Time value of money -refers to the observation than it is better to receive the money sooner than later.

Timeline -depicts the cash flows associated with a given investment Negative values represent cash outflow Positive values represent cash inflows

Principal: -amount of money on which the interest is paid (Most common type: annual compounding) FVn future value at the end of the period PV principal /present value r Annual rate of interest paid n no. of period that money is left on deposit Future value equation:

Future value technique: compounding Present value technique: discounting Computational tools: -facilitate the calculations in finding the future value and present value (i.e. financial calculators and electronic spreadsheet) Basic pattern of cash flow: Single amount lump sum amounts at some future date Annuity level periodic stream of cash flows Mixed stream not an annuity; stream of unequal periodic cash flow that reflects no particular pattern

Present value of a single amount: -current value of a future amount Discounting cash flow -process of finding present values (annual rate of return: discount rate, required return, cost of capital, opportunity cost)

Single amount: Future value of single amount -value at a given future date of an amount placed on a deposit today and earning interest at a specified date (Accumulated amount) Compound interest: -interest earned has become part of the principal at the end of the period 2 basic types of cash flow stream: 1. Annuity Ordinary annuity: occurs every end of the period Annuity due: occurs at the beginning of each period Future value of ordinary annuity:

Present value of ordinary annuity:

(Weekly: m=52; daily: m=365) Continuous compounding: Involves compounding every nano second

Future value of annuity due:

(Smallest period of time imaginable)

Present value of annuity due:

Nominal rate: contractual annual rate of interest charged by lender/promised by borrower Effective annual rate: annual ret of interest actually paid or earned; (reflects the effect of compounding frequency)

Comparison: the future value and present value of an annuity is always greater than the future value and present value of an otherwise identical ordinary annuity. Perpetuity:

EAR for continuous compounding: -annuity with an infinite life PV = CF r 2. Mixed Stream: Future value of a mixed stream: find all the future value of each cashflow at specified future date then find the total. (n=total no. years-present year) Present value of mixed stream: determine all the present value of all cash flow and then total. (n= year1-n=1, year2-n=2) Semiannual compounding: interest involves two compounding periods within a year Quarterly compounding: interest involves four compounding periods within the year. APR = periodic rate *m (Annual percentage rate) APY (annual percentage yield)= EAR Interest or Growth rates: -compound annual interest of a series of cash flow (annual rate of change in values)

Finding (n): ( )

Cost of capital: -represents the firms cost of financing and is the minimum rate of return -acts as a major link between the firms long term investment decisions and the wealth of the firms owner as determined by the market rate of their shares Investment rate > cost of capital (increase the cost of capital) Projects rate of return > cost of capital Weighted average cost of capital: mix of equity and debt Long term source of capital: -source that supply the financing necessary to support the firms capital budgeting activities (Capital budgeting: process of evaluating and selecting long term investment; purpose is to maximize shareholders wealth) 4 basic sources of long term capital 1. Cost of long term debt (non-current) -financing cost from long term borrowing (Usually through the sale of corporate bonds) Net proceeds: funds that the firm received from the sale Net proceed = total proceed flotation cost Flotation cost: cost of issuing and selling securities. (i.e. underwriting cost and administrative cost)

Before-tax cost of debt: -rate of return the firm must pay on new borrowings Can be computed using the ff: Using market quotation: reflects the rate of return required by the market Calculating the cost: finding the interest yield (YTM- nominal rate) Approximating the cost

I = annual interest in dollars Nd = net proceed from sale n = no. of years After-tax cost of capital

2. Cost of preferred stock -ratio of preferred stock dividend to the firms net proceeds from the sale of preferred stock (Preferred stock: represent special type of ownership interest in the firm)

3. Cost of common stock -return required on the stock investors in the market place -rate at which investors discount the expected common stock dividends of the firm to determine its share value. Two technique to measure cost of common stock equity: 1. Constant-Growth valuation model (Gordon growth)

(market price issue price)

*The net proceeds from sale of new common stock, Nn, will be less than the current market price, P0. Therefore, the cost of new issues, rn, will always be greater than the cost of existing issues, rs, which is equal to the cost of retained earnings, rr. The cost of new common stock is normally greater than any other long-term financing cost. Weighted average cost of capital: -reflects the expected average future costs of capital over the long run

2. CAPM capital asset pricing model

Weighting schemes: 4. Cost of retained earnings *Book value weights: use accounting values to measure the proportion of each type of capital in the firms capital structure *Market value weights: measure the proportion of each type of capital at its market value Cost of new issues of common stock: -calculating the cost of common stock, net of under pricing and associated flotation costs Sold at a discount *Historical weights: based on actual structure proportions *Target weights: reflects the firms desired capital structure proportions