Foster MBA 2010 Finance Jump Start - Gilbert - Day 1 With Notes and Answers

MBA Jump Start
Finance - Day 1
Thomas Gilbert
September 17th 2010
About Myself
• Finance assistant professor
– Ph.D. in Finance from U.C. Berkeley, 2008
– Masters in Finance from U.C. Berkeley, 2005
– Masters in Physics from Imperial College (London, U.K.), 2002
• Teaches finance and investment classes in various executive programs, as

well as in the full-time MBA and Ph.D. programs at the University of
Washington and at U.C. Berkeley
• Winner of the Professor of the Quarter and Professor of the Year Awards in
2009-2010 as well as the PACCAR Award for Teaching Excellence
• Research focus is on the impact
p of ppublic information releases ((GDP,,
employment, earnings…) on financial markets
• Contact information:
gilbertt@u.washington.edu
http://faculty.washington.edu/gilbertt/
Finance – Day 1 Thomas Gilbert Page 2
1
“Bad” news:
Jump Start Goals All the material in this
workshop will be assumed
• Your goals:
known at the start of BA 500 -
– Build skills Finance (assignment due on
• Learn financial calculations second day of class)
• Time value of money
• Find a “real” use
se for math
– Get comfortable with a new schedule
• Transition from work schedule to academic schedule
• Meet new classmates
– Set expectations for the coming year
• Answer questions you might have
• Discuss class formats
• My goals:
– Introduce you to finance
– Get you prepared and enthusiastic for your core MBA finance class
– Get to know more of you!
1. Time Value of Money
2
Time Value of Money
• Jump right in and learn!!!
• Understand how to compare:

– Payments made today
– Payments made in the future
• Understand the following terms:

– Present value (PV)
– Discount rate (r)
– Future value (FV)
– Net present value (NPV)
• Learn how to draw project cashflows
Inter-Temporal Choices
• Which would you rather receive?
– $100,000 today
– $250,000 in exactly seventeen years
• Both payments are riskless

– Consider the payments as backed by the U.S. government
– They are backed by collateral accounts that contain $100,000 or
$250,000 and only accessible by you
– There is a 100% probability that you will be paid
– There is a 0% probability that you will not be paid
• Why is this riskless stuff important?
3
Risk
• What is risk?
• Risk means that there is uncertainty in the delivery of the future cashflows
– Probability distribution of future outcomes
• Get paid if…, with probability…
• Don’t get paid if…, with probability…
• Riskless cashflows are easier to deal with than risky cashflows since we do
not have to think about risk
– They serve as a baseline/benchmark for comparison
• Risk is a major topic of the core finance class
Definition #1: Cashflow

• A “cashflow” is a time-dated money amount
– It has an amount (such as 2 or 3,000,000,000)
– It has a unit (such as USD or CHF)
– It has a date (one point in time)
– It has a sign (positive = inflow, negative = outflow)
• Absolute rule of finance:
ALWAYS DRAW A TIMELINE!!!
4
Inter-Temporal Choices (2)
• Why is it hard to compare?
– $100,000 today
• This is not an “apples to apples” comparison
• Rule #1 of time travel:
You can only compare cashflows at the same point in time
• Your first timeline:
Definition #2: Present Value

• In order to compare, we need to convert the future cashflows into present
values:
CFt
PVt =0 =
(1 + rt )
t
where PVt=0 = present value at time zero

CFt = cashflow at time t
rt = discount rate for payments in t years (annualized)
1/(1+rt)t = discount factor
• Calculating present values (moving cashflows backwards in time) is also

called discounting
• Can we now answer our first question?
5
Present Value
• Which would you rather receive?
– $100,000 today
• If the discount rate for year-seventeen cashflows is 6% per year, then:
• Decision?
Compound Interest
• The ability to earn interest on interest
– Interest payments are reinvested
– Subsequently, these payments earn interest
• Example 1: $100 invested for 3 years at 8% per year

$100 → 100*(1+0.08) → 100*(1+0.08)2 → 100*(1+0.08)3
$100 → 108.00 → 116.64 → 125.97
• Example 2: $523 invested for 20 years at 7% = ???
6
Why is the PV Math Reasonable?
• Think about the opposite direction of time travel: forward
• You place $100,000 today in a secured savings account which earns an

interest rate of 6% per year for seventeen years
• How much do you have at the end?
• This is called the Future Value
Definition #3: Future Value

• To move cashflows forward in time, we compound:
FVt = CFt =0 × (1 + rt )
t
where FVt = future value at time t

CFt=0 = cashflow at time zero
rt = discount rate for payments in 17 years (annualized)
• The Present Value calculation is simply the inverse of this
• Did we reach the same conclusion about our problem?
7
Summary
• Rule #1: You can only compare $ at the same point in time
• Rule #2: To move cash flows backwards in time, we discount them: …/(1+r)t
• Rule #3: To move cash flows forward in time, we compound them: …*(1+r)t
• The Rule: CFt

PV0 =
(1 + rt )
t
• ALWAYS DRAW A TIMELINE!!!!
2. Problem-Solving
8
Class Expectations #1: Practice
• To get better at piano, a reasonable person can expect to practice piano…
…a lot!!!
– Some practice may be “boring”, like doing scales
– Some practice time may be spent learning new pieces
– Some practice may be repetitive
– Some practice time may be spent trying new things
• Finance is very, very similar

– You should do practice problems on your own and/or with your study
group
– Your ability to learn finance depends on your ability to motivate
yourself to do problems
• Practice makes perfect!!!
Problem #1
• What is the present value of $100,000 received in one year (one year in the
future) if the discount rate (for one-year horizons) is 6%?
• Step 1: Think!
PV <?>
? $100,000
$100 000
• Step 2: Draw timeline
• Step 3: Solve
9
Problem #2
• What is the present value of $100,000 received in year 10 if the discount
rate (for ten-year horizons) is 6%?
• Step 1: Think!
PV <?>
? $94,340
$94 340
• Step 3: Solve
Problem #3
• What is the present value of $100,000 received in year 17 if the discount
rate (for seventeen-year horizons) is 6%?
• Step 1: Think!
PV <?>
? $55,839
$55 839
• Step 3: Solve
10
Class Expectations #2: Calculators
• All students are required to have and use a financial calculator
• I will use (and thereby require you to use) the HP-12C
– The platinum version is recommended since it allows algebraic notation
– The regular version only allows reverse polish notation
• In the CFA exam, only the HP-12C (regular or platinum) or the TI-BA2+
(reg lar or professional) are allo
(regular allowed
ed in the exam
e am room
• In your finance exam, you will only be allowed to use a calculator
• If you want to use another calculator, make sure that it has financial
functions built in, such as IRR, bond pricing…
Solving for PV and FV on the HP-12C
n Number of periods
i Interest rate in % (constant for all periods)
PV Present value at time 0
PMT Periodic payment (repeats every period, starting at time 1)
FV Future value (one-time payment at time n)
11
Problem #3 on HP-12C
• An earlier problem, now done on the HP-12C:
What is the present value of $100,000 received in year 17 if the
discount rate (for seventeen-year horizons) is 6%?
• Using
U i my HP
HP-12C:
12C
n =
i =
PV = ???
PMT =
FV =
Inter-Temporal Rates
• Is it reasonable to assume the same discount rate for 1-year cashflows and
for 17-year cashflows?
• Do you receive the same interest rate for 1-year loans and for 17-year
loans?
• We have a “menu” of inter-temporal discount rates:

1 year: r1 = 6%
2 years: r2 = 7%
3 years: r3 = 7.5%
4 years: r4 = 8.25%
5 years: r5 = 8%
• This is called the term structure of interest rates (spot rates)
12
Present Value of Multiple Cashflows
• Cashflows at different points in time are discounted at their own discount
rates: r1 for CF1, r10 for CF10, r17 for CF17…
• Timeline for multiple cashflows:
• The present value of multiple cashflows is simply the sum of their present
values:
CF1 CF2 CF3 CFt

PV0 = + + +… + +…
(1 + r1 ) (1 + r2 ) (1 + r3 )
2 3
(1 + rt )
t
Problem #4
• If you are given the following set of cashflows and discount rates, can you
calculate the PV?
C1 = $50 and r1 = 6%
C2 = $60 and r2 = 7%
• Step 1: Think!
PV <?> $110
• Step 2: Draw the timeline
• Step 3: Solve
13
3. Net Present Value
Projects
• A “project” is a general term used in finance
– Invest some money today (cash outflow)
– Receive payoffs in the future (cash inflows)
• This is a stylized
st li ed way
a to draw
dra project cashflows:
cashflo s:
Expected payoff
0
Time (years)
1 2
Investment
• Projects come in varied forms

– Entrepreneur starts a company (real investment)
– Investor purchases a stock (monetary investment)
– My friend buys a lottery ticket (gamble)
14
Problem #5
A merchant pays $100,000 for a load of grain and is certain that it can be
resold at the end of one year for $132,000.
a. What is the return on this investment?
b. If this return is lower than the rate of interest, does the investment have a
positive or negative NPV?
Problem #5 (2)
c. If the rate of interest is 10 percent, what is the PV of the future cash
flow(s)?
d. What is the NPV?
15
Definition #4: Net Present Value
• The net present value combines the initial investment (usually made at
time zero) and the PV of the expected future cashflow(s):
CF1 CF2 CF3 CFt

NPV0 = CF0 + + + +… + +…
(1 + r1 ) (1 + r2 ) (1 + r3 )
2 3
(1 + rt )
t
T
CFt
= CF0 + ∑
(1 + rt )
t
t =1
• It basically is a cost-benefit analysis, but taking into account the time value
of money
money, ii.e.
e the fact that cashflows do not occur at the same point in time
• In firms, managers have to choose projects, and the following rule applies:
Choose projects with NPV > 0
Problem #6
• If you are given the following set of cashflows and discount rates, can you
calculate the NPV?
C0 = -$90
C1 = $50 and r1 = 6%
C2 = $60 and r2 = 7%
• Step 1: Think!
PV <?> $20
• Step 2: Draw the timeline
• Step 3: Solve
16
Discount Rates
• What does the rt represent?
• The discount rate used for computing NPV should represent the best
alternative use of your capital
– This is sometimes referred to as the hurdle rate or opportunity cost of
capital
• In practice, the discount rate often comes from the return on an asset (bond,
traded stock, etc.) with comparable risk
– This is called the risk-adjusted discount rate
• In the world of riskless payoffs, we can get the rate from U.S. Government
bonds and bills (since they are considered riskless)
Problem #7
• A parcel of land costs $500,000. For an additional $800,000 you can build
a motel on the property. The land and motel should be worth $1,500,000
next year. Suppose that common stocks with the same risk as this
investment offer a 10 percent expected return. Would you construct the
model?
17
Practice Quiz #1 and Break
• Please spend a few minutes and complete the practice quiz on the next page
– Timeline
– NPV
– Decision
• The answers will be handed in at the end of class
• Then take a 10-minute break to stretch your legs
4. Perpetuities & Annuities
18
Class Expectations #3: Lectures
• Your professors use a variety of lecturing styles
– Some write on the board
– Some use Powerpoint
– Some lead case discussions
– Some use Tablet PCs ☺
• Professors choose the method that most enhances learning
– Different styles for different subjects
– Different styles for different parts of the same subject
• Some professors make class notes available before class; some make them
available after class
• Some professors gi givee you
o home
homework
ork problems to prepare ahead of class;
some professors give you homework problems after class
• Cases are always to be prepared ahead of class and you have to be ready for
in-class discussion
Definition #5: Perpetuities

• If a project makes a level, periodic payment forever, it is called a
perpetuity
• Let’s suppose your friend promises to pay you $1 every year, starting in
one year, forever
f
– His future family will continue to pay you and your future family
– The discount rate is assumed constant at 8.5%
– How much is this promise worth?
$1 $1 $1 $1 $1 $1
Time (years)
1 2 3 4 5 infinity
PV0 = ?
19
Perpetuity Formula
• Valuing the perpetuity could be hard:
1 1 1 1 1
PV0 = + + +… + +… +
(1 + r ) (1 + r )2 (1 + r )3 (1 + r )
t
(1 + r )
∞
∞
1
=∑
(1 + r )
t
t =1
= ???
• Luckily, mathematicians figured this out a long time ago (students who like
math can work on this)
• The value
al e of a perpetuity that pays
pa s a periodic cashflo
cashflow “C” starting next
ne t
period and has a periodic discount rate “r” is:
C
PV =
r
Problem #8
• Let’s suppose your friend promises to pay you $1 every year, starting in
one year, forever
– His future family will continue to pay you and your future family
– The discount rate is assumed constant at 8.5%
– How much is this promise worth?
20
Real-World Example
• There is common saying in the investment world:
“Businesses are worth ten times cashflow”
• Given what we have just learned about perpetuities, can someone explain
thi ?
this?
Definition #6: Growing Perpetuities

• Suppose now that the cashflow next year is “C” and then grows every year
after that at “g” percent per year
• Timeline:
• The value of a growing perpetuity that pays cashflow “C” next period,
where the cashflow then grows at rate “g”
g per period after that
that, and has a
periodic discount rate “r” is:
C
PV =
r−g
21
Problem #9
• Suppose your friend now promises to pay you $100 next year and this
cashflow will grow by 3% every year forever. The discount rate is 12%
• How much is this promise worth?
Real-World Example (2)

• There is common saying in the investment world:
“Businesses are worth ten times cashflow”
• Given what we have just learned about growing perpetuities, can someone
explain
l i this?
thi ?
22
Jump Start Website
• For information related to the summer workshop website
– http://faculty.washington.edu/gilbertt
– Go to MBA Teaching, 2009 Foster MBA Finance Jump Start
• Syllabus, class notes, quizzes, answers, and Excel spreadsheets are all
posted there
• I also posted some files on how to use the HP-12C
• I will
ill post the slides with
ith my
m Tablet annotations after each class
Definition #7: Annuities

• A project might not pay you forever
• Instead, consider a project that promises to pay you a level amount “C”
every year (starting next year), for the next “T” years
• This is called an annuity
$C $C $C $C $C $C
Time (years)
1 2 3 4 5 T
PV0 = ?
• Can you think of examples of annuities in the real world?
23
Annuity Formula
• How do we value an annuity?
• Again, students who like math can work on this by starting with the
intuition that an annuity is the difference between two perpetuities, one that
starts
t t att time
ti 1 andd one that
th t starts
t t att time
ti T+1
• The value of an annuity with constant cashflow “C” starting at time 1 and
ending at time “T”, with discount rate “r” is:
C ⎛ ⎛ 1 ⎞ ⎞
T
PV = × ⎜1 − ⎜ ⎟ ⎟
r ⎜⎝ ⎝ 1 + r ⎠ ⎟⎠
Problem #10
• You just won the $20,000,000 lottery!!! However, you are actually getting
paid $1,000,000 per year for the next 20 years.
• If the discount rate is a constant 8% and the first payment is in one year,
how much have you actually won (in PV-terms)?
24
Annuities on the HP-12C
• Annuities are very easy on the HP-12C:
n = number of periodic payments
i = discount rate
PV = ???
PMT = periodic payment
FV = 0 (the last periodic payment is included in PMT)
• Problem #10 on the HP-12C:
First introduction to risk!

NPV of Problem #10
• Paper reports: Today’s jackpot = $20 million!!!
– Paid in installments exactly as previously described (tax-free)
– Odds of winning the lottery are 13 million to 1
– Ticket costs $1
• Is this a positive NPV project?
25
Definition #8: Growing Annuities
• Suppose now that the cashflow next year is “C” and then grows every year
after that at “g” percent per year, for “T” years
• Timeline:
• The value of a growing annuity that pays “C” starting next period, with a
periodic growth rate “g” after that, for the next “T” periods, and a periodic
discount rate “r” is
C ⎛ ⎛ 1 + g ⎞T ⎞
PV = × ⎜1 − ⎜ ⎟ ⎟
r − g ⎜⎝ ⎝ 1 + r ⎠ ⎟⎠
• There unfortunately is no calculator shortcut for this
Formula Overview Slide
Perpetuities Annuities
C ⎛ ⎛ 1 ⎞ ⎞
T
C
Level PV = PV = × ⎜1 − ⎜ ⎟ ⎟
Payments r r ⎜⎝ ⎝ 1 + r ⎠ ⎟⎠
C C ⎛ ⎛ 1 + g ⎞T ⎞
Growing PV = PV = × ⎜1 − ⎜ ⎟ ⎟
Payments r−g r − g ⎜⎝ ⎝ 1 + r ⎠ ⎟⎠
26
Very Important Thing to Remember
• WARNING!!!
• If you want to use any of the perpetuity/annuity formulae, you must

understand something critical
– The formulae give you present values at time “t” given that the
first periodic cashflow is at time “t+1”
• Problem #11: What is the PV of a $10 perpetuity starting in year 11 if the

discount rate is 5%?
Very Important Thing to Remember (2)

• End of Problem #11:
27
Problem #12
• This morning, you received a promissory note guaranteeing annual
payments of $15,000 for 30 years, starting today. If your opportunity cost
of capital is 7%, what is the PV of this note?
Quiz #2 and Summary

• Please spend a few minutes and complete the practice quiz on the next page
– Annuity
– Growing perpetuity
• The answers will be handed in at the end of class
• Today, we learned about the time value of money

– Comparing payments made today and payments made in the future
– Present values
– Drawing cashflow timelines
– Net present values
– Special streams of cashflows: perpetuities and annuities
28
Next Class
• This afternoon/tonight, you should review today’s class
– Do the practice problems listed on the syllabus
• And prepare for the next class
– Do the reading
• I expect students to spend one to two hours per night studying finance
• Next time
– Learn to calculate mortgage payments
– Learn to price bonds
– Learn to calculate yield-to-maturity
– Learn about compounding
29

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MBA Jump Start

September 17th 2010

• Teaches finance and investment classes in various executive programs, as

Finance – Day 1 Thomas Gilbert Page 3

1. Time Value of Money

• Understand how to compare:

• Understand the following terms:

• Learn how to draw project cashflows

Finance – Day 1 Thomas Gilbert Page 5

• Both payments are riskless

• Why is this riskless stuff important?

Finance – Day 1 Thomas Gilbert Page 6

• Risk is a major topic of the core finance class

Finance – Day 1 Thomas Gilbert Page 7

Definition #1: Cashflow

• Absolute rule of finance:

ALWAYS DRAW A TIMELINE!!!

Finance – Day 1 Thomas Gilbert Page 8

• This is not an “apples to apples” comparison

• Rule #1 of time travel:

You can only compare cashflows at the same point in time

• Your first timeline:

Finance – Day 1 Thomas Gilbert Page 9

Definition #2: Present Value

where PVt=0 = present value at time zero

• Calculating present values (moving cashflows backwards in time) is also

• Can we now answer our first question?

Finance – Day 1 Thomas Gilbert Page 10

• If the discount rate for year-seventeen cashflows is 6% per year, then:

Finance – Day 1 Thomas Gilbert Page 11

• Example 1: $100 invested for 3 years at 8% per year

• Example 2: $523 invested for 20 years at 7% = ???

Finance – Day 1 Thomas Gilbert Page 12

• You place $100,000 today in a secured savings account which earns an

• How much do you have at the end?

• This is called the Future Value

Finance – Day 1 Thomas Gilbert Page 13

Definition #3: Future Value

where FVt = future value at time t

• The Present Value calculation is simply the inverse of this

• Did we reach the same conclusion about our problem?

Finance – Day 1 Thomas Gilbert Page 14

• The Rule: CFt

• ALWAYS DRAW A TIMELINE!!!!

Finance – Day 1 Thomas Gilbert Page 15

• Finance is very, very similar

• Practice makes perfect!!!

Finance – Day 1 Thomas Gilbert Page 17

• Step 2: Draw timeline

Finance – Day 1 Thomas Gilbert Page 18

• Step 2: Draw timeline

Finance – Day 1 Thomas Gilbert Page 19

• Step 2: Draw timeline

Finance – Day 1 Thomas Gilbert Page 20

Finance – Day 1 Thomas Gilbert Page 21

Solving for PV and FV on the HP-12C

i Interest rate in % (constant for all periods)

PV Present value at time 0

PMT Periodic payment (repeats every period, starting at time 1)

FV Future value (one-time payment at time n)

Finance – Day 1 Thomas Gilbert Page 22

Finance – Day 1 Thomas Gilbert Page 23