L1 - Time Value of Money & Analysis of Financial Statements

MSc Economics & Strategy
for Business
Corporate Finance
Lecture Notes 1
Course Structure
Instructor:
▪ Iva Koci – Postdoctoral Research Associate @ Imperial Business School
i.koci@ic.ac.uk
Textbook:
Berk and Demarzo
Readings on Insendi
Imperial College Business School Imperial means Intelligent Business 2

My background
Academic Background:
Postdoc at the Finance Department @Imperial College Business School
Research Associate @CCFI
PhD in Finance @Kings College London
MSc Finance @VU University Amsterdam
Professional Experience :
Fixed Income Researcher @Robeco Asset Management
Valuation Associate @Deloitte
Research Focus:
Sustainable Investments
Climate Finance

What is Corporate Finance?
Corporate Finance is about financial decisions made by corporations:
1. Investment Decisions: How to value an investment opportunity?

▪ Should Apple introduce a new Mac product?
▪ Should Microsoft acquire LinkedIn?
▪ Should GAP open new stores? Should they buy or lease the shops?
2. Financing Decisions: How to finance corporate activities:

▪ P&G want to expand the healthcare sector. Should they issue more stock or borrow?
Short- or long-term?
▪ Should Dropbox go public with an IPO?
▪ Should Facebook keep its profits in cash, or pay it out as dividends or share
repurchase?

Corporations – Flow of Cash

Course Structure
Assessment:
▪ 2 team work case studies (30%)
- 1st case due on 14th November
- 2nd case due on 25th November
▪ Final Exam (70%) 16th December
Calendar
▪ 10 two-hour Lectures & 4 one-hour Tutorials over 5 weeks
▪ Lectures: Mondays & Wednesdays
▪ Tutorials: Thursdays

Course Overview
Primer
1. Time Value of Money 2. Analysis of Financial Statements
Company Valuation
Financing Decisions
Investment Decisions 1. DCF Method:
1. Bond Valuation
1. Capital Budgeting a. Forecast CFs
2. Equity Valuation
2. NPV/IRR/Payback b. Discount rate
3. Capital Structure
2. Relative Valuation

Week by Week
Week 1:
24 October Financial Statements Analysis Chapters 1, 2 & 4
26 October Capital Budgeting (NPV & IRR) Chapters 5, 7 & 8
Week 2:
31 October Bonds Chapters 3 & 6
2 November Capital Asset Pricing Method Chapter 10 & 11
Week 3:
7 November Equity Valuation Chapters 9
9 November Financing Investment Chapters 14 & 15
Assignment 1 deadline 14 November
Week 4:
14 November Business Valuation – Case Study Chapters 19
16 November Climate Finance -- Academic Papers --
Week 5:
21 November Revision Session
23 November Introduction to Valuation – Guest Speaker (not assessed)
Assignment 2 deadline 25 November

Course Aim
Analyse how managers raise capital and make investment decisions.
- Evaluate different investment opportunities;

- Evaluate different methods of raising capital, and selecting the capital
structure of the firm;
- Apply these skills to determine the value of entire companies.
- Understand the theory behind corporate finance.

- Understand practical aspects of corporate finance and apply theory in real-
world business situations.
- Understand the wider context of the workings of financial markets and
financial institutions.
- No prerequisites (just Excel at basic level)

Your expectations

Course Overview
Primer
Company Valuation
Financing Decisions
1. Bond Valuation
2. Equity Valuation

Time Value of Money

Time Value of Money
Imagine a simple investment opportunity with the following cash flows:

Cost: £1,000 today
Benefit: £1,030 in one year
Can we judge the opportunity as valuable by noting that £1,030 > £1,000?
No! £1 today is worth more than £1 tomorrow.
- In order to compare cash flows, those should be expressed in terms of money

at the same point in time
- The difference in value between money today and money in the future is due to
the time value of money.

The Timeline
Assume that you make a loan of £1,000 to a friend. You will be repaid in two
annual payments of $600 each, one at the end of each year over the next 2
years.
Year 1 Year 2
Date 0 1 2
Cash Flow -£1,000 $600 $600

Rules of Time Travel
Discount Rate
Interest rate used to compute present
value of future cash flows
Future Value
Present Value Amount to which an
Value today of a investment will grow
future cash flow after earning interest
Discount Factor
Present value of a £1 future payment

Future Value
To move a cash flow forward in time, you must compound it.

Suppose you invest £1,000 in an account paying 10% interest per year.
Year 1 Year 2
Date 0 1 2
Cash Flow £1,000 $1,100 $1,210

x 1.10 x 1.10
The future value of a cash flow C in year n is given by:

𝐹𝑉𝑛 = 𝐶 𝑥 1 + 𝑟 𝑥 1 + 𝑟 𝑥 … . 1 + 𝑟 = 𝐶 𝑥 (1 + 𝑟)𝑛
n times
Compound Interest: the effect

Present Value
To move a cash flow backward in time, we must discount it.

Discount factors can be used to compute the PV of any cash flow.
Year 1 ……Year n
Date 0 1 n
PV Cash Flow = 𝑃𝑉 ∗ (1 + 𝑟)𝑛
𝐶𝑛
PV = = 𝐶𝑛 𝑥 𝐷𝐹𝑛
(1+𝑟)𝑛
Discount factor
Example
Suppose you are offered an investment that pays £10,000 in five years
The discount rate is 10% p.a.
What is the value of this investment today?
10,000
PV = = 10,000 ∗ 1.1−5 = £6,209
(1+0.1)5

Stream of cash flows
Consider a stream of cash flows

0 1 2 3 4 n
……..
𝐶0 𝐶1 𝐶2 𝐶3 𝐶4 𝐶𝑛
𝐶1 𝐶2 𝐶𝑛
PV = 𝐶0 + + + …+
(1+𝑟1 ) (1+𝑟2 )2 (1+𝑟𝑛 )𝑛
Note that in general 𝑟1 , 𝑟2 , 𝑟3 ,… can be different.

Example
A project produces cash flows of £432,000 in year 1, £437,000 in year 2, and

£330,000 in year 3. The discount rate is 15%. What is the project’s PV?
432,000 437,000 330,000

PV = + + = £923,067
(1+0.15) (1+0.15)2 (1+0.15)3

Special Cases
Sometimes there are shortcuts that allow us to cut through the calculations
quickly.
Annuity: an asset that pays a fixed sum each period for a specified number of
periods.
- e.g., car loans, mortgages, etc.
Perpetuity: an asset that pays a fixed sum forever

- e.g., preferred stock. Stockholders promised a fixed cash dividend every
quarter, forever.

Perpetuity
When a constant cash flow will occur at regular intervals forever it is called a
perpetuity.
0 1 2 3 4
……..
C C C C
The value of a perpetuity is simply the cash flow divided by the discount rate.
Present value of a perpetuity (that starts paying in one year from today) is:
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
PV =
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒

Perpetuity: Example
The British Government used to issue perpetual bonds (called Consols).

Suppose they issue a new Consol, which will pay the owner GBP 100 per year,
starting next year.
The discount rate is 4% per year.
What is the PV of the bond’s cash flows?
100
PV = = £2,500
0.04

Perpetuity with Growth
Assume you expect the amount of your perpetual payment to increase at a

constant rate g.
0 1 2 3
……..
C C(1+g) 𝐶(1 + 𝑔)2
The present value of a Growing Perpetuity that starts paying in one year from
now and grows by g from year 2 onwards (discount rate is r):
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
PV =
(𝑟 −𝑔)

Perpetuity with Growth: Example
Suppose the Consol bond from the previous example promises to pay £100 in
the first year, by the payment will increase by 1% per year. The discount rate is
4%.
0 1 2 3
……..
100 101 102.01
What is the present value of the bond?
100
PV = = £3,333.33
(0.04 −0.01)

Perpetuity with Growth: Example 2
The British Government issues the following Consol bond

- It promises to pay £100 immediately
- The initial payment increases by 2% from year 1 onwards
- Discount rate is 4%
0 1 2 3
……..
100 102 104.04 106.12
What is the present value of the bond?

Perpetuity with Growth: Example 2
100
The present value is not = £5,000
(0.04 −0.02)
This would be the value of the following perpetuity
0 1 2 3
……..
100 102 104.0.4
102
The value of our perpetuity is + 100 = £5,200
(0.04 −0.02)
That is the value of a regular perpetuity with the starting payment of £102 in year
1 (growing @ 2%) PLUS our promised initial payment.

Annuity
Suppose you want to determine the present value (PV) of the following financial
security:
- Annual constant payments of £1 mln;
- There are 30 annual payments;
- Discount rate is 8%.
n
0 1 2 3
……..
C C C C
Solution!
We have all the ingredients to calculate the present value; just discount all 30
annual payments!
1 1 1 1 1
PV = + + + +………+ = £11.26
1.081 1.082 1.083 1.084 1.0830

Annuity
This is quite tedious! We have to sum 30 terms.

An alternative is to use a simple formula. The present value of an annuity of C for
T periods with discount rate r is:
𝐶 1
PV = 1−
𝑟 (1+𝑟)𝑡
In our previous example:
1 1
PV = 1 − = £11.26
0.08 (1+0.08)30

Annuity with Growth
0 1 2 3 t
……..
C C(1+g) 𝐶(1 + 𝑔)2 𝐶(1 + 𝑔)𝑡−1
𝐶 (1+𝑔)𝑡
PV = 1−
𝑟−𝑔 (1+𝑟)𝑡
We can get all formulas from this one.

Discount Factors Table

Course Overview
Primer
Company Valuation
Financing Decisions
1. Bond Valuation
2. Equity Valuation

Financial Statements
Financial Statements are:
- Accounting reports with past performance information:
- Useful tool through which investors, financial analysts, creditors obtain

information on a corporation.
- Filed with the Securities & Exchange Commission (SEC)

• 10Q (Quarterly)
• 10K (Annual)
- Must also send an annual report with financial statements to shareholders

Annual Reports
What’s inside?
- Management Discussion
- Auditor’s report
- Balance Sheet
We will use these
- Income Statement
- Cash Flow Statement
- Statement of Changes in Equity

- Other Comprehensive Income
- Notes

Financial Statements Online
Where to find financial statements?
- Company investor relations website

- YAHOO Finance: finance.yahoo.com
- Compustat: https://wrds-www.wharton.upenn.edu/
- SEC EDGAR Database (SEC) for US firms; Company House in the UK

The 3 main accounting statements
Balance Sheet
Information about financial condition of the firm at a specific point in time
(snapshot).
Income Statement (or Profit & Loss Statement)

Information about a firm’s financial performance over a
period of time, most often a year.
Cash flow statement:

Information about the sources and uses of a firm’s cash over
a period of time, usually a year.

Balance Sheet
The Balance Sheet has 3 components:

1. Assets (what the company owns)
2. Liabilities (what the company owes)
3. Shareholder’s equity (residual claim on assets)
Total Assets Total Liabilities & Equity
Non current assets Non Current Liabilities
Current assets Current Liabilities

Total Liabilities
Total Equity
Total assets Total Liabilities & Equity

Balance Sheet
(https://investor.apple.com/investor-relations/default.aspx)

Balance Sheet

Equity: Market vs. Book Value
Does the Balance Sheet provide an accurate assessment of a firm’s equity?
Unfortunately, NO!
1. Many items are valued based on historical cost (book value) rather than their
current market value.
2. Not all assets/liabilities appear on the Balance Sheet
Book value of equity ≠ Market value of equity (or Market Capitalization = Market
Price per Share * No. shares outstanding)

Intangible Assets
An intangible asset is an identifiable non-monetary asset without physical

substance: computer software, licences, trademarks, patents, films, copyright etc.
(i) Purchased intangible assets If an asset has been purchased, it will be

recognised initially at cost
(ii) Internally generated Generally, internally generated

Intangible assets intangible assets cannot be capitalised

Income Statement
Presents information on revenue earned and expenses incurred over a fixed

period of time.
Net Income = Revenue – Expenses
Net Income is a measure of firm’s profitability during a period.
Positive (negative) net income increases (decreases) shareholders’ equity.

Income Statement
Revenues
- Cost of Sales
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
Gross Profit Gross Margin = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
- Administrative & Operating expenses
- Depreciation and Amortization
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
Operating Profit Operating Margin = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
- Interest
- Other non-operating expenses
Earnings Before Taxes
- Taxes
Net Profit/ Loss Net Profit – Dividends is added to RE
(part of the Equity in BSH)

Income Statement

Cash versus Accrual Accounting
When should revenue and expenses be recognised?
The Income Statement & Balance Sheet are prepared on accrual accounting:
▪ Revenue is recognised at time of sale of goods or provision of service.
▪ Expenses are recognised at the same time as corresponding revenue
(matched).
Hence, revenue from sale appear on the IS, even though there might not be a
cash inflow yet.
Therefore, Net Profit does not indicate the amount of cash the firm has earned!

Cash Flow Statement
However, investors want to know whether the firm is producing cash flow and
how cash is generated.
- Quite possible for a firm to operate profitably (on accrual basis), but be
unable to generate cash to fund investments, pay debt etc…
For such reason, firms are required to prepare a cash flow statement: the
sources and uses of a firm’s cash over an accounting period.
- Starting point is Net Income, but need to make several adjustments to get
the firm’s cash flow.

Cash Flow Statement
The cash flow statement is divided into three sections:
1. Cash flow form operating activities:

Cash flows from the purchase and the sale of goods and services as part of
the firm’s normal operations.
2. Cash flows from investing activities:

Cash flows from the acquisitions and sale of non-current assets (e.g. a
factory, building, land etc.)
3. Cash flows from financing activity:

Cash flows from raising or repaying debt and equity finance (e.g. a share
buyback, dividend, taking out a new loan etc.)

Usefulness of Cash Flow Statement
Not all cash is created equal!
A likely recurring source

that can sustain the Not likely to recur.
company. . Repayment
Will replacement required.
assets be needed?

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MSc Economics & Strategy

Imperial College Business School Imperial means Intelligent Business 2

Imperial College Business School Imperial means Intelligent Business 3

Corporate Finance is about financial decisions made by corporations:

1. Investment Decisions: How to value an investment opportunity?

2. Financing Decisions: How to finance corporate activities:

Imperial College Business School Imperial means Intelligent Business 4

Imperial College Business School Imperial means Intelligent Business 5

▪ Final Exam (70%) 16th December

Imperial College Business School Imperial means Intelligent Business 6

Imperial College Business School Imperial means Intelligent Business 7

Imperial College Business School Imperial means Intelligent Business 8

Analyse how managers raise capital and make investment decisions.

- Evaluate different investment opportunities;

- Understand the theory behind corporate finance.

- No prerequisites (just Excel at basic level)

Imperial College Business School Imperial means Intelligent Business 9

Imperial College Business School Imperial means Intelligent Business 10

Imperial College Business School Imperial means Intelligent Business 11

Imperial College Business School Imperial means Intelligent Business 12

Imagine a simple investment opportunity with the following cash flows:

No! £1 today is worth more than £1 tomorrow.

- In order to compare cash flows, those should be expressed in terms of money

Imperial College Business School Imperial means Intelligent Business 13

Cash Flow -£1,000 $600 $600

Imperial College Business School Imperial means Intelligent Business 14

Imperial College Business School Imperial means Intelligent Business 15

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

Cash Flow £1,000 $1,100 $1,210

The future value of a cash flow C in year n is given by:

Imperial College Business School Imperial means Intelligent Business 18

To move a cash flow backward in time, we must discount it.

PV Cash Flow = 𝑃𝑉 ∗ (1 + 𝑟)𝑛

Imperial College Business School Imperial means Intelligent Business 22

Consider a stream of cash flows

Note that in general 𝑟1 , 𝑟2 , 𝑟3 ,… can be different.

Imperial College Business School Imperial means Intelligent Business 23

A project produces cash flows of £432,000 in year 1, £437,000 in year 2, and

432,000 437,000 330,000

Imperial College Business School Imperial means Intelligent Business 24

Perpetuity: an asset that pays a fixed sum forever

Imperial College Business School Imperial means Intelligent Business 25

Imperial College Business School Imperial means Intelligent Business 26

The British Government used to issue perpetual bonds (called Consols).

The discount rate is 4% per year.

What is the PV of the bond’s cash flows?

Imperial College Business School Imperial means Intelligent Business 27

Assume you expect the amount of your perpetual payment to increase at a

C C(1+g) 𝐶(1 + 𝑔)2

Imperial College Business School Imperial means Intelligent Business 28

100 101 102.01

What is the present value of the bond?

Imperial College Business School Imperial means Intelligent Business 29

The British Government issues the following Consol bond

100 102 104.04 106.12

What is the present value of the bond?

Imperial College Business School Imperial means Intelligent Business 30

This would be the value of the following perpetuity

100 102 104.0.4

Imperial College Business School Imperial means Intelligent Business 31

Imperial College Business School Imperial means Intelligent Business 32

This is quite tedious! We have to sum 30 terms.

In our previous example: