Corporate Finance

Prof. Daniel Metzger (Ph.D.)

Disclaimer

• Credits for the slides go to Dr. Guosong Xu (Department of Finance, RSM)

Prof. Daniel Metzger (Ph.D.)

Introduction

• Modern financial theories are based on the assumption that firms are
established to serve the interests of their shareholders

o Is this a reasonable assumption?

• How: Value creation for shareholders

o What do we mean by “value creation”?

Prof. Daniel Metzger (Ph.D.)

Managing for value

Foundation concepts: Present and future values

Investment rules: NPV, IRR, etc.

Ingredient 1: Ingredient 2:
Capital Budgeting Discount Rate
(project cash flows) (Risk, return, CAPM)

Financing a business

Prof. Daniel Metzger (Ph.D.)

 “Compound interest is the eighth wonder of
the world. He who understands it, earns it;
he who doesn't, pays it.”
-- Albert Einstein

TIME VALUE OF MONEY

Prof. Daniel Metzger (Ph.D.)

A simple choice

• Suppose you were offered the choice between receiving €100 today, or
receiving €100 next year.
• When you should want the money?

Prof. Daniel Metzger (Ph.D.)

A simple choice

• Suppose you were offered the choice between receiving €100 today, or
receiving €100 next year.
• When you should want the money?

• Of course you should opt for taking it today. WHY?

Prof. Daniel Metzger (Ph.D.)

A simple choice

Today Next year

put in a bank account,

• Choice 1:
earn 5% interest rate
Get today

€100 €105

• Choice 2:
Get next year
€100

Prof. Daniel Metzger (Ph.D.)

Prevent value and future value

Today Next year

I have some put in a bank account, “Future value”

• Choice 1:
€ today earn some interests

Prof. Daniel Metzger (Ph.D.)

Prevent value and future value

Today Next year

I have some put in a bank account, “Future value”

• Choice 1:
€ today earn some interests

?
How much should
I want to have
• Choice 2: I set apart?
“discounting” some € in a year
“Present value”

?
Prof. Daniel Metzger (Ph.D.)
Prevent value and future value

• We consider two distinct problems:

1. Future value: You have some money now that you put at a savings
account, and wish to know how much it is worth somewhere in the
future
2. Present value: You get some money somewhere in the future, and
wish to know how much today’s equivalent would be worth

Prof. Daniel Metzger (Ph.D.)

Future value

• “Simple interest” — you receive interest on your deposit, but do not get
interest on interest
• You start off with €1,000 and receive 4% simple interest per year. What is
the value of your savings account after 1, 2, 3, or t years?

Prof. Daniel Metzger (Ph.D.)

Simple interest

• Intuitively, we know that all interest we earn each year is:

Interest earned = Interest rate × Initial deposit

• or, in our example:

I = 0.04 × €1,000 = €40

Prof. Daniel Metzger (Ph.D.)

Simple interest

Let A(t) be the value of your account at time t, then we have:

Prof. Daniel Metzger (Ph.D.)

Simple interest

• Let’s denote the original amount that we put on the savings account as P
(the so-called “principal amount”)

• Interest rate = r

• From the previous table, we know:

A(t) = 40 × t + 1,000

which is equal to:

A(t) = r × P × t + P = P × (1 + rt)

Prof. Daniel Metzger (Ph.D.)

Simple interest

A(t) = P × (1 + rt)

A(t)

A straight line

0 t

Prof. Daniel Metzger (Ph.D.)

Compound interest

• A popular phrase in finance:

“You don’t need a million dollars to become a millionaire.”
— As long as you start saving at a young age, and are capable of getting a
decent return on your savings, it is possible to let your money grow to
enormous levels...

Prof. Daniel Metzger (Ph.D.)

Compound interest

• “You don’t need a million dollars to become a millionaire.” — As long as you

start saving at a young age, and are capable of getting a decent return on
your savings, it is possible indeed to let your money grow to enormous
levels...
• In this animation, the claim is…

earn a 10% annual interest

save $158 / month

40 years later
$1 million
Prof. Daniel Metzger (Ph.D.)
Example

First, calculate how much will you have if you earn simple interests
• Every month, save $158; for 40 years
• 10% annual interest rate: equals to monthly interest of 0.83% (=10%/12)

Prof. Daniel Metzger (Ph.D.)

Example

First, calculate how much will you have if you earn simple interests
• Every month, save $158; for 40 years
• 10% annual interest rate: equals to monthly interest of 0.83% (=10%/12)

Prof. Daniel Metzger (Ph.D.)

Example

First, calculate how much will you have if you earn simple interests
• Every month, save $158; for 40 years
• 10% annual interest rate: equals to monthly interest of 0.83% (=10%/12)

Prof. Daniel Metzger (Ph.D.)

Example

First, calculate how much will you have if you earn simple interests
• Every month, save $158; for 40 years
• 10% annual interest rate: equals to monthly interest of 0.83% (=10%/12)

Prof. Daniel Metzger (Ph.D.)

Example

Now, calculate how much will you have if you earn compound interests
→ Meaning that we receive interest both over principal AND over interest earned
(interests over interests)
• Every month, save $158; for 40 years
• 10% annual interest rate: equals to monthly interest of 0.83% (=10%/12)

Prof. Daniel Metzger (Ph.D.)

Example

Now, calculate how much will you have if you earn compound interests
→ Meaning that we receive interest both over principal AND over interest earned
(interests over interests)
• Every month, save $158; for 40 years
• 10% annual interest rate: equals to monthly interest of 0.83% (=10%/12)

Prof. Daniel Metzger (Ph.D.)

Example

Now, calculate how much will you have if you earn compound interests
→ Meaning that we receive interest both over principal AND over interest earned
(interests over interests)
• Every month, save $158; for 40 years
• 10% annual interest rate: equals to monthly interest of 0.83% (=10%/12)

Prof. Daniel Metzger (Ph.D.)

Example

Now, calculate how much will you have if you earn compound interests
→ Meaning that we receive interest both over principal AND over interest earned
(interests over interests)
• Every month, save $158; for 40 years
• 10% annual interest rate: equals to monthly interest of 0.83% (=10%/12)

Prof. Daniel Metzger (Ph.D.)

Example

Now, calculate how much will you have if you earn compound interests
→ Meaning that we receive interest both over principal AND over interest earned
(interests over interests)
• Every month, save $158; for 40 years
• 10% annual interest rate: equals to monthly interest of 0.83% (=10%/12)

Prof. Daniel Metzger (Ph.D.)

Simple vs. compound interest

earn a 10% annual interest

save $158 / month

How does it look like in a graph if you earn simple vs. compound interest?

Prof. Daniel Metzger (Ph.D.)

Simple vs. compound interest

t=0 t=1 t=2 t=n

…
Simple:

Principal Interest 1 Interest 2 Interest n

A(t) = P × (1 + rt)

…
Compound:

Principal Interest 1 Interest 2 Interest n

A(t) = P × (1 + r)t

Prof. Daniel Metzger (Ph.D.)

Compound interest

• The fact whether I will become a millionaire indeed will depend on:
1. The level of the monthly payment
2. The level of the interest rate
3. The lifespan of my savings project

• Assuming (3) cannot be adjusted, which one do you believe has a bigger
impact on the terminal value: (1) The monthly payment, or (2) The
interest rate?

Prof. Daniel Metzger (Ph.D.)

Sensitivity analysis

• The outcome of the analysis is more sensitive to the interest rate

than to the amount of monthly savings!

Prof. Daniel Metzger (Ph.D.)

Summary

• Future value: How much is a given amount of money worth in the future?
• Two types of interests: Simple vs. Compound
o Compound interests are mostly used in reality
o FV is more sensitive to compound interest rate than to principal amount

Prof. Daniel Metzger (Ph.D.)

Future value: Example

• In the year 1626, Peter Minuit purchased Manhattan Island from the
Algonquians for $24, an apparent bargain compared with the price of
Manhattan real estate today.
• If the current value of Manhattan real estate is $344 billion,* did Peter pay
too few for Manhattan?

*Source: NY city council, ‘FY2013/14

Tentative Assessment Roll’, 15 January,
2013.

Prof. Daniel Metzger (Ph.D.)

Future value: Example

• In the year 1626, Peter Minuit purchased Manhattan Island from the
Algonquians for $24, an apparent bargain compared with the price of
Manhattan real estate today.
• If the current value of Manhattan real estate is $344 billion,* did Peter pay
too few for Manhattan?
What’s the problem?

1626 2022
$24 Invest somewhere for 396 years, “Future value”
earn a return

?
Current price:
$344

Prof. Daniel Metzger (Ph.D.)

Example of Peter Minuit

• Assume a 6.5% annual increase in real estate over the last few centuries

FVT = P × ( 1 + r )T

• That is, P = $24, r = 6.5%, T = 396. We have:

FV394 = 24 × ( 1 + 6.5% )396 = 1,624 billion

Prof. Daniel Metzger (Ph.D.)

Example of Peter Minuit

• Assume a 6.5% annual increase in real estate over the last few centuries

FVT = P × ( 1 + r )T

• That is, P = $24, r = 6.5%, T = 396. We have:

FV394 = 24 × ( 1 + 6.5% )396 = 1,624 billion

For the price paid in 1626, that cost

equals to 1,624 billion in 2022!
But you can buy at $344 billion at
the current price

Prof. Daniel Metzger (Ph.D.)

Example of Peter Minuit

• Assume a 6.5% annual increase in real estate over the last few centuries

FVT = P × ( 1 + r )T

• That is, P = $24, r = 6.5%, T = 396. We have:

FV394 = 24 × ( 1 + 6.5% )396 = 1,624 billion
• We conclude that Peter overpaid Manhattan Island (for about 400%)!
• This example has been manipulated — If the average return on the
investment would have been 5%, then the $24 would have grown to “only”
~$6 billion.

Prof. Daniel Metzger (Ph.D.)

Exercise

• Suppose you deposit €1,000 in one year, €2,000 in two years, and €4,000 in
three years from now. Assume you get a 4% interest rate. How much do you
get after 5 years, assuming compound interest?

Prof. Daniel Metzger (Ph.D.)

Exercise

• Suppose you deposit €1,000 in one year, €2,000 in two years, and €4,000 in
three years from now. Assume you get a 4% interest rate. How much do you
get after 5 years, assuming compound interest?

One tedious solution:

Prof. Daniel Metzger (Ph.D.)

Exercise

• Suppose you deposit €1,000 in one year, €2,000 in two years, and €4,000 in
three years from now. Assume you get a 4% interest rate. How much do you
get after 5 years, assuming compound interest?

A smarter way to solve it is to look at each cash flow separately:

t=0 +1 +2 +3 +4 +5

€1,000 FV1 = ?
€2,000 FV2 = ?
€4,000 FV3 = ?

Prof. Daniel Metzger (Ph.D.)

Exercise

• Alternatively, you can calculate the FV of the three cash flows separately:

Prof. Daniel Metzger (Ph.D.)

Present value

How much should

I set apart? I want to have some
“Present value” “discounting” € in the future

Prof. Daniel Metzger (Ph.D.)

Present value

Example: You are entitled to receive four times €100: today, next year, in two
years from now, and in three years from now.

Cash flow (CF)

EUR100 nominal amount

0 1 2 3 t

Prof. Daniel Metzger (Ph.D.)

Present value

Key question: What’s the present value of these 4 future cash flows?
• Assume that interest rate (= discount rate) is 5%
• First, let’s consider the cash flow of next year
present value equation:
𝐶𝐹𝑡
𝑃𝑉(𝐶𝐹𝑡) =
1+𝑟 𝑡

• Compare this to the future value equation: FVt = P × (1 + r )t

Prof. Daniel Metzger (Ph.D.)

Present value

Cash flow (CF)

EUR100

95.24 100
𝑃𝑉1 = 1
1 + 0.05

0 1 2 3 t

Prof. Daniel Metzger (Ph.D.)

Present value

If we would receive €95.24 today, we

would put it on a savings account and
get 5% interest. After a year we would
Cash flow (CF) get €95.24 × (1+0.05) = €100

EUR100

95.24 100
𝑃𝑉1 = 1
1 + 0.05

0 1 2 3 t

Prof. Daniel Metzger (Ph.D.)

Present value

Cash flow (CF)

EUR100
100
𝑃𝑉2 =
95.24 1 + 0.05 2

90.70 100
𝑃𝑉3 =
86.38 1 + 0.05 3

0 1 2 3 t

Prof. Daniel Metzger (Ph.D.)

Present value

• Alternatively, we can present the graph like this:

Cash flow (CF)

EUR100

95.24
90.70
86.38

0 1 2 3 t

Prof. Daniel Metzger (Ph.D.)

Present value

• Alternatively, we can present the graph like this:

Cash flow (CF)

nominal amount
EUR100 (future value)

95.24
90.70
86.38
present value that
is equivalent to the
future value

0 1 2 3 t
We pretend we do not want to wait and
calculate a value we would now be happy
with instead of waiting
Prof. Daniel Metzger (Ph.D.)
Present value: Formula

• General formula (for multiple future cash flows):

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑇

𝑃𝑉 = + + ⋯+
1+𝑟 1 1+𝑟 2 1+𝑟 𝑇

$
𝐶𝐹𝑡
𝑃𝑉 = ,
1+𝑟 𝑡
!"#

• Note that these cash flows CFt may fluctuate at each t

Prof. Daniel Metzger (Ph.D.)

Special cases

• Two special cases of cash flows:

C C … C
1. Annuity:
t=0 1 2 T T+1 T+2
time

C C … C C C …

2. Perpetuity: time
t=0 1 2 T T+1 T+2

Important: first CF starts at t + 1!

Prof. Daniel Metzger (Ph.D.)

Annuity

• “Term loan”

Prof. Daniel Metzger (Ph.D.)

Perpetuity

“Perpetual bonds”: the so-called

“consols,” bonds issued by the UK
government (in the 18th century).
These bonds pay constant amounts
of interest for an unlimited period

Prof. Daniel Metzger (Ph.D.) | January, 2020

Perpetuity

• Imagine an endless series of constant cash flows:

𝐶𝐹1 𝐶𝐹2 𝐶𝐹∞

𝑃𝑉 = + + ⋯+
1+𝑟 1 1+𝑟 2 1+𝑟 ∞

𝐶𝐹
Equals 𝑃𝑉 =
𝑟

Proof: use limit theorem

• We don’t have a time dimension (t) in this formula. WHY?

Prof. Daniel Metzger (Ph.D.)

Perpetuity

• Imagine you will earn €2,000 net per month for the next 40 years. The
relevant annual discount rate is 10%, resulting in 0.8333% per month.
o The PV of the first payout (after one month):
2,000/(1+0.008333)1= €1,983.47
o The PV of the second payout would be €1,967.08,
o etc.

Prof. Daniel Metzger (Ph.D.)

Perpetuity

Monthly income

PV
month

Prof. Daniel Metzger (Ph.D.)

Perpetuity

Monthly income

PV of your income in 40
years ≈ €37 today.
(2,000/(1+0.008333)480)
Negligible!

PV
month

Prof. Daniel Metzger (Ph.D.)

Annuity

• If you pay or receive fixed amounts per period during a finite time horizon
$
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑇 𝐶𝐹𝑡
𝑃𝑉 = + + ⋯+ = ,
1+𝑟 1 1+𝑟 2 1+𝑟 𝑇 1+𝑟 𝑡
!"#

• Because CFs are constant (CF1 = CF2 = …), we can drop t in CF

$ $
𝐶𝐹 1
𝑃𝑉 = , = 𝐶𝐹× ,
1+𝑟 𝑡 1+𝑟 𝑡
!"# !"#

2. This part equals to:

1. We can take CF out of the 1
summation operation 1−
1+𝑟 𝑇
because it is a constant 𝑟
(also called “annuity factor”)

Prof. Daniel Metzger (Ph.D.)

Annuity

𝐶𝐹 𝐶𝐹 𝐶𝐹
𝑃𝑉 = + + ⋯+
1+𝑟 1 1+𝑟 2 1+𝑟 𝑇

1 1 1
= 𝐶𝐹× + + ⋯+
1+𝑟 1 1+𝑟 2 1+𝑟 𝑇

1
1− 𝐶𝐹 1
1+𝑟 𝑇
= 𝐶𝐹× = × 1−
𝑟 𝑟 1+𝑟 𝑇

• When T is infinite (∞), an annuity becomes a perpetuity, and the “annuity

1
factor” becomes . That’s why PV of a perpetuity is simply 𝐶𝐹
𝑟 𝑟

Prof. Daniel Metzger (Ph.D.)

Exercise

• We can build an office building for $20m. The office building has an
estimated life of 20 years. One customer expressed interest in leasing the
building for its entire life for $1.7m per year. The discount rate for the real
estate company is 6%.
• Should you build the office building?

Prof. Daniel Metzger (Ph.D.)

Exercise

• We can build an office building for $20m. The office building has an
estimated life of 20 years. One customer expressed interest in leasing the
building for its entire life for $1.7m per year. The discount rate for the real
estate company is 6%.
• Should you build the office building?

What’s the problem?

Build the office if the costs ($20m) are lower than all future revenues
Are we making decisions today? Translate future revenues into PV
Do cash flows resemble a perpetuity or annuity?
Apply the formula. But check if the first CF occurs at t +1

Prof. Daniel Metzger (Ph.D.)

Exercise

• We can build an office building for $20m. The office building has an
estimated life of 20 years. One customer expressed interest in leasing the
building for its entire life for $1.7m per year. The discount rate for the real
estate company is 6%.
• Should you build the office building?
• Solution:
o First, be clear that this is an annuity: constant CFs for 20 years.
1
1−
1 + 0.06 20
o PV of annuity: = 1.7× = 19.5 (𝑚𝑖𝑙𝑙𝑖𝑜𝑛)
0.06

o Initial investment = 20 million > 19.5

That is, the net present value (NPV) = 19.5 – 20 = -0.5 million

Prof. Daniel Metzger (Ph.D.)

Exercise

• Now assume that after 20 years, the building can be sold for $4.5 m. Should
you build the office building now?

Prof. Daniel Metzger (Ph.D.)

Exercise

• Now assume that after 20 years, the building can be sold for $4.5 m. Should
you build the office building now?
• Solution:
o The PV of receiving $4.5m after 20 years at a 6% discount rate:
4.5
𝑃𝑉 = = 1.4 (𝑚𝑖𝑙𝑙𝑖𝑜𝑛)
1 + 0.06 20

o Add this to our previous NPV (-0.5) and now have an NPV of $0.9
million.

Prof. Daniel Metzger (Ph.D.)

Frequency of discounting

• Convention: In reality, interest rates are quoted on a per-year basis

o But compounding can happen at any frequency: quarterly, monthly, daily…

Prof. Daniel Metzger (Ph.D.)

Frequency of discounting

• Convention: In reality, interest rates are quoted on a per-year basis

o But compounding can happen at any frequency: quarterly, monthly, daily…

You earn interests monthly, but the

0.01% rate is a nominal annual rate

Prof. Daniel Metzger (Ph.D.)

Frequency of discounting

• Converting interest rates:

“Interest of 12%
You see
compounded monthly”

You know Nominal annual rate (r)

Prof. Daniel Metzger (Ph.D.)

Frequency of discounting

• Converting interest rates:

“Interest of 12% “Interest of 1%

You see
compounded monthly” per month”

𝒓
You know Nominal annual rate (r) periodic rate =
𝒎
(m is compounding period)

Prof. Daniel Metzger (Ph.D.)

Frequency of discounting

• Converting interest rates:

“Interest of 12% “Interest of 1%

You see
compounded monthly” per month”

𝒓
You know Nominal annual rate (r) periodic rate =
𝒎
(m is compounding period)

• You know your effective annual rate is >12% (because of compounding)

𝒓 𝒎
Effective annual rate (EAR) = (𝟏 + ) −𝟏
𝒎

Prof. Daniel Metzger (Ph.D.)

Exercise
https://www.abnamro.nl/en/personal/savings/interest-rates/when-and-how-often-do-
you-receive-interest.html

Prof. Daniel Metzger (Ph.D.)