Financial Decision Making

We have several tools to help with making financial

decisions.

The first tools that we review are

(i) time value of money,
(ii) interest rate; and
(iii) net present value (NPV)
Class 1 Part 2: The Time Value of Money

Outline :
4.1 The Timeline of Cash Flow
4.2 The Three Rules of Time Travel
4.3 Valuing a Stream of Cash Flows
4.4 Calculating the Net Present Value
4.5 Perpetuities
5.0 Interest rates
Review: The Three Rules of Time Travel

..
Calculating the Net Present Value

The NPV of future cash flows helps us to evaluate

an investment decision.
- Net Present Value = PV of Positive and
Negative Flows, Add and Subtract…
- Net Present Value combines:
• (A) the PV of cash inflows (benefits) with
• (B) the present value of cash outflows
(costs).
• +A-B is NPV….
The NPV Decision Rule

Accepting or Rejecting a Project; THE NPV

RULE
• Accept those projects (or investments)
with a positive NPV.
• Increase your wealth.
• Reject those projects with negative NPV.
• They reduce your wealth
NPV Choosing Among Alternatives

We can also use the NPV decision rule to

choose among different projects.
• To do so, we compute the NPV of each
alternative, and then select the one with
the highest NPV.
• This choice leads to the largest increase
in the value of the firm, or the best value
for firm investors.
Value a large project of an entire
company?
Make cash flow

Assign discount rate

Calculate PV
4.5 Perpetuities

Perpetuities
• When a constant cash flow will occur at
regular intervals forever, it is called a
perpetuity.
4.5 Perpetuities

The value of a perpetuity is simply the cash

flow divided by the interest rate.

- Present Value of a Perpetuity

 Growing Cash Flows

Growing Perpetuity
• Assume you expect the amount of your
annual perpetual payment to increase at
a constant rate, g.

- Present Value of a Growing Perpetuity

Chapter 5 Interest Rates

Outline
1. Interest rates
2. Yield curve
3. Credit risk
Interest Rates

Rates are determined by:

• Term (life) of the loan, or bond.

• Credit risk, or default risk, of the borrower.
The Yield Curve and Discount Rates

Term Structure: The relationship between (i)

the investment term and (ii) the interest rate
Yield Curve: A graph of the term structure
Generally, the longer the term, the higher the
rate.
For investors, a longer term means more
uncertainty – lots of things can happen in 20
years vs. 1 year – more risk: they want a higher
rate…..
 Credit Risk and Interest Rates

• The stronger and more

creditworthy a borrower is, the
less interest rate such a
borrower has to pay.

• Investors accept a lower return

for lower default, or bankruptcy,
risk.
 Another Tool in Finance: Arbitrage and
the Law of One Price

Arbitrage
• Law: Similar goods should sell
at similar prices in different
markets, adjusted for
transaction and/or
transportation costs.
• “Arbitrage” is simultaneously (i)
buying and (ii) selling the same
product in different markets.
Why?
• To take advantage of a price
difference.
Hedge Fund and Law of One price

• After much work, the analysts of Hedge Fund LLC

conclude that the three divisions of Offtake Inc. are
worth $1.1B, $0.6 and $0.5 B, if each division is sold
separately to different M&A buyers.

• All the common equity of Offtake, Inc. trades in the US

public market. The total value of the Offtake public
equity is $1.7 billion.

• What is a good decision for Hedge Fund LLC ? Buy or

sell Offtake stock?