year 5 and thereafter, growth should be a constant 10% per year. What is the maximum price per share that
an investor who requires a return of 14% should pay for Home Place Hotels common stock?

Solution:
107

Here, 𝐷0 = $3.40, 𝑔1 = 5% = 0.05, 𝑔2 = 15% = 0.15, 𝑔3 = 10% = 0.10

𝑟 = 14% = 0.14
Page
Expected dividends for next five years:
𝐷1 = 𝐷0 = 3.40

𝐷2 = 𝐷0 (1 + 𝑔1 )1 = 3.40 × (1 + 0.05)1 = $3.57

𝐷3 = 𝐷0 (1 + 𝑔1 )2 = 3.40 × (1 + 0.05)2 = $3.7485

𝐷4 = 𝐷0 (1 + 𝑔1 )2 (1 + 𝑔2 ) = 3.40 × (1 + 0.05)2 × (1 + 0.15) = $4.3108

𝐷5 = 𝐷0 (1 + 𝑔1 )2 (1 + 𝑔2 )(1 + 𝑔3 ) = 3.40 × (1 + 0.05)2 × (1 + 0.15) × (1 + 0.10) = $4.7419

𝐷5 4.7419
Now, 𝑃4 = = = $118.5475
𝑟 − 𝑔3 0.14 − 0.10

𝐷1 𝐷2 𝐷3 𝐷4 𝑃4
∴ 𝑃0 = 1
+ 2
+ 3
+ 4
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)4

3.40 3.57 3.7485 4.3108 118.5475

= 1
+ 2
+ 3
+ 4
+ = $𝟖𝟏
(1 + 0.14) (1 + 0.14) (1 + 0.14) (1 + 0.14) (1 + 0.14)4

P7–14 (Slide 44):

Lawrence Industries’ most recent annual dividend was $1.80 per share (𝐷0 = $1.80), and the firm’s required
return is 11%. Find the market value of Lawrence’s shares when:

a. Dividends are expected to grow at 8% annually for 3 years, followed by a 5% constant annual growth
rate in years 4 to infinity.
b. Dividends are expected to grow at 8% annually for 3 years, followed by a 0% constant annual growth
rate in years 4 to infinity.
c. Dividends are expected to grow at 8% annually for 3 years, followed by a 10% constant annual growth
rate in years 4 to infinity.

Solution:
Here, 𝐷0 = $1.80, 𝑟 = 11% = 0.11

(a) Given, 𝑔1 = 8% = 0.08, 𝑔2 = 5% = 0.05

Expected dividends for next four years:

𝐷1 = 𝐷0 (1 + 𝑔1 )1 = 1.80 × (1 + 0.08)1 = $1.9440

𝐷2 = 𝐷0 (1 + 𝑔1 )2 = 1.80 × (1 + 0.08)2 = $2.0995

𝐷3 = 𝐷0 (1 + 𝑔1 )3 = 1.80 × (1 + 0.08)3 = $2.2675

108

𝐷4 = 𝐷0 (1 + 𝑔1 )3 (1 + 𝑔2 ) = 1.80 × (1 + 0.08)3 × (1 + 0.05) = $2.3809

Page
 𝐷4 2.3809
Now, 𝑃3 = = = $39.6817
𝑟 − 𝑔2 0.11 − 0.05

𝐷1 𝐷2 𝐷3 𝑃3
∴ 𝑃0 = 1
+ 2
+ 3
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)3

1.9440 2.0995 2.2675 39.6817

= 1
+ 2
+ 3
+ = $𝟑𝟒. 𝟏𝟑
(1 + 0.11) (1 + 0.11) (1 + 0.11) (1 + 0.11)3

(b) Given, 𝑔1 = 8% = 0.08, 𝑔2 = 0%

Expected dividends for next four years:

𝐷1 = 𝐷0 (1 + 𝑔1 )1 = 1.80 × (1 + 0.08)1 = $1.9440

𝐷2 = 𝐷0 (1 + 𝑔1 )2 = 1.80 × (1 + 0.08)2 = $2.0995

𝐷3 = 𝐷0 (1 + 𝑔1 )3 = 1.80 × (1 + 0.08)3 = $2.2675

𝐷4 = 𝐷0 (1 + 𝑔1 )3 (1 + 𝑔2 ) = 1.80 × (1 + 0.08)3 × (1 + 0) = $2.2675

𝐷4 2.2675
Now, 𝑃3 = = = $20.6136
𝑟 0.11

𝐷1 𝐷2 𝐷3 𝑃3
∴ 𝑃0 = 1
+ 2
+ 3
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)3

1.9440 2.0995 2.2675 20.6136

= 1
+ 2
+ 3
+ = $𝟐𝟎. 𝟏𝟗
(1 + 0.11) (1 + 0.11) (1 + 0.11) (1 + 0.11)3

(c) Given, 𝑔1 = 8% = 0.08, 𝑔2 = 10% = 0.10

Expected dividends for next four years:

𝐷1 = 𝐷0 (1 + 𝑔1 )1 = 1.80 × (1 + 0.08)1 = $1.9440

𝐷2 = 𝐷0 (1 + 𝑔1 )2 = 1.80 × (1 + 0.08)2 = $2.0995

𝐷3 = 𝐷0 (1 + 𝑔1 )3 = 1.80 × (1 + 0.08)3 = $2.2675

𝐷4 = 𝐷0 (1 + 𝑔1 )3 (1 + 𝑔2 ) = 1.80 × (1 + 0.08)3 × (1 + 0.10) = $2.4942

𝐷4 2.4942
Now, 𝑃3 = = = $249.42
𝑟 − 𝑔2 0.11 − 0.10

𝐷1 𝐷2 𝐷3 𝑃3
∴ 𝑃0 = 1
+ 2
+ 3
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)3

1.9440 2.0995 2.2675 249.42

= + + + = $𝟏𝟖𝟕. 𝟒𝟗
109

(1 + 0.11)1 (1 + 0.11)2 (1 + 0.11)3 (1 + 0.11)3

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7-16 (Slide 45):
Microtech Corporation is expanding rapidly. Because it needs to retain all of its earnings. It does not currently
pay any dividends. Investors expect Microtech to begin paying dividends eventually, with the first dividend
of $1.00 coming three years from today. The dividend should grow rapidly–at a rate of 50 percent per year–
during Years 4 and 5. After Year 5, the company should grow at a constant rate of 8 percent per year. If the
required return on the stock is 15 percent, what is the value of the stock today?

Solution:
Here, 𝐷0 = $0, 𝑔1 = 50% = 0.50, 𝑔2 = 8% = 0.08, 𝑟 = 15% = 0.15

Expected dividends for next six years:

𝐷1 = 0

𝐷2 = 0

𝐷3 = $1.00

𝐷4 = 𝐷3 (1 + 𝑔1 )1 = 1.00 × (1 + 0.50)1 = $1.50

𝐷5 = 𝐷3 (1 + 𝑔1 )2 = 1.00 × (1 + 0.50)2 = $2.25

𝐷6 = 𝐷3 (1 + 𝑔1 )2 (1 + 𝑔2 ) = 1.00 × (1 + 0.50)2 × (1 + 0.08) = $2.43

𝐷6 2.43
Now, 𝑃5 = = = $34.7143
𝑟 − 𝑔2 0.15 − 0.08

𝐷1 𝐷2 𝐷3 𝐷4 𝐷5 𝑃5
∴ 𝑃0 = + + + + +
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4 (1 + 𝑟)5 (1 + 𝑟)5

1.00 1.50 2.25 34.7143

= 0+0+ + + + = $𝟏𝟗. 𝟖𝟗
(1 + 0.15)3 (1 + 0.15)4 (1 + 0.15)5 (1 + 0.15)5

7-19 (Slide 46):

Sanger Music Company's preferred stock, which currently sells for $105 per share, pays an annual dividend
equal to $12.60. What is the yield–that is, the rate of return–that Sanger's preferred stockholders earn?

Solution:
Here, 𝐷0 = $12.60, 𝑃0 = $105

𝐷0
Now, 𝑃0 =
𝑟
𝐷0 12.60
⇒ 𝑟= = = 0.12 = 𝟏𝟐%
110

𝑃0 105
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7-12 (Slide 47):
Investors require a 15 percent rate of return on Goulet Company's stock (𝑟𝑠 = 15%).
a. What will be Goulet's stock value if the previous dividend was 𝐷0 = $2 and if investors expect dividends
to grow at a constant compound annual rate of (1) – 5 percent, (2) 0 percent, (3) 5 percent, and (4) 10
percent?
b. Using data from part a, calculate the value for Goulet 's stock if the required rate of return is 15 percent
and the expected growth rate is (1) 15 percent or (2) 20 percent. Are these results reasonable? Explain.
c. Is it reasonable to expect that a constant growth stock would have 𝑔 > 𝑟𝑠 ?

Solution:
Here, 𝑟𝑠 = 15% = 0.15

(a) Given, 𝐷0 = $2

(1) Growth rate, 𝑔 = −5% = −0.05

𝐷0 (1 + 𝑔) 2(1 − 0.05)
Now, 𝑃0 = = = $𝟗. 𝟓
𝑟−𝑔 0.15 + 0.05
(2) Growth rate, 𝑔 = 0%
𝐷0 2
Now, 𝑃0 = = = $𝟏𝟑. 𝟑𝟑
𝑟 0.15
(3) Growth rate, 𝑔 = 5% = 0.05
𝐷0 (1 + 𝑔) 2(1 + 0.05)
Now, 𝑃0 = = = $𝟐𝟏
𝑟−𝑔 0.15 − 0.05
(4) Growth rate, 𝑔 = 10% = 0.10
𝐷0 (1 + 𝑔) 2(1 + 0.10)
Now, 𝑃0 = = = $𝟒𝟒
𝑟−𝑔 0.15 − 0.10

(b) Given, 𝐷0 = $2

(1) Growth rate, 𝑔 = 15% = 0.15

𝐷0 (1 + 𝑔) 2(1 + 0.15)
Now, 𝑃0 = = =∞
𝑟−𝑔 0.15 − 0.15
(2) Growth rate, 𝑔 = 20% = 0.20
𝐷0 (1 + 𝑔) 2(1 + 0.20)
Now, 𝑃0 = = = −$𝟒𝟖
𝑟−𝑔 0.15 − 0.20

The results for both growth rates are not reasonable because they lead the stock values to infinite
or negative. These outcomes indicate that the given combination of growth rates and required
rate of return for Goulet Company's stock does not align logically with the constant growth
111

model. The model assumes that the growth rate should be less than the required rate of return.
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(c) In the context of the Constant Growth Model, it's generally unrealistic to expect a constant
growth stock to have a growth rate higher than the required discount rate. This situation can lead
to mathematically invalid valuations. Typically, the growth rate should be lower than the
required rate of return for the model to generate meaningful and positive stock valuations.

7-17 (Slide 48):

̂1 =
Bayboro Sails is expected to pay dividends of $2.50, $3.00, and $4.00 in the next three years–that is, D
̂ 2 = $3.00, and D
$2.50, D ̂ 3 = $4.00, respectively. After three years, the dividend is expected to grow at a

constant rate of 4 percent per year indefinitely. Stockholders require a return of 14 percent to invest in
Bayboro’s common stock. Compute the value of Bayboro’s common stock today.

Solution:
Here, 𝐷1 = $2.50, 𝐷2 = $3.00, 𝐷3 = $4.00, 𝑔 = 4% = 0.04, 𝑟 = 14% = 0.14

𝐷3 (1 + 𝑔) 4 × (1 + 0.04)
Now, 𝑃3 = = = $41.60
𝑟−𝑔 0.14 − 0.04

𝐷1 𝐷2 𝐷3 𝑃3
∴ 𝑃0 = 1
+ 2
+ 3
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)3

2.50 3.00 4.00 41.60

= + + + = $𝟑𝟓. 𝟐𝟖
(1 + 0.14)1 (1 + 0.14)2 (1 + 0.14)3 (1 + 0.14)3

112
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