Man 101 Course Notes

Introduction to Finance

Background
The problems in this module deal with cash flows that occur at different points in time. What makes
these problems nontrivial is a simple notion: the time value of money. A lira earned today is not the
same as a lira earned tomorrow. A very simple example: if you deposit 1,000TL into an account
that pays 3% interest, in one year you will have 1,000TL x 1.03 = 1,030TL. Likewise, if you want to
have 1,000TL in the bank at the end of the year, you have to deposit 1,000TL / 1.03 = 970.87TL
today (at 3% interest). This relatively simple calculation allows us to move the relevant cash flow(s)
to an appropriate point in time (usually the present) which is useful for financial decision-making.
The crucial piece of information in these calculations is the interest rate, usually abbreviated as "i".

Traveling forward in time

Suppose you have 1,000TL today, and you can invest it at 5% per year. You wish to know what this
investment will be worth 10 years from now. Here is the detailed calculation:
 At the end of Year 1: 1,000 x 1.05 = 1,050.
 At the end of Year 2: 1,050 x 1.05 = 1,102.50
 At the end of Year 3: 1,102.5 x 1.05 = 1,157.63
 ... etc.
And here is the quick calculation:
At the end of Year 10: 1,000 x (1.05)10 = 1,628.90.
The general formula for calculating the future value of a present investment is as follows:
n
FV = PV (1 + i) , where
FV = future value
PV = present value
i = interest rate
n = number of periods
It is of course important that the units of i and n match. If you are working in years, then you should
use the annual interest rate, and if you are working in months, you should use the monthly interest
rate.

Traveling backward in time

Suppose you want to know how much to invest today at 6% so you can have 2,000TL in 10 years.
Here is the detailed calculation:
 To have 2,000 at the end of year 10, you need to have 2,000 / 1.06 = 1,886.79 at the end of
Year 9.
 To have 1886.79 at the end of Year 9, you need to have 1,886.79 / 1.06 = 1,780 at the end of
Year 8.
 ... and so on.
And here is the quick calculation:
2,000 / (1.06)10 = 1116.79
Using the same notation as above, the general formula for calculating the present value of a future
payment is as follows:
PV = FV / (1 + i)n.
Note that we could get the second formula from the first one by dividing both sides by (1+i)n.

We can do more with this formula than compute the present value or future value. Note that there
are four components in these formulas: present value, future value, interest rate, and number of
periods. If we know three of them, we can always solve for the fourth. For example, we might want
to know how many years are required to turn 1,000TL into 2,000TL at 5% interest rate. Or we might
want to know what interest rate is necessary to turn 1,000TL into 2,000TL in 10 years. Solving for i
or for n is more difficult than solving for PV or FV using a calculator. However, if we use a
spreadsheet (and its "Goal Seek" tool), then solving for i or n becomes easy.

Now that we have the basic formula for moving money in time (converting oranges to apples), we
can deal with more complicated cash flows. Here is a simple example.

Example 1: An investment opportunity requires an initial payment of 100,000TL now. The

investment pays 25,000TL at the end of Year two, 50,000TL at the end of Year five, and 100,000TL
at the end of Year ten. Assuming an interest rate of 7%, calculate the net present value of this
investment.

Solution: The NPV of the

 first payment: 25,000 / (1.07)2 = 21,835.97TL
 second payment: 50,000 / (1.07) = 5
35,649.31TL
 10
third payment: 100,000 / (1.07) = 50,834.93TL
TOTAL: 108,320.21TL
NPV = 108,320.21 (PV of payments) - 100,000 (initial payment) = 8,320.21 (positive!)

100,000

Year 2 Year 5 Year 10

Now 25,000
50,000

100,000

The NPV is positive, which implies that this is a desirable project. For example, if the cost of
obtaining funds to finance this investment was 7%, we would be making 8,320TL on this investment
(assuming we can manage the cash flow for the loan). Another way of looking at this outcome: The
annual rate of return of this investment exceeds 7%. The annual rate of return (or the “internal rate
of return”) is the interest rate at which the NPV is equal to zero. Using the Goal Seek tool in Excel
we can determine an annual return of 8.3% for this project.
Example 2: An investment opportunity requires an initial payment of 100,000TL now. The
investment pays 10,000TL at the end of every year for 20 years, and then pays a lump sum
payment (a payment that is made all at once) of 70,000TL at the end of Year 20. Assuming an
interest rate of 10%, calculate the net present value of this investment.

Solution: We now have a total of 21 payments, and it could be cumbersome (a lot of work) to follow
the same solution method as in the first example. However, the payments can be classified into two
groups: an annual payment (an amount that is paid each year) and a lump sum payment (an
amount that is all paid at one time), and there is a formula to compute the NPV of the annual
payment:

NPV = ( C / i ) x [1-1/(1+i)n], where C = annual payment, i = interest rate, n = number of payments.

NPV = (10,000TL/0.1) x (1-1/(1.1)20 = 85,135.64TL.

The NPV of the lump sum payment is 70,000TL / (1.1)20 = 10,405.05TL. Hence the NPV of the
entire investment is 85,135.64TL + 10,405.05TL - 100,000TL = -4,459.31TL. The implication is that
this investment is losing over 4,400TL at 10% interest. (Note that if you ignore the discounting, you
may think that this is a good investment since you are putting in 100,000TL, and taking out
270,000TL.)

Excel's financial functions

Excel has a number of built-in financial functions that simplify calculations. Below is a short list. You
should be familiar with every function on this list – exams and homeworks will require the use of
them.
 NPV (interest, cash flows) --- Given an interest rate and a cash flow series (in a column or
row), computes the net present value of the series
 PV (interest, number, payment, [future value], [type]) --- Given an interest rate, number of
periods, and periodic future payments, computes the present value of the payments. Future
value and type are optional parameters; if omitted they are assumed to be zero.
 IRR (cash flows, [guess]) --- Given a cash flow series (including positive and negative flows)
computes the internal rate of return. Guess is an optional parameter, and is assumed to be
0.1 or 10% if omitted.
 PMT (interest, number, principal, [future value], [type]) -- Given an interest rate, number of
periods, and a principal, computes the per-period payment which pays off the principal.
Future value and type are optional parameters; if omitted they are assumed to be zero.
 NPER (rate, payment, present value, [future value], [type]) --- Given an interest rate, per-
period payment, and the present value of the payments, computes the number of periods
required to pay off the principal. Future value and type are optional parameters; if omitted
they are assumed to be zero.
Student Expectations (upon completion of this case)
Conceptual (specific): This module gives you a brief introduction to financial calculations. You will
learn much more about finance in the Corporate Finance course and in other finance courses.
However, we expect that you understand the fundamental concept of discounting cash flows and
that you can use it for evaluating simple investments. Examples of problems we expect you to solve
can be found in the homeworks and the practice problems in the course notes.

Conceptual (general): The case used demonstrated the use of what-if analysis, the use of the
goal seek tool to find the value of an unknown variable (in the presence of a single unknown), and
dealing with uncertainty via parametric (or sensitivity) analysis. These general modeling skills are
useful in a number of areas.

Excel skills: We learned or reinforced a number of Excel skills in this module:

 Propagating formulas and using absolute and relative cell references
 Using finance functions (such as NPV, IRR, and PMT)
 The use of the "Goal Seek" tool
 Data  Table
 Conditional formatting