Fundamentals of Business Finance, FIN 3563,

Study Guide

Section-1: Time Value of Money

The time value of money refers to the observation that it is better to receive money sooner than later.
You can invest the money you have in hand today to earn a positive rate of return, producing more
money tomorrow. A dollar today is worth more than a dollar in the future- that is the main idea behind
the concept of the time value of money.

How to use a Financial Calculator

Let’s review the five “time value of money” keys on a financial calculator.

Calculator Key Description

N N Stores (or calculates) the total number of payments or compounding periods
I/Y I/Y Stores (or calculates) the interest (or discount or growth) rate per period.
PV PV Stores (or calculates) the present value of a cash flow (or series of cash flows).
PMT PMT Stores (or calculates) the dollar amount of each annuity (or equal) payment
deposited or received.
FV FV Stores (or calculates) the future value, that is, the dollar amount of a final cash
flow (or the compound value of a single flow or series of cash flows).

An important thing to remember when using a financial calculator is that cash outflows (investments
you make) generally have to be entered as negative numbers. In effect, a financial calculator sees money
as “leaving your hands” and therefore taking on a negative sign when you invest it.

Compounding and Future Value

Most of us encounter the concept of compound interest at an early age. Anyone who has ever had a
savings account or purchased a government savings bond has received compound interest. Compound
interest results when the interest paid on the investment during the first period is added to the principal
so that during the second period the interest is earned on the original principal plus the interest earned
during the first period. The process of adding interest to an investment’s principal and paying interest on
the new, higher balance is called compounding. We often need to know to what extent the money we
invest now will grow in the future. Future value is the value on some future date of money that you
invest today. To calculate the future value of a sum of money that we have on hand today, we will apply
compound interest over time.

Everything else being equal, the higher the interest rate, the higher the future value, and the longer the
money remains invested, the higher the future value. With a higher interest rate, investments made
early will have a more compounding impact and will result in a higher future value.
Example: Finding Future Value
If you put $1,000 into an investment paying 20 percent interest compounded annually, how much will
your account grow to in 10 years?

Financial Calculator
N 10
I/Y 20
PV -1,000 The negative sign is used to indicate a cash outflow.
PMT 0
FV CPT Answer: Future Value = 6192

Discounting and Present Value

Most investments made by businesses and individuals involve an exchange of money today for money in
the future. For example, a company must spend money today to build a plant, but over time the
products made in that plant will generate cash inflows for the firm. Therefore, the firm must decide
whether those future cash inflows are worth the cost of building the plant. Thus, the firm needs a way to
determine the present value of cash flows that come in the future. The present value is the value of
some future cash flow in today’s dollars. An equivalent definition is that the present value is the amount
that one would have to invest today such that the investment would grow to a particular value in the
future. In fact, we will be doing nothing other than inverse compounding, which is called discounting.
Instead of finding the future value of present dollars invested at a given rate, discounting determines
the present value of a future amount, assuming an opportunity to earn a certain return on the money.

Everything else being equal, the higher the discount rate, the lower the present value; and the longer
the waiting period, the lower the present value. With a higher discount rate, investments with larger
cash flow early will be discounted to a lesser extent and thus will result in a higher present value.

Example: Finding Present Value

What is the present value of $500 to be received 10 years from today if our discount rate is 6 percent?

Financial Calculator
N 10
I/Y 6
PV CPT Answer: Present Value = 279.20
PMT 0
FV -500

Annuities
An annuity is a stream of equal periodic cash flows over a specified time. These cash flows may arrive at
annual intervals, but they can also occur at other intervals, such as monthly rent or car payments. The
cash flows in an annuity can be inflows (the $3,000 received at the end of each of the next 20 years) or
outflows (the $1,000 invested at the end of each of the next 5 years). Annuities are of two general types.
For an ordinary annuity, the cash flow occurs at the end of each period. For an annuity due, the cash
flow occurs at the beginning of each period. When we talk about annuities, we are referring to ordinary
annuities unless otherwise noted.
Example: Finding Future Value of an Annuity
If you deposit $500 at the end of each year for the next 5 years in a bank where it will earn 6 percent
interest, how much will we have at the end of 5 years?

Financial Calculator
N 5
I/Y 6
PV 0
PMT -500
FV CPT Answer: Future Value = 2,818.50

Example: Finding Present Value of an Annuity

Assuming an 11 percent discount rate, what is the present value of an investment project that pays
$2,350 each year for eight years?

Financial Calculator
N 8
I/Y 11
PV CPT Answer: Present Value = 12,093
PMT 2350
FV 0

Section-2: Stock and Bond Valuation

Bonds Valuation
A bond is a type of long-term debt instrument, issued by the borrower (i.e., a business or the
government) promising to pay its holder a predetermined and fixed amount of interest per year and the
face value of the bond at maturity. For example, a corporation would issue corporate bonds to borrow
money from the public. Bonds will have specific terms specified in the bond contract. Most corporate
bonds pay periodic interest (typically semiannually) at a stated coupon rate; have an initial maturity of
10 to 30 years; and have a par value, principal, or face value, of $1,000 that the corporation must repay
at maturity.

A firm can obtain equity capital by selling either common or preferred stock. All corporations initially
issue common stock to raise equity capital. Some later issue either additional common stock or
preferred stock to raise more equity capital. Although both common and preferred stocks are forms of
equity capital, preferred stock has some similarities to debt that significantly differentiate it from
common stock. Ownership of the firm, voting rights, and limited liability are the major features of
Commons stock. The true owners of a corporate business are the common stockholders. Common
stockholders are sometimes referred to as residual owners because they receive what is left—the
residual—after all other claims on the firm’s income and assets have been satisfied. They are assured of
only one thing: They cannot lose any more than they have invested in the firm (i.e., limited liability). As a
result of their generally uncertain position, common stockholders expect to earn relatively high returns.
Those returns may come in the form of dividends, capital gains, or both. Common stock does not have a
maturity date but exists as long as the firm does. Common stocks also do not have an upper limit on
their dividend payments. That is, common stock dividends are not fixed. Depending on the firm’s
performance, dividend payments may be declared by the firm’s board of directors. However, common
stock dividends are not contractual obligations. In the event of bankruptcy, the common stockholders,
as owners of the corporation, will not receive any payment until the firm’s creditors, including the
bondholders and preferred shareholders, have been paid.

Here are the key differences between Debt (bonds) and Equity (Common Stocks):

Characteristics Debt (i.e., Bonds) Equity (i.e., Common Stocks)

Voice in management No Yes
Claims on income and assets Senior to Equity (i.e., Subordinate to Debt (i.e.,
bondholders get paid first) stockholders get paid last)
Maturity Stated Maturity None
Tax treatment Interest payments are tax- None
deductible
Cash Flows Fixed periodic Interest and Face Dividends (depends on firm
Value (both are contractual performance, have no upper
obligations) limit, and are not a contractual
obligation)

The value of an asset is the present value of all the future cash flows it is expected to provide. Therefore,
calculating an asset’s value means discounting the expected cash flows back to the present using a
discount rate or required return commensurate with the asset’s risk. Both Bond and stock valuation
follow this basic valuation approach.

The value of a bond is the present value of both the future interest to be received and the par or
maturity value of the bond. The process for valuing a bond requires knowing three essential elements:
(1) the amount and timing of the cash flows to be received by the investor, (2) the time to maturity of
the bond, and (3) the investor’s required rate of return. The amount of cash flows is dictated by the
periodic interest to be received and by the par value to be paid at maturity. Given these elements, we
can compute the value of the bond, or the present value

Example: Bond Valuation

A bond issued by Toyota has a stated annual coupon rate of 3.4 percent, and 5 years left to maturity. If
investors require a 2.7 percent rate of return, what would be the value of the bond?

Financial Calculator
N 5 Time to maturity
I/Y 2.7 This is the required rate of return
PV CPT Answer: Present Value = 1,032.33
PMT 34 Calculated as Par Value x Coupon Rate = 1000 x 3.4% = 34
FV 1000 Face Value or Par Value, assume $1000 unless otherwise stated

Stock Valuation
Like bonds, a common stock’s value is equal to the present value of all future cash flows—dividends in
this case—expected to be received by the stockholder. However, the common stock does not provide
the investor with a predetermined, constant dividend. For common stock, the dividend is based on the
profitability of the firm and its decision to pay dividends or retain the profits for reinvestment. As a
consequence, dividend streams tend to increase with the growth in corporate earnings. Thus, the
growth of future dividends is a prime distinguishing feature of common stock. According to the dividend
growth model, common stocks can be valued using the following formula:

dividend expected ∈ year 1

Common stock value=
required rate of return−growthrate
D1
V CS =
r CS −g
Example: Common Stock Valuation
XYZ Company’s common stock paid a $2 dividend at the end of last year and is expected to pay a cash
dividend every year from now to infinity. Each year the dividends are expected to grow at a rate of 4
percent. Based on an assessment of the riskiness of the common stock, the investor’s required rate of
return is 14 percent. What is the value of the common stock?

Because the $2 dividend was paid last year, we must compute the next dividend to be received (D 1).

D1 = D0 x (1+g) = 2(1+0.04) = 2.08

D1
V CS =
r CS −g
2.08
V CS =
0.14−0.04
V CS =20.80

Section-3: Cost of Capital

Just as the individuals that lend the firm money (bondholders) and those that invest in its stock have
their individual required rates of return, we can also think about a combined required rate of return for
the firm as a whole. This required rate of return for the firm is a blend of the required rates of return of
all investors, which we estimate using a weighted average of the individual rates of return called the
firm’s weighted average cost of capital or simply the firm’s cost of capital. Just like any cost of doing
business, the firm must earn at least the cost of capital for each dollar it has invested, if it is to create
value for its owners and maintain the market value of its stock.

Firms need money to pay for their investments. The term capital refers to a firm’s long-term sources of
financing, which include both debt and equity. Firms raise capital by selling securities such as common
stock, preferred stock, and bonds to investors and by reinvesting profits back into the firm. The mix of
sources of financing (i.e., the mixture of debt and equity financing) used by the firm is commonly
referred to as the firm’s capital structure. To estimate the cost of capital to the firm, we need two
things: (1) the firm’s capital structure (the mix of sources of financing) and (2) the cost to the firm of
each of the sources of capital.
The investor’s required rate of return is not the same thing as the cost of capital. Tax differences in the
treatment of debt and equity as well as transaction costs incurred in raising money (i.e., flotation costs)
drive a wedge between the investor’s required rate of return and the cost of capital to the firm.

Tax Differences: When a firm borrows money to finance the purchase of an asset, the interest expense is
deductible for federal income tax calculations. Firms borrow money and then deduct interest expenses
from their revenues before paying taxes. So, if the marginal tax rate is 21 percent, then for each dollar of
interest it pays, the firm reduces its taxes by $0.21. Consequently, the firm’s actual cost of borrowing is
lower than its before-tax cost of debt. There is no such tax advantage from using preferred stock and
common stock as sources of financing.

Flotation costs: Flotation costs refer to the costs the firm incurs when it raises funds by issuing a
particular type of security. The net proceeds from the sale of any security are the funds that the firm
receives from the sale. For example, if a firm sells new shares for $25 per share but incurs flotation costs
of $5 per share, then the firm’s net proceeds from the sale of the new stock will be $25 - $5 = $20 per
share. Net proceeds are less than total proceeds due to flotation costs, which represent the total costs
of issuing and selling securities. These costs apply to all public offerings of securities: debt, preferred
stock, and common stock. They include two components: (1) underwriting costs, or compensation
earned by investment bankers for selling the security; and (2) administrative costs, or issuer expenses
such as legal and accounting costs.

Cost of Debt
The before-tax cost of debt is simply the rate of return the firm must pay on new borrowing. You can
calculate the cost of debt associated with a particular bond issue by calculating the bondholder’s
required rate of return, which is commonly referred to as the bond’s Yield to Maturity (YTM). To
calculate the YTM, you must know the cash flows the bond will provide (interest payments and par
value) as well as its market price. Because firms must pay flotation costs when they sell bonds, the net
proceeds per bond received by the firm are less than the market price of the bond. Consequently, the
cost of debt capital is higher than the bondholder’s required rate of return (YTM). The adjustment for
flotation costs simply involves replacing the market price of the bond with the net proceeds per bond.
The final adjustment that we need to s to account for the fact that interest is tax deductible. The interest
expense on debt reduces taxable income and, therefore, the firm’s tax liability. In effect, this means the
after-tax cost of debt to the firm will be less than the stated rate of return paid to bondholders on their
bonds. To find the firm’s after-tax cost of debt, we simply multiply the before-tax cost of debt with 1
minus the marginal tax rate.
Example: Before-tax Cost of Debt
Allen Corporation is considering issuing long-term debt. The debt would have a 30-year maturity and a
10 percent annual coupon rate. The firm would have to pay flotation costs of 10 percent of face value.
The firm's tax rate is 21 percent. What is the after-tax cost of debt for Allen Corporation?

Net Proceeds = 1000 – (1000 x 10%) = 900

Financial Calculator
N 30
I/Y CPT Answer: Before-tax Cost off Debt = 11.17
PV -900 Net Proceed is used in place of bond price
PMT 100 Calculated as Par Value x Coupon Rate = 1000 x 10% = 100
FV 1000

Example: After-tax Cost of Debt

If a firm borrows funds at 8 percent and has a 21 percent marginal tax rate, what is its after-tax cost of
debt?

After-tax cost of debt = before-tax cost of debt x (1- tax rate) = 0.08 (1 - 0.21) = 0.0632

Therefore, the firm’s actual cost of borrowing (i.e., after-tax cost of debt) is 6.32%

Cost of Preferred Stock

The required rate of return of the preferred stockholder is calculated as the ratio of the preferred stock
dividend to the Price of a share of Preferred stock. Once again because flotation costs are usually
incurred when new preferred shares are sold, the investor’s required rate of return is less than the cost
of preferred capital to the firm. To calculate the cost of preferred stock, we must adjust the
required rate of return to reflect these flotation costs. We replace the price of a preferred share with
the net proceeds per share from the sale of new preferred shares. That is, the cost of preferred stock is
the ratio of the preferred stock dividend to the firm’s net proceeds from the sale of the preferred stock.

D1
Cost of Preferred Stock: k ps =
NP ps
Here, the net proceeds per share are equal to the price per share of preferred stock minus the flotation
cost per share of newly issued preferred stock. In the case of preferred stock, no tax adjustment must be
made because, unlike interest payments, preferred dividends are not tax-deductible.

Example: Cost of Preferred Stock

A firm has issued 10 percent dividend preferred stock, which sold for $100 per share par value. The cost
of issuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. What is the
cost of the preferred stock?

Net Proceeds = 100 – 2= 98

Preferred Dividend = 100 x 10% = 10

D1 10
k ps= = = 0.102 or 10.2 Percent
NP ps 98
Cost of Common Equity
The cost of common stock equity reflects the costs that firms incur to utilize common stock financing.
Just as the costs of debt and preferred stock were influenced by the required returns of bondholders
and preferred stockholders, the cost of common stock equity will reflect the return required by the
firm’s stockholders. The cost of common equity is the return required on the stock by investors in the
marketplace, possibly adjusted to account for the costs of issuing new shares of stock. There are two
forms of common equity financing: (1) retained earnings and (2) new issues of common stock.

D1
Cost of Common Equity (Retained Earnings): k cs= +g
Pcs

Note that k CS is the investor's required rate of return for investing in the firm's stock. It also serves as
our estimate of the cost of equity capital, where new equity capital is obtained by retaining a part of the
firm's current-period earnings (i.e., retained earnings). When the firm retains earnings, it doesn't incur
any flotation costs; thus, the investor's required rate of return is the same as the firm's cost of equity
capital in this instance.

If the firm issues new shares to raise equity capital, then it incurs flotation costs. In that case, we need to
adjust the investor's required rate of return for flotation costs by substituting the net proceeds per share
( NP cs), for the stock price ( Pcs ) to estimate the cost of new common stock (k ncs).

D1
Cost of Common Equity (New Issue of Common Stock): k ncs= +g
N PCS
The costs associated with the new sale of common stock and retained earnings are different from one
another because the firm does not incur any flotation costs when it retains earnings, but it does incur
costs when it sells new common shares. Therefore, the cost of retained earnings is less than the cost of
new common stock issue.

Example: Cost of Common Equity

Arnold Construction, Inc. just paid a dividend of $4.25. The company’s stock price is $55.00, dividends
are expected to grow at 8.5 percent indefinitely, and flotation costs are $6.25 per share. What is the cost
of retained earnings and cost of new issue of commons stock for the company?

Dividend Expected in Year 1 (D1): = D0 x (1+g) = 4.25 x (1+0.085) = 4.61125

Net Proceed = 55 – 6.25 = 48.75

D1 4.61125
Cost of Retained Earnings: k cs= +g = +0.085=0.1688∨16.88 percent
PCS 55

D1 4.61125
Cost of New Issue of Common Stock: k ncs= +g = +0.085=0.1796∨17.96 percent
NP CS 48.75

It is important to note that long-term debt (i.e., bonds) is the least expensive source of capital. The cost
of preferred stock is typically higher than the after-tax cost of bonds because interest payments are tax-
deductible, whereas preferred dividends are not, and because the preferred stock is riskier than long-
term debt and therefore must pay a higher return. Since common stockholders are residual owners and
bear the most risk, the cost of common stock equity is the highest among the three major sources of
capital.
Weighted Average Cost of Capital
Now that we have calculated the individual costs of capital for each source of financing the firm might
use, we turn to the combination of these capital costs into a single weighted average cost of capital. The
weighted average cost of capital (WACC) reflects the expected average cost of the different forms of
capital used by a company. It equals the weighted average cost of each specific type of capital, where
the weights equal the proportion of each capital source in the firm’s capital structure.

To estimate the weighted average cost of capital, we need to know the cost of each of the sources of
capital used and the proportion of each source of capital in the firm’s capital structure mix.

WACC = (Proportion of long-term debt in capital structure x after-tax cost of debt) + (Proportion of
preferred stock in capital structure x cost of preferred stock) + (Proportion of common stock equity in
capital structure x cost of common stock equity)

Note: Cost of Common stock equity can be the cost of retained earnings or the cost of a new issue of
common stock. The appropriate cost for equity to use in WACC calculation will depend on whether the
company using retained earnings or issuing new common stock to fund its equity portion.

Example: Weighted Average Cost of Capital

A firm has determined its cost of each source of capital and the percentage of each source
making up the firm's capital structure:

What is the Weighted Average Cost of Capital (WACC) for the firm?

WACC = (0.40 x 0.06) + (0.10 x 0.11) +(0.50 x 0.15) = 0.11 or 11 percent

Section-4: Capital Budgeting

Long-term investments represent sizable outlays of funds that commit a firm to some course of action.
Consequently, the firm needs procedures to analyze and select its long-term investments. Capital
budgeting is the process of evaluating and selecting long-term investments that contribute to the firm’s
goal of maximizing owners’ wealth. That is Capital budgeting deals with the decision of whether a
proposed project should be accepted or rejected.

Four major capital budgeting techniques are: (a) Payback period, (b) Net Present Value (NPR), (c)
Profitability Index (PI), and Internal Rate of Return

Payback Period
The payback period is the number of years needed to recover the initial cash outlay related to an
investment; in effect, it tells us how long it takes to get our money back. Thus, the payback period
becomes the number of years prior to the year of complete recovery of the initial outlay, plus a fraction
equal to the remaining unrecovered dollar amount of that year divided by the cash flow in the year in
which recovery is fully completed. The decision criterion is to accept the project if the payback period is
less than the maximum acceptable payback period and to reject the project if the payback period is
greater than the maximum acceptable payback period. What is the maximum acceptable payback
period? Ultimately, managers decide what payback period they deem acceptable, but that decision is
quite subjective—perhaps even arbitrary.

Unrecovered amount at the beginning of year backback is completed

Payback Period=
Cash flow∈ year payback is completed
Example: Payback Period
If a firm’s maximum desired payback period is 3 years, and an investment proposal requires an initial
cash outlay of $10,000 and yields the following set of annual cash flows, what is its payback period?

Year Cash Flow

1 $2,000
2 4,000
3 3,000
4 3,000
5 9,000

In this case, after 3 years the firm will have recaptured 2,000 + 4,000 + 3,000 = $9,000. So, after 3 years,
only $1,000 of the $10,000 initial investment will be remaining to be recouped. During the fourth year,
$3,000 will be returned from this investment, it will take one-third of the year ($1,000/$3,000) to
recapture the remaining $1,000. Thus, the payback period on this project is 3.33 years, which is more
than the desired payback period. Using the payback period criterion, the firm would reject this project
without even considering the $9,000 cash flow in year 5.

Net Present Value (NPV)

The net present value (NPV) of an investment proposal is equal to the present value of its annual cash
flows less the investment’s initial outlay. For example, if present value of future cash flows from an
investment proposal is $20,000 and the initial investments is $15,000, then the project will have $20,000
- $15,000 = $5,000 net present value. The decision criterion is to accept the project if the NPV is greater
than or equal to $0 and to reject the project if the NPV is less than $0.

Profitability Index (PI)

The profitability index (PI) is the ratio of the present value of the future free cash flows to the initial
outlay. Although the NPV investment criterion gives a measure of the absolute dollar desirability of a
project, the profitability index provides a relative measure of an investment proposal's desirability—that
is, the ratio of the present value of its future net benefits to its initial cost. The profitability index can be
calculated by dividing the present value of all the future annual cash flows by the initial cash outlay. The
decision criterion is to accept the project if the PI is greater than or equal to 1.00 and to reject the
project if the PI is less than 1.00.

Internal Rate of Return (IRR)

The internal rate of return (IRR) attempts to answer the question, what rate of return does this project
earn? For computational purposes, the internal rate of return is defined as the discount rate that
equates the present value of the project's cashflows with the project's initial cash outlay. The decision
criterion is to accept the project if the IRR is greater than or equal to the firm's cost of capital, and to
reject the project if its IRR is less than the cost of capital.