Corporate Finance Mod 2: Readings for Ninth Ed


Corporate Finance Mod 2: Readings for Ninth Ed

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Corporate Finance, Module 2: "How to Calculate Present Values"

Readings for Ninth Edition from Brealey and Myers, chapter 3

(The attached PDF file has better formatting.)

Updated: November 19, 2007

The page numbers here are for the ninth edition of Brealey and Myers. You may also use the seventh or eighth editions of this text. The page numbers for the seventh and eighth editions are in separate postings.

Module 2 deals with material that is covered in greater depth on SOA Course FM (CAS Exam 2). If you have already taken Course FM, you know this material; if you have not yet sat for Course FM, you must learn this material anyway.

Focus on sections 3.2 and 3.3, shortcuts using perpetuities and annuities. Know especially the following formulas:

Page 40: present value of perpetuity and growing perpetuity

Pages 41-45: present value of annuity

 

The notation for Course FM is slightly different, but the formulas are the same. This course focuses on the financial theory, not on annuity valuation. The final exam questions can be solved by writing out the present values of each cash flow, but the annuity and perpetuity formulas simplify the mathematics.

Jacob: Where do we use these formulas in corporate finance?

Rachel: The present value of a perpetuity is the market value of perpetual debt. The debt always itself has a maturity; it is not permanent. Perpetual debt means that the firm intends to refinance the debt at its maturity. We use this formula to evaluate the tax shields from perpetual debt for the capital structure modules of this course.

The next module takes the present value of common stock dividends, assuming a steady growth rate and no maturity; this is the growing perpetuity. A growing perpetuity starting after N years is a stock that pays no dividends now, but will begin paying after N years, or a stock that will change its dividend yield in N years. The annuity formulas are used to value finite debt.

Read section 3.4, "Compound Interest and Present Values," pages 48-52. Know the section on pages 47-48 regarding continuous compounding. This subject is covered on Course FM; know the three examples on pages 51-52. Option pricing uses continuous compounding. Brealey and Myers show the formulas with annual compounding, since not all their readers can handle exponentiation. The final exam for this course follows the formulas in the Brealey and Myers text.

The Summary on pages 53-54 lists the major formulas. From the quiz on pages 54-55, review questions 1-7 and 11; these do not require much arithmetic. Review practice questions 12, 13, and 14 on page 55).

Most of the practice questions deal with Course FM material. The final exam for this course focuses on the finance aspects, not the annuity and bond aspects.


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For practice question #14, 2nd question: "What will the factory be worth at the end of five years?"... I calculated the PV of the remaining five cash flows (from years 6 thru 10) and then discounted back to year 5 as follows:

PV (in year 5) = $170,000 x [1/.14 - 1/(.14*(1.14)^5)] = $583,623.76

I reckoned the value of the factory (at end of year 5) would be the most that someone would be willing to pay for the remaining cash flows using discount rate of 14%.

Was this correct?
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I have already taken FM, so I know very well the annuity formula (1-vn)/i.

Is there any reason why we would need to use the books formula over this one?  I believe they are algebraically the same but perhaps there is an application later that goes well with the formula from the book.

[NEAS: Use any annuity formula you want.]


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