Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 1/54

Principles of Finance

Topic 1 Financial Decision Making and Time Value of Money

Section 1: Financial Decision Making

Dr Yue (Lucy) Liu

University of Edinburgh Business School

Slides are based on Chapter 3 in Berk and DeMarzo (3rd edition)

Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 2/54

Outline

1 Valuing decisions Competitive market price

2 Interest rates and the time value of money Compare price at different points in time

3 Present value and the NPV decision rule Evaluate projects (costs and benefits)

4 Arbitrage and the law of one price Always competitive market price?

5
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 3/54
Valuing decisions

Outline

1 Valuing decisions

2 Interest rates and the time value of money

3 Present value and the NPV decision rule

4 Arbitrage and the law of one price

5
Principles of Finance | Topic 1 - Section1: Financial Decision Making | 4/54
Valuing decisions

1 What is a good investment decision?

It is a decision that increases firm value.

2 How would the firm value increase?

If the value of benefits brought by the decision exceeds the value of costs
brought by it.

3 How do we measure the value of benefits and costs?

We use market prices.
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 5/54
Valuing decisions

Valuation principle

An asset has a unique value, if it is traded on a competitive market. This

value is its competitive market price.

The asset has a range of values, if it is not traded on a competitive

market. This range of values depends on the individual’s preferences
and tastes.

In a competitive market, assets can be bought and sold at the same

price.

If an asset is not traded on a competitive market it may not be traded at

the same price.
Your grandmother gave you 10 ounces of gold,
the current market price is £8,000.

• You don’t need the gold

• You think the current price of gold is too high

Would you value the gold at less than £8,000?

No. You can always sell at £8,000.

Whether the price is fair (view)
It doesn’t matter!
Whether you will use the gold (preference)
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 7/54
Interest rates and the time value of money

Outline

1 Valuing decisions

2 Interest rates and the time value of money Compare benefits and costs that
occur at different points in time?

3 Present value and the NPV decision rule

4 Arbitrage and the law of one price

55
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 8/54
Interest rates and the time value of money

The time value of money

In general, £1 today is worth more than £1 in one year.

You can save your £1, and earn more than £1 in one year.

The amount you earn is determined by the interest rate.

Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 9/54
Interest rates and the time value of money

Future Value

You can deposit £1,000 in your savings account today. The savings rate
is 10% per annum.

How much will you have in your savings account in 1 year?

“What is the future value of your present savings?”

FV = (1 + r ) × Present Savings = (1.1) × £1, 000 = £1, 100

(1 + r ) is the compounding factor.

£1,000 today is worth more in one year, hence the compounding.

Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 10/54
Interest rates and the time value of money

Present Value

You want to have £1,100 in your savings account in one year. The
savings rate is 10% per annum.

How much do you need to save today?

“What is the present value of your future savings?”

Future Savings £1,100

PV = = = £1, 000
1+r 1.1

1/(1 + r ) is the discount factor.

£1,100 in one year is worth less today, hence the discounting.

Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 11/54
Present value and the NPV decision rule

Outline

1 Valuing decisions

2 Interest rates and the time value of money

3 Present value and the NPV decision rule

4 Arbitrage and the law of one price

5
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 12/54
Present value and the NPV decision rule

Example 1: Choosing among job offers

You received two 1-year job offers. The first one promises to pay you £1,000
in advance (i.e., today, before the job is done). The second one promises to
pay you £1,210 in arrears (i.e., in 1 year, once the job is done). Which offer
should you take if the market interest rate is 10%?
You cannot compare £1,000 today with £1,210 in 1 year, because they
are at different points in time.

You need to calculate either the future value of £1,000, or the present
value of £1,210.
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 13/54
Present value and the NPV decision rule

Solution 1a: Choosing among job offers

1 Calculate the future value of £1,000:

FV = (1 + r ) × Present Salary = (1.1) × £1, 000 = £1, 100

2 Compare the future value of £1,000, with £1,210 in 1 year:

£1, 100 < £1, 210

3 Make your decision:

Accept the second job offer.
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 14/54
Present value and the NPV decision rule

Solution 1b: Choosing among job offers

1 Calculate the present value of £1,210:

Future Salary £1,210
PV = = = £1,100
1+r 1.1

2 Compare the present value of £1,210, with £1,000:

£1, 100 > £1, 000

3 Make your decision:

Accept the second job offer.
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 15/54
Present value and the NPV decision rule

Net present value of a project is the present value of the project’s

benefits minus the present value of its costs:

NPV = PV (Benefits) − PV (Costs) (1)

Accept positive NPV projects, because they add value.

If two projects are mutually exclusive, select the one with the higher
NPV, because it adds more value.

Sign
Magnitude
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 16/54
Present value and the NPV decision rule

Example 2: Buying a house as an investment

You are thinking of buying a house as an investment today for £205,000. Your
real estate expert is sure that you can sell this house next year for £222,000.
If the market interest rate is 11%, what should you do?

1 Calculate the net present value of this investment:

NPV (Investment) = PV (Sell in 1 year ) − PV (Purchase now )

£222, 000
= − £205, 000
1.11
= −£5, 000

2 Make your decision:

Do not invest in the house.
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 17/54
Arbitrage and the law of one price

Outline

1 Valuing decisions

2 Interest rates and the time value of money

3 Present value and the NPV decision rule

4 Arbitrage and the law of one price Is there always only one competitive price?

55
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 18/54
Arbitrage and the law of one price

Arbitrage opportunity

Suppose gold is trading for $1,000 per ounce in New York and £800 in
London. Moreover, the exchange rate is 1.5$ / £.

Can you devise a trading strategy that exploits these prices and
generates riskless profit?

The answer is yes: buy cheap, sell high.

First, let’s have a common currency for the price of gold. The price in
London is £800 × 1.5$/£=$1,200. Thus, gold is cheaper in New York.
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 19/54
Arbitrage and the law of one price

Then, your strategy is:

1 Buy 1 ounce of gold in New York for $1,000.

2 Sell it in London for £800.

3 Convert £800 into $1,200.

4 Your profit (or NPV) per ounce is $1,200 - $1,000 = $200.

If you repeat this trading strategy for 10,000 ounces, your profit is 10,000
ounces × $200/ounce = $2 million. You are an instant millionaire!
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 20/54
Arbitrage and the law of one price

Why would this not work?

Because, you would not be the only one following this trading strategy!

New York would be flooded with buy orders which would push the price
of $1,000/ounce up.

London would be flooded with sell orders which would pull the price of
£800/ounce down.

Prices would meet somewhere in the middle. For instance $1,050/ounce

in New York and £700/ounce in London.
Principles of Finance | Topic 1 - Section1: Financial Decision Making | Slide 21/54
Arbitrage and the law of one price

A trading strategy that yields profit without taking risk or making any
investment is an arbitrage opportunity.

Only few investors who spot the opportunity first may benefit from it, and
only for a very brief amount of time.

Arbitrage opportunities are like money lying in the street; once spotted,
they will quickly disappear.The normal state in markets should be
that no arbitrage opportunities exist.

The Law of One Price: equivalent investment opportunities must trade

for the same price in different competitive markets.
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 22/54

Principles of Finance

Topic 1 Financial Decision Making and Time Value of Money

Section 2: Time Value of Money

Dr Yue (Lucy) Liu

University of Edinburgh Business School

Slides are based on Chapter 4 & 5 in Berk and DeMarzo (3rd edition)
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 23/54

Outline

1 The three rules of time travel

2 Valuing a stream of cash flows

3 Perpetuities, annuities, and other special cases

4 Interest rate quotes and adjustments

5 The determinants of interest rates

6
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 24/54
Timeline

Outline

1 The three rules of time travel

2 Valuing a stream of cash flows

3 Perpetuities, annuities, and other special cases

4 Interest rate quotes and adjustments

5 The determinants of interest rates

6
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 25/54
The three rules of time travel

1 It is only possible to compare or combine values at the same point in

time.

2 To move a cash flow forward in time you must compound it.

3 To move a cash flow back in time you must discount it.

Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 26/54
The three rules of time travel

Example 1

Suppose you deposit $1,000 into a savings account today. Your bank pays an
interest of 10% each year. How much savings will you have in 3 years?
1 Calculate the value of savings at the end of year 1:

V1 = (1 + r) × $1, 000 = (1.1) × $1, 000 = $1, 100

2 Calculate the value of savings at the end of year 2:

V2 = (1 + r) × V1 = (1.1) × $1, 100 = $1, 210

3 Calculate the value of savings at the end of year 3:

FV = (1 + r ) × V2 = (1.1) × $1, 210 = $1, 331

Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 27/54
The three rules of time travel

Notice that we can rewrite FV as follows:

FV = (1.1) × V2
= (1.1) × (1.1) × V1
= (1.1) × (1.1) × (1.1) × $1, 000

A mathematically convenient way of writing this is:

3
FV = (1.1) × $1, 000

In general, for a fixed market interest rate r , the future value of a single cash
flow C that is compounded n periods forwards is:
n
FV = (1 + r ) × C
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 28/54
The three rules of time travel

Example 2

Suppose you want to have $1,000 in a savings account in three years. Your
bank pays an interest of 10% each year. How much do you need to save
today?
1 Calculate the value of savings at the end of year 2:

V2 = $1, 000/(1 + r) = $1, 000/1.1 = $909.09

2 Calculate the value of savings at the end of year 1:

V1 = V2/(1 + r) = $909.09/1.1 = $826.45

3 Calculate the value of savings now:

PV = V1/(1 + r ) = $826.45/1.1 = $751.31

Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 29/54
The three rules of time travel

Notice that we can rewrite PV as follows:

PV = V1/(1 + r)
= V2/(1 + r)/(1 + r)
= $1, 000/(1 + r )/(1 + r )/(1 + r )

A mathematically convenient way of writing this is:

3
PV = $1, 000/(1.1)

In general, for a fixed market interest rate r , the present value of a single
cash flow C that is discounted n periods backwards is:
n
PV = C/(1 + r )
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 30/54
The three rules of time travel

The present value of a single cash flow is:

C
PV (single) = n
(1 + r )
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 31/54
Valuing a stream of cash flows

Outline

1 The three rules of time travel

2 Valuing a stream of cash flows

3 Perpetuities, annuities, and other special cases

4 Interest rate quotes and adjustments

5 The determinants of interest rates

6
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 32/54
Valuing a stream of cash flows

Most investment opportunities have multiple cash flows that occur at

different points in time.

How do we value a stream of cash flows?:

1 Compute the present value of each single cash flow.

2 Add these present values up.

Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 33/54
Valuing a stream of cash flows

Figure: PV of a cash flow stream

Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 34/54
Valuing a stream of cash flows

The present value of each single cash flow is:

0
PV (C0) = C0/(1 + r)
1
PV (C1) = C1/(1 + r)
.
.
.
.
N
PV (CN ) = CN/(1 + r)

The present value of this stream of cash flows is:

PV = PV (C0) + PV (C1) + · · · + PV (CN )

C0 C1 CN
= + + ··· + N
1
(1 + r )
0
(1 + r ) (1 + r )

A mathematically convenient way of writing this is:

N
Cn
PV = ∑ (1 + r )n
n=0
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 35/54
Valuing a stream of cash flows

The present value of a stream of cash flows is:

N
Cn
PV (stream) = ∑
n=0
(1 + r )n
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 36/54
Perpetuities, annuities, and other special cases

Outline

1 The three rules of time travel

2 Valuing a stream of cash flows

3 Perpetuities, annuities, and other special cases

4 Interest rate quotes and adjustments

5 The determinants of interest rates

6
Example: Consol bonds

Promise a fixed CF every year, forever.

C C C C C C C C
. . . .
…………
1 2 3 4 5 6 7 8
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 37/54
Perpetuities, annuities, and other special cases

Perpetuity

A perpetuity is a special stream of cash flows such that it pays the same
cash flow at regular intervals for an infinite number of periods. Remember the
formula for the PV of a stream of cash flows:

N Cn
PV = ∑ n
n=0 (1 + r )

For a perpetuity, C0 = 0, Cn = C and N = ∞:

∞ C
PV = ∑ n
n=1 (1 + r )

This simplifies into:

C
PV =
r
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 19/36

of Mathematical Derivation of the Perpetuity Formula

Perpetuities, annuities, and other special cases

Perpetuity
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 38/54
Perpetuities, annuities, and other special cases

The present value of a perpetuity is:

C
PV (perpetuity ) =
r
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 39/54
Perpetuities, annuities, and other special cases

Example 3

A bank offers to pay you £100 every year and forever, if you deposit £600
today. Would you accept this offer if the market interest rate is 20%?

At first sight the offer is attractive, but mind the time value of money.

Calculate the NPV:

NPV = PV (being paid £100 perpetually) − PV (paying £600)

£100
= − £600 = −£100
0.20

Make your decision:

Reject the offer.
Examples: mortgages, car loans, some bonds…

Promise a fixed CF every year for 8 years.

C C C C C C C C
. . . .

1 2 3 4 5 6 7 8
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 41/54
Perpetuities, annuities, and other special cases

Annuity

An annuity is another special stream of cash flows such that it pays the
same cash flow at regular intervals for a finite number of periods. Again,
remember the formula for the PV of a stream of cash flows:

N Cn
PV = ∑ (1 + r )n
n=0

For an annuity, C0 = 0 and Cn = C:

N
C
PV = ∑ n
n=1 (1 + r )

This simplifies into:

C C
PV = −
r r (1 + r )N
 Principles of More Intuitive Derivation?
Perpetuity C C
E.g. N=3, then we have PV (annuity ) = r − 3
r (1 + r )

0 1 2 3
Perpetuity 1 … C
PV (Perpetuity 1) =
C r
C C

C
3 4 5 6 V at time point 3 (Perpetuity 2) = r
Perpetuity 2 …
C C C
V at time point 3
PV at time point 0 (Perpetuity 2) = 3
(1+ r)

C
= 3
r (1+ r)

0 1 2 3
Annuity PV (Annuity) = PV (perpetuity 1) – PV (Perpetuity 2)
C C C C
C
PV (annuity ) = -
3
r r (1 + r )
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 43/54
Perpetuities, annuities, and other special cases

The present value of an annuity is:

C C
PV (annuity ) = −
r r (1 + r )N
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 44/54
Perpetuities, annuities, and other special cases

Example 4

A friend of yours offers to sell you his car for £2,000. You would really like to
buy this car, but you do not have any cash at the moment. You decide to
borrow money from a bank. You can pay the bank back in equal amounts
over 10 years. How much will the bank ask you to pay each year if the market
interest rate is 9%?

Plug the numbers into the annuity formula:

C C
£2, 000 =
0.09
- 0.09(1 + 0.09)10
Solve for C:
1 1
C = £2,000 / (
0.09
- 0.09(1 + 0.09) 10
) = £311.64
Examples: other cashflow patterns…

Growing perpetuity

C(1+g)2
C(1+g)
C
…………
1 2 3
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 46/54
Perpetuities, annuities, and other special cases

Growing Perpetuity and Annuity

The present value of a growing perpetuity is:

C
PV (g.perpetuity ) =
r −g
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 47/54
Perpetuities, annuities, and other special cases

Outline

1 The three rules of time travel

2 Valuing a stream of cash flows

3 Perpetuities, annuities, and other special cases

4 Interest rate quotes and adjustments

5 The determinants of interest rates

6
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 48/54
Interest rate quotes and adjustments

Annual percentage rate (APR) versus effective annual rate (EAR)

APR indicates the amount of simple interest earned in one year.

EAR indicates the amount of total interest earned in one year.

If interest is paid m times in a year, then:

APR m
1 + EAR = ( 1 + )
m

If interest is paid continuously in a year, then:

1 + EAR = eAPR
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 49/54
Interest rate quotes and adjustments

APR EAR
6% compounded annually: (1 + 0.06/1)1 − 1 = 6.000%

6% compounded semiannually: (1 + 0.06/2)2 − 1 = 6.090%

6% compounded monthly: (1 + 0.06/12)12 − 1 = 6.168%

6% compounded daily: (1 + 0.06/365)365 − 1 = 6.183%

6% compounded continuously: e0.06 − 1 = 6.184%

Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 50/54
The determinants of interest rates

Outline

1 The three rules of time travel

2 Valuing a stream of cash flows

3 Perpetuities, annuities, and other special cases

4 Interest rate quotes and adjustments

5 The determinants of interest rates

6
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 51/54
The determinants of interest rates

The interest rates that banks offer on investments or charge on loans

depend on the term of the investment or loan.

The relationship between the investment term and the interest rate is
called the term structure of interest rates.

The term structure is determined in the market based on the individuals’

willingness to borrow and lend.

What factors could influence individuals’ willingness to borrow and lend?

• Inflation rr ≈ r-i
• Government policy (e.g. raise interest rates to reduce investment if “overheating”)
• Expectations of future growth / future interest rate changes
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 52/54
The determinants of interest rates

• Decreasing (inverted) yield curve indicates: interest rates are

expected to decline in the future.
• It is often interpreted as a negative forecast for economic growth.

Increasing (steep) yield curve indicates:

interest rates are expected to rise in the future.

Figure: Term structure of risk-free U.S. interest rates

Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 53/54
The determinants of interest rates

The present value of a stream of cash flows, given a

term structure of discount rates is:

N
Cn
PV (stream | term structure) = ∑ n
n=0 (1 + rn )
Principles of Finance | Topic 1 - Section2: Time Value of Money | Slide 54/54
The determinants of interest rates

Concepts in Section 2

Perpetuity: a special stream of cash flow that pays the same amount
regularly for an infinite number of periods.

Annuity: a special stream of cash flow that pays the same amount
regularly for a finite number of periods.

APR: the annual interest rate that indicates the simple interest earned.

EAR: the annual interest rate that indicates the total interest earned.

Term structure: it shows the relationship between the interest rates and
the term of investment.