Seminar Instructor

Savvas Pallaris
Seminars
E1 Monday 2:00-2:50 PM, BUS 2-9
E2 Wednesday 2:00-2:50 PM, BUS 2-9
E3 Wednesday 4:00-4:50 PM, BUS 1-10
E4 Friday 2:00-2:50 PM, BUS 2-9
Office hours
Monday, 12:00am-1:50pm, BUS 2-33
Friday, 12:00am-1:50pm, BUS 2-33
fin301@ualberta.ca
Subject line: Savvas or Pallaris
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Other Information

Refer to the course calendar on Ulearn and your syllabus.

Note that there are no seminars on certain dates.
Textbook: Fundamentals of Corporate Finance, 7th (or 6th)
Canadian edition. Authors: Ross, Westerfield, Jordan and
Roberts, 2010 (2007), McGraw-Hill Ryerson, Toronto.
Calculator: Your are responsible for familiarizing yourself
with the instrument. You could consult your manual or
seek more information under Resources on the course
website.
Note: Owning a financial calculator is not required.
Bring your textbook, seminar notes, and your financial
calculator (if you have one) to all seminars.
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 Seminar 1:
Time Value of Money
Part I

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Future Value and Present Value

For whatever problem you solve: DRAW A TIMELINE!

compounding
$1 FV

0 1 2 T Period
PV $1
discounting

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Future Value: Example

Suppose you invest $1000 for one year at 5%

per year. What is the future value in one year?
Interest = 1000(0.05) = 50
Value in one year = principal + interest = 1000 + 50
= 1050
Future Value (FV) = 1000(1 + 0.05) = 1050
Suppose you leave the money in for another
year. How much will you have two years from
now?
FV = 1000(1.05)(1.05) = 1000(1.05)2 = 1102.50

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Future Value: General Formula

FV = PV(1 + r)t
FV = future value
PV = present value
r = period interest rate, expressed as a
decimal
t = number of periods
Future value interest factor = (1 + r)t

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Effects of Compounding

Simple interest earn interest on principal only

Compound interest earn interest on principal
and reinvested interest
Consider the previous example
FV with simple interest = 1000 + 50 + 50 =
1100
FV with compound interest = 1102.50
The extra 2.50 comes from the interest of
0.05(50) = 2.50 earned on the first interest
payment
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Present Values

How much do I have to invest today to have

some specified amount in the future?
FV = PV(1 + r)t
Rearrange to solve for PV = FV / (1 + r)t
If we know any three, we can solve for the
fourth.
When we talk about discounting, we mean
finding the present value of some future amount.
The value of something means the present
value unless we specifically indicate that we want
the future value.
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Present Value: Example

You want to begin saving for your daughters

college education and you estimate that she will
need $150,000 in 17 years. If you can earn 8%
per year, how much do you need to invest
today?

t = 17
r = 8%
FV = 150,000
PV = 150,000 / (1.08)17 = 40,540.34

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Discount Rate

Often we will want to know what the implied

interest rate is in an investment

Rearrange the basic PV equation and solve for r

FV = PV(1 + r)t
r = (FV / PV)1/t 1

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Discount Rate: Example

You are looking at an investment that will pay

$1200 in 5 years if you invest $1000 today.
What is the implied rate of interest?

FV = 1,200
PV = 1,000
t=5
r = (FV / PV)1/t 1 = (1200 / 1000)1/5 1 =
0.03714 = 3.714%

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Exercise

Suppose you are offered the following

investment choices:
You can invest $500 today and receive $600 in
5 years.
You can invest the $500 in a bank account
paying 4%.
What is the implied interest rate for the first
choice and which investment should you
choose?

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Annual Percentage Rate (APR)

This is the annual rate that must be quoted by

law.
By definition APR = periodic rate times the
number of compounding periods per year.
Consequently, to get the period rate we
rearrange the APR equation:
Periodic rate = APR / number of periods per
year
Note, the number of compounding periods tells
us how many times interest is added to the
principal throughout the year.
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Computing APRs

What is the monthly compounded APR if the monthly

rate is 0.5%?
0.5%(12) = 6%
What is the semiannually compounded APR if the
semiannual rate is 0.5%?
0.5%(2) = 1%
What is the monthly rate if the APR is 12% with monthly
compounding?
12% / 12 = 1%
Can you divide the above APR by 2 to get the
semiannual rate? NO!!! You need an APR based on
semiannual compounding to find the semiannual rate.
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Effective Annual Rate (EAR)

Actual rate paid (or received) after accounting

for compounding that occurs during the year
To compare two alternative investments with
different compounding periods, compute the
EAR for both investments and then compare
the EARs.
Never divide the effective rate by the number of
periods per year

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EAR Formula

m
APR
EAR 1 1
m
Remember that the APR is the quoted rate
m is the number of times the interest is
compounded in a year

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Computing EARs: Example

Suppose you can earn 1% per month on $1

invested today.
What is the APR? 1%(12) = 12%
How much are you effectively earning?
FV = 1(1.01)12 = 1.1268
EAR = (1.1268 1) / 1 = .1268 = 12.68%
Suppose another account earns 3% per quarter.
What is the APR? 3%(4) = 12%
How much are you effectively earning?
FV = 1(1.03)4 = 1.1255
EAR = 12.55%
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Computing APRs from EARs

If you have an effective annual rate (EAR), how

can you compute the APR (with m compounding
periods)? Rearrange the EAR equation and you
get:

APR m 1 EAR 1
1/m

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Example

Suppose you want to earn an annual effective

rate (EAR) of 12% and you are looking at an
account that compounds on a monthly basis.
What APR must they pay?

APR 12 1 0.12 1 0.1138655 11.39%

1/12

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Compounding: Example

You are looking at two savings accounts. One

pays 5.25% (APR), with daily compounding. The
other pays 5.3% (APR) with semiannual
compounding. Which account should you use?
First account:
EAR = (1 + 0.0525/365)365 1 = 5.39%
Second account:
EAR = (1 + 0.053/2)2 1 = 5.37%
You should choose the first account.

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Present Value with Daily Compounding

You need $15,000 in 3 years for a new car. If

you can deposit money into an account that pays
an APR of 5.5% based on daily compounding,
how much would you need to deposit?
Daily rate = 0.055 / 365 = .00015068493
Number of days = 3(365) = 1095
PV = 15,000 / (1.00015068493)1095 =
12,718.56

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Multiple Cash Flows: FV Example
You currently have $7,000 in a bank account earning
8% interest. You will deposit an additional $4,000 at
the end of each of the next three years. How much will
you have in three years?

Find the value at year 3 of each cash flow and add

them together.
Today (year 0): FV = 7000(1.08)3 = 8,817.98
Year 1: FV = 4,000(1.08)2 = 4,665.60
Year 2: FV = 4,000(1.08) = 4,320
Year 3: value = 4,000
Total value in 3 years = 8817.98 + 4665.60 + 4320
+ 4000 = 21,803.58
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Multiple Cash Flows: PV Example
An investment will pay $200 in one year, $400 the next
year, $600 the year after, and $800 at the end of the
following year. You can earn 12% on similar
investments. How much is this investment worth today?

Find the PV of each cash flow and add them

Year 1 CF: 200 / (1.12)1 = 178.57
Year 2 CF: 400 / (1.12)2 = 318.88
Year 3 CF: 600 / (1.12)3 = 427.07
Year 4 CF: 800 / (1.12)4 = 508.41
Total PV = 178.57 + 318.88 + 427.07 + 508.41 =
1432.93
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Annuities and Perpetuities

Annuity finite series of equal payments that

occur at regular intervals
If the first payment occurs at the end of the
period, it is called an ordinary annuity
If the first payment occurs at the beginning of
the period, it is called an annuity due
Unless stated, all annuities are considered
ordinary
Perpetuity infinite series of equal payments

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Basic Formulas

Perpetuity: PV = C / r
We will come back to perpetuities later
Annuities:
1
1 (1 r) t C 1
PV C 1 t
r r (1 r)

(1 r) t 1
FV C
r
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Annuity: Example

After carefully going over your budget, you

have determined that you can afford to pay
$632 per month towards a new sports car.
Your bank will lend to you at 12% APR
compounded monthly for 48 months. How
much can you borrow?

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Annuity: Example, continued

You borrow money today so you need to

compute the present value.

632 1
PV 1 48
23,999.54
0.01 (1.01)

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Annuity: Sweepstakes Example

Suppose you win the Publishers Clearinghouse

$10 million sweepstakes. The money is paid in
equal annual installments of $333,333.33 over 30
years. If the appropriate discount rate is 5%,
how much is the sweepstakes actually worth
today?

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Future Values for Annuities: Example

Suppose you begin saving for your retirement by

depositing $2000 per year (starting in one year)
in an RRSP. If the interest rate is 7.5%, how
much will you have in 40 years?
Solution 1: Calculate FV of annuity directly
FV = 2,000(1.07540 1)/0.075 = 454,513
Solution 2: Calculate PV of annuity first, then FV
PV = 2,000/0.075(11/1.07540) = 25,188.817
FV = 25,188.8171.07540 = 454,513

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Annuity Due

Ordinary Annuity
0 1 2 3

C C C
Annuity Due
0 1 2 3

C C C

PV (Annuity Due) = PV (Regular Annuity) (1+r)

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Annuity Due: Example

You are saving for a new house and you put $10,000 per year in an
account paying 8% compounded annually. The first payment is
made today and the last payment at the end of year 2 (= 3
payments). How much will you have at the end of 3 years?
0 1 2 3

10,000 10,000 10,000 FV?

Solution 1: Calculate PV of annuity due first, then FV

PV annuity due = PV ordinary annuity(1+r)
= 10,000/0.08(1 1 / 1.083)1.08 = 27,832.648
FV = 27,832.6481.083 = 35,061.12
Solution 2: Calculate FV of annuity due directly
FV = 10,000[(1.083 1) / 0.08](1.08) = 35,061.12

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