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# THE TIME VALUE OF MONEY

## THE KEY TO THE VALUATION OF FINANCIAL MARKETS

INTRODUCTION

Compound interest calculations help to determine the future sums of money from an
investment.

Compounding, is a technique which is used to evaluate the cash ﬂow associated with the
valuation of ﬁnancial markets such as discounting, or the calculation of present values.
CONT.
FUTURE VALUES – COMPOUNDING

A 2000 rupees in hand today is worth more than 2000 rupees to be received tomorrow.

Because money could earn the interest from putting it in a savings account. This process of
earning interest on money is known as compounding.

## Compounding interest means that interest earns interest.

FUTURE VALUE INTEREST FACTOR
COMPOUNDED FUTURE VALUE OF \$1 (FVIF)
PRESENT VALUES – DISCOUNTING

## Present value is the present worth of future sums of money.

The process of calculating present values, or discounting, is actually the opposite of ﬁnding
the compounded future value.

## Recall, the future value of investment annually, at interest rate i.

CONT.
CONT.

Example: 2
Nadia has been given an opportunity to receive \$20 000 six years from now. If she can earn 10 per cent on
investing it, what is the most she should pay for this opportunity?
Conclusion
In other words she could invest \$11 280 today at 10 per cent and have \$20 000 in six years.
PRESENT VALUE OF \$1 (PVIF)
BOND AND STOCK VALUATION

The process of determining security valuation involves ﬁnding the present value of an asset’s expected
future cash ﬂows using the investor’s required rate of return.

Thus the basic security valuation model can be deﬁned mathematically as equation
CONT.
BOND VALUATION

The valuation process for a bond requires a knowledge of three basic elements:

 The amount of the cash ﬂows to be received by the investor, which is equal to the periodic interest to be
received and the par value to be paid at maturity.

## The periodic interest can be received annually or semiannually.

The value of a bond is simply the present value of these cash ﬂows.
PAR VALUE

## Par value is important for a bond or ﬁxed-income instrument.

Because it determines its maturity value as well as the dollar value of coupon payments.

CONT.

CONT.

## If the interest payments are made annually then we derive equation,

where
PRESENT VALUE OF AN ANNUITY OF \$1 (PVIFA)
EXAMPLE
Consider a bond, maturing in 10 years and having a coupon rate of 8 per cent. The par value is \$1000.
Investors consider 10 per cent to be an appropriate required rate of return in view of the risk level
associated with this bond. The annual interest payment is \$80 (8% × \$1000).
Solution
The present value of this bond is given by equation
COMMON STOCK VALUATION
EXAMPLE

Mathematical expression:

Assume an investor is considering the purchase of stock A at the beginning of the year. The dividend at year-
end is expected to be \$1.50, and the market price by the end of the year is expected to be \$40. If the investor’s
required rate of return is 15 per cent, then what is the stock value?
CONT.
GENERAL FORMULA FOR STOCK VALUATION
Since common stock has no maturity date and is held for many years, a more general, multi-period
model is needed. The general common stock valuation model is deﬁned as follows:

## There are three cases of growth in dividends:

 Zero growth
 Constant growth
 Super normal growth
In the case of zero growth,
CONT.

Example
CONSTANT GROWTH

## This formula is known as the Gordon growth model.

Example:
Consider a common stock that paid a \$3 dividend per share at the end of last year and is expected to
pay a cash dividend every future year with a growth rate of 10 per cent. Assume that the investor’s
required rate of return is 12 per cent. What is the stock value?
SUPER NORMAL GROWTH

Firms typically go through life cycles, during part of which their growth is faster than that of the
economy and then falls sharply. The value of stock during such supernormal growth can be found by
taking the following steps:
 compute the dividends during the period of supernormal growth and ﬁnd their present value.
 ﬁnd the price of the stock at the end of the supernormal growth period and compute its present
value.
 add these two present value ﬁgures to ﬁnd the value (P0) of the common stock.
EXAMPLE

Consider a common stock whose dividends are expected to grow at a 25 per cent rate for two years,
after which the growth rate is expected to fall to 5 per cent. The dividend paid last period was \$2. The
investor desires a 12 per cent return. To ﬁnd the value of this stock, take the following steps:
CONT.

## Present Value of Dividends:

CONT.

Step: 2 Find the price of stock at the end of the supernormal growth period.
The dividend for the third year is
CONT.

Step: 3 Add the two PV ﬁgures obtained in steps 1 and 2 to ﬁnd the value of the stock.
SIMPLE INTEREST AND COMPOUND
INTEREST

Simple interest
When money of valueP on a given date increases in value toS at some later date.
P is called the principal,
S is called the amount or accumulated value ofP ,
andI =S –P is called the interest.
When only the principal earns interest for the entire life of the transaction, the interest due at the end of
the time is called simple interest.
The simple interest on a principalP fort years at the rater is given by
EXAMPLE
COMPOUND INTEREST

If the interest due is added to the principal at the end of each interest period and thereafter earns interest,
the interest is said to be compounded.
The sum of the original principal and total interest is called the compound amount or accumulated value.
The difference between the accumulated value and the original principal is called the compound interest.
The interest period, the time between two successive interest computations, is also called the
conversion period.
CONT.

Interest may be converted into principal annually, semiannually, quarterly, monthly, weekly, daily, or
continuously.
The number of times interest is converted in one year, or compounded per year, is called the frequency of
conversion.
The rate of interest is usually stated as an annual interest rate, referred to as the nominal rate of interest.
CONT.
CONT.
SIMPLE INTEREST VERSUS COMPOUND INTEREST
EXAMPLE
EXAMPLE
CONT.
NOMINAL AND EFFECTIVE RATES OF
INTEREST

The annual rates of interest with different conversion periods are called equivalent if they yield the same
compound amount at the end of one year.

When interest is compounded more often than once per year, the given annual rate is called the nominal
annual rate or nominal rate.

The rate of interest actually earned in one year is called the effective annual rate of the effective rate.
EXAMPLE
EXAMPLE