Jan Mahrt-Smith jmahrt@rotman.utoronto.

ca 1
RSM 5301
EMBA Finance 1

Jan Mahrt-Smith

Fall 2012

Pre-Course Session
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 2
Plan (this is a pre-course workshop)
Skip all the basic introductions, rules, syllabus, etc.
Basic skills to make your life easier during the course
Time Value of Money (bit of math)
Some other concepts and vocabulary (ask!!!)
Applications
End: now what?
What can you do to prepare well?
What to read
What to work on
Q&A but do this throughout!
Today
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 3
1) Suppose I offer you $1 today or some higher amount $X
exactly 6 months from now. What would you accept as $X?
2) How about you? Why? What are the important factors?
3) Now suppose a stranger walks in the door and offers you $1
today or $Y in 6 months. What would you accept as $Y?
4) Suppose I offer you $1 today or a risky payment of $0.9
(half of the time) and $1.30 (the other half of the time) in 6
months time. Would you take it?
(aside): what is the expected return?
5) Which would you prefer: $1.30 when the economy is
booming and $0.90 in a recession (assume they are equally
likely 6 months from now) or the opposite? Why?
A few questions for you
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 4
We need to make this all a bit more precise
Assume that the interest rate is 10% and there is NO RISK
(aside: what do we mean by the interest rate is ?)

How much money will you have after one year if you invest
$100 today? => FV = $100(1+10%) = $1001.1 = $110

How much money will you have after two years?
FV=[$1001.1](1.1)=$1101.1=$100(1.1)
2
= $121

General: FV(C,r,T) = $C (1+r)
T

In EXCEL
Future Values
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 5
In pictures:
Time Line 1
0
1
FV = ?
PV = $100
rate = 10%
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 6
Retirement Planning:
1) You want to have $1,000 per month when you retire,
growing at the rate of inflation (expected to be 0.2% per
month). You expect to live 25 years after retirement.
2) You want to leave your 4 children $1M (available 1 year
after your death)
3) You want to start saving today and you plan on working 20
more years. Your savings will remain constant as a
percentage of your salary, which increases at 0.4% per
month.
4) The interest rate is 10%.
=> How much do you have to save each month?
It can get complicated
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 7
Time Line 2: Retirement Planning
0
539 Pmt
1
= ??? p.m.
Period
1
= 240 mo.
Growth
1
= 0.4%
rate = 10% p.a.
Pmt
2
= $1,000 p.m.
Period
2
= 300 months
Growth
2
= 0.2% 239
240
551
$1M
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 8
Even with Future Values it gets (a bit) more tricky:
Assume that the interest rate is 6%

How much money will you have after one year if you invest
$100 today but interest is paid monthly?

NOTE: if I say the interest rate is 6% (per year) with monthly
compounding (or if interest is paid monthly) then I mean
6%/12 = 0.5% = 0.005 per month. APR=6% works that way!

FV = $100(1+0.5%)
12
= $1001.005
12
= $106.17
Interesting: 6% per year leads to $106.17 the magic of
compound interest (interest on interest) => EAY = 6.17%
More on Future Values
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 9
Get out a pen and paper (and a calculator or EXCEL)

The interest rate is 10%.

What is the future value in two years time when you put
$10,000 into a bank account today and another $10,000 one
year from now?

Bonus: what is it worth in two and a half years?

All: what implicit assumptions did you need to make?

Solution:
Mini-quiz 1 (solo)
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 10
Now that we know payoffs, we can compute returns

Suppose you invest $100 and receive $115 at the end of the
year. What return have you earned?
$100 (1+r) = $115
(1+r) = $115/$100 = 1.15
r = 0.15 = 15%

Suppose you invest $100 and get $130 after two years?
$100 (1+r)
2
= $130
(1+r)
2
= $130/$100 = 1.3
((1+r)
2
)
1/2
= (1.3)
1/2
= = 1.140175
r = 0.1402 = 14.02% EXCEL
Rates of Return
1.3
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 11
Unfortunately, returns are hard to compute by hand
when there are multiple cash flows

Suppose you invest $100 today and $110 next year and you
receive $250 at the end of the second year. What return have
you earned?
$100 (1+r)
2
+ $110 (1+r) = $250
This is a quadratic equation
We dont do those in this course
(the answer is 12.41% approximately)

Fortunately, calculators and EXCEL are happy to compute rates
of return. We refer to these as internal rates of return (IRR).
Rates of Return - complications
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 12
There is an alternative representation for returns

Suppose you invest $100 today and receive $120 at the end of
the year. What return have you earned?
$100(1+r) = $120 => (1+r)=$120/$100 => r = 0.2 = 20%

Also: rate of return = income divided by initial investment
Income = $120 - $100 = $20
Initial Investment = $100
=> return = $20/$100 = 20%
Rates of Return final word
1 0
0
V V Gains
Rate of Return
Investment V

= =
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 13
Get out a computer

What rate of return would you have earned if you invested in
Facebook on the evening of its IPO date (use the closing
price)?

Bonus: what is the ANNUALIZED rate of return on the
investment?

Bonus 2: who made the most money off the Facebook IPO?

Solution:
Mini-quiz 2 (groups of 3)
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 14
The most important question in finance: what is it
worth?

An investment opportunity offers to pay you $120 next year.
What is it worth to you today?

Answer: the value (call it present value or PV) depends on
what else you could do with your money.

Assume: you can earn 10% elsewhere for equivalent risk

Answer: PV(1+10%)=$120 => PV=$120/(1.1)=$109.09
Present Values
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 15
Lets think about that: Getting $120 next year is worth
$109.09 today! If you can invest in the opportunity at less
than $109.09 then you have created value (Net Present
Value, NPV)

The opportunity cost of capital is 10% for this risk
Financial Markets set the risk-adjusted opportunities
$120 is the expected payoff
You will get either $140, $120, or $100 with equal
probability - depending on the economy/industry/luck
A shareholder who gives the firm $109.09 to invest will
expect the firm to earn 10% for taking the risk
NPV > 0 is value creation by definition
Present Values - Logic
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 16
Recap (formulas)
( ) ( )
( ) ( )
( )
( )
( )
3
1 0 1
0 0
1
3
0.3333
FV $100,10%,1yr $100 1 10% $110.00
FV $100,10%,3yrs $100 1 10% $133.10
V V V $110
Return 1 1 1.1 1 0.1 10%
V V $100
$133.10
Return 1 1.331 1.1 1 10%
$100
$110
PV $110,10%,1yr
1 10%
= + =
= + =
| |
| |
= = = = = =
|
|
\ .
\ .
| |
= = = =
|
\ .
=
+
( )
( )
3
$100
"Discounting"
$133.10
PV $133.10,10%,3yrs $100
1 10%

= =

+
)
EXCEL
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 17
1) A firm must allocate capital to create value

An investment project is a series of expected future cash
flows that come with some risk
An investment decision must ensure that the present value
of all future cash (in-)flows discounted at the risk
adjusted opportunity cost of capital exceeds the
required investment only then will the investment create
value:
Why does TVM matter? => NPV
( )
( )
( ) ( )
1 2 T
1 2 T
2 T
Required Investment < PV [C ,C ,...,C ],r
C C C
I ...
1 r
1 r 1 r
< + + +
+
+ +
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 18
Investment Project Time Line
0
Cost of capital = 10% p.a.
1
3
$2M
2
Growth rate = 10%
g = 5%
4
13 30
$5M
$7M
$4M
$1M
Is the PV(Investments) < PV(Inflows)?
What is the NPV of the project?
EXCEL
Jan Mahrt-Smith jmahrt@rotman.utoronto.ca 19
If you have time, prepare in this order:
Read chapters 1-3, dont worry about problems or math
Read chapter 5, spend as much time as you can on it, do
as many problems as you can
Use Excel for everything from now on (calculations,
budgets, playing games, making doodles, etc.)
Log onto MBA Math and work on Time Value of Money
Listen to parts of this pre-course again if you missed bits;
look at the associated spreadsheets (posted) but try the
exercises first on your own before you look at solutions!
Look over the list of end-of-chapter problems (posted
solutions still to come)
What should you do?