Minors in Quantitative Finance
(FinIQ Consulting)
Introduction to Financial Instruments
Lecture 2
- Nidhish
Time Value of Money
Rs. 1000 Rs. 1050
Now 1 Year Later
The time value of money is also referred to as the Present Discounted Value.
Time Value of Money
The time value of money (TVM) is the concept that a sum of money is worth
more now than the same sum will be at a future date due to its earnings
potential in the interim.
The time value of money is a core principle of finance. A sum of money in the
hand has greater value than the same sum to be paid in the future. The time value
of money is also referred to as the Present Discounted Value.
Time Value of Money- Factors at play
1. Opportunity cost: Money you have today can be invested and accrue interest, increasing its value.
2. Inflation: Your money may buy less in the future than it does today.
3. Uncertainty: Something could happen to the money before you’re scheduled to receive it. Until you have it, it’s not a given.
Time Value of Money
??? Rs. 1050
Now 1 Year Later
Assume that there is another investment opportunity which is providing 7% of annual interest.
What should be the value of this investment opportunity as of today, to make it profitable?
Time Value of Money
Rs. 1000 Rs. 1050
Now 1 Year Later
PV = FV / [ 1 + (i) ] (t)
PV = 1000 PV = 1050 / [ 1 + 0.07 ] 1
PV = 981.30
Time Value of Money (single compounding period)
PV = FV / [ 1 + (i) ] (t)
In the TVM formula:
● FV = cash’s future value
● PV = cash’s present value
● i = interest rate (when calculating future value) or discount rate (when calculating present value)
● t = number of years
Time Value of Money (with multiple periods)
PV = FV / [ 1 + (i / n) ] (n x t)
In the TVM formula:
● FV = cash’s future value
● PV = cash’s present value
● i = interest rate (when calculating future value) or discount rate (when calculating present value)
● n = number of compounding periods per year
● t = number of years
Similarly, Future value can be calculated as
FV = PV x [ 1 + (i / n) ] (n x t)
Numerical Example
Numerical Example
● Sully is considering pursuing their M B A.
● The one-time upfront cost is $75,000.
● Higher education costs are expected to increase by 3.5% over the next year
● If the interest rate is 5%, what is the cost waiting one year to enter the M B A
● program?
Numerical Example
Questions:
● What will be the PV of Rs.50,000 opportunity, receivable after 3 years? (Discount rate = 10% p.a.)
● What will be the FV after 4 years for Rs.100,000 Investment done today, if the interest rate on another
similar investment opportunity is 8% per annum.
● What will be the PV of the Investment Opportunity which is providing Rs. 20,000 after 2 years and Rs.
40,000 after 3 years, if inflation rate = 6% is taken as a base for discounting the future value of
currency?
1) With annual Compounding &
2) With Semi-annual Compounding
● Find the FV of my investment at the end of 3rd year, if I invest Rs.10,000 every new year for next 3
years, expecting the growth rate on my investment to be 12% p.a.
1) Without compounding &
2) With Quarterly Compounding
NPV : Net Present Value
Net Present Value (NPV) is the value of all future cash flows (positive and
negative) over the entire life of an investment discounted to the present.
NPV analysis is a form of intrinsic valuation and is used extensively across finance
and accounting for determining the value of a business, investment security, capital
project, new venture, cost reduction program, and anything that involves cash flow.
NPV : Net Present Value
● The Net Present Value (N P V) of a project or investment is the difference between the present value of
its benefits and the present value of its costs
• Net Present Value
•NPV=PV(Benefits) − PV(Costs)
•NPV=PV(All project cash flows)
● When making an investment decision, take the alternative with the highest NPV
● Choosing this alternative is equivalent to receiving its NPV in cash today
NPV
Net Present Value
The value of all future cash flows (positive and negative) over the entire life of an
investment discounted to the present.
THE NPV DECISION RULE
● Accepting or Rejecting a Project
1. Accept those projects with positive N P V because accepting them is equivalent to receiving their
NPV in cash today
2. Reject those projects with negative N P V because accepting them would reduce the wealth of investors
NPV : Net Present Value
What is Discount rate?
Discount Rate:
What is Discount rate?
• The discount rate is the interest rate used to calculate the present value of future cash
flows of a project or investment.
• The discount rate makes it possible to estimate how much the project’s future cash
flows would be worth in the present.
• The financial analyst needs to set the Discount Rate to calculate the NPV of the
project.
• Many companies use WACC (Weighted Average Cost of Capital) to set the value of
Discount rate.
• Discount Rate is not necessary to be based only on the inflation rate or intrest rate in
the market, but depends on the cost of capital of the particular project and other
factors as well.
NPV : Example
NPV : Example
NPV : Applications in Finance
NPV of a Business:
To value a business, an analyst will build a detailed discounted cash flow DCF model in Excel. This financial model will include all
revenues, expenses, capital costs, and details of the business
NPV of a Project
To value a project is typically more straightforward than an entire business. A similar approach is taken, where all the details of the project
are modeled into Excel, however, the forecast period will be for the life of the project, and there will be no terminal value. Once the free cash
flow is calculated, it can be discounted back to the present at either the firm’s WACC or the appropriate hurdle rate
WACC
What is WACC?
● WACC represents a company’s average cost of financing, weighted by the proportion of equity and debt in its capital structure.
● It reflects the minimum return a company must earn on its projects to satisfy investors and lenders.
● Commonly used as the discount rate in NPV and valuation models.
● Lower WACC → cheaper capital → more projects become value-accretive.
WACC - Example
Assume:
● Equity (E) = $600,000
● Debt (D) = $400,000
● Cost of Equity (Re) = 14%
● Cost of Debt (Rd) = 8%
● Tax Rate (T) = 25%
Step 1: Total Capital
V = 600,000 + 400,000 = 1,000,000
Step 2: Weights
● E/V = 600,000 / 1,000,000 = 0.60
● D/V = 400,000 / 1,000,000 = 0.40
Step 3: After-tax Cost of Debt
Rd × (1 − T) = 8% × (1 − 0.25) = 6%
Step 4: WACC
WACC = (0.60 × 14%) + (0.40 × 6%) => WACC = 8.4% + 2.4% = 10.8%
Questions:
● Invest 20,000 USD now and receive 3 yearly payments of 5,000 USD each along with 12,000 USD in
the 3rd year. Assume Discount rate as 10%. Justify whether it is a good Investment opportunity or not.
● A project with a 4 year life and a cost of Rs. 225,000 generates revenue of Rs. 48,000 in year 1,
Rs.67,000 in year 2, Rs. 95,000 in year 3 and Rs. 110,000 in year 4. If the discount rate is 15%,
should we accept this project?
● Invest 9,000 USD now and receive three yearly payments of 2,500 USD each along with 4,000 USD in
the 3rd year. What is the NPV? Assume discount rate=5%
● Find the NPV of an investment having initial cash outflow of Rs. 280,000. The cash inflows at first,
second, third and fourth years are expected to be Rs. 72,000, Rs. 97,000, Rs.105,000 and Rs, 110,000
respectively. What is the NPV? Assume discount rate=5%