Chapter 5

Evaluation Method of
Investment Opportunities
 Focus

• We will study present value and internal rate of return

more in detail and also the method which is called
dividend discount model.

• The point of discussion is how you are going to

evaluate the investment opportunities such as bonds
and stocks.
 SECTION 1

PRESENT VALUE METHOD

 To value a Bond with 1-year Maturity

1) Concept of Present Value

• You can buy a corporate bond at the price of $1,000

now.

• After one year you will receive $1,050 which includes

$50 as an interest.

• Is the bond worth investing?

• As you pay your money, you need to decide how
much return you want to obtain from your
investment. In other word, you need to decide your
required rate of return.
• Recall the formula.

Present Value ＝ Future Value ÷（1＋Required Rate of Return）years of investment

• The formula indicates that when you know the future

value and also if you decide your required rate of
return, you can calculate the present value (PV) for
you.
 2) Present value for the person with 4% required rate of
return
When you buy the bond, cash flows out from your deposit.
When you receive money after one year, cash comes in.
Exhibit 5-1. Cash Flow Diagram
Now Year 1

1,050
（Required Rate of Return : 4％）

Present Value
1,050 ÷ (1+.04)
-1,000 =1,009.62
• Your present value is $1,009.6 = $1,050 ÷ (1＋0.04)

• Therefore, you are willing to pay up to $1,009.6 if you

really want to buy the bond because the amount will
still satisfy your requirement of 4% return.

• But, you can buy the bond at the amount of $1,000.

• Therefore, $9.6 ($1,009.6－$1,000) can be judged as

your true value. In corporate finance, this $9.6 is
called Net Present Value (NPV).
• This concept is different from accounting.

• If you buy the bond, your profit is $50 ($1,050－

$1,000) in accounting, but your true value (=NPV) is
$9.6 in corporate finance.
 3) Present value for the person with 6% required rate of
return

• If Mr. B’s required rate of return is 6%, would he buy the

bond?

• The future value is $1,050

• As his required rate of return is 6% and year of investment

is 1 year, the present value for him is $990.6 = $1,050 ÷ (1
＋0.06).

• Meaning that Mr. B is willing to pay only up to $990.6 if he

wants to satisfy his requirement of 6% return
• For him, the bond has negative value because the
bond is sold at $1,000 although the value for him is
$990.6. Therefore, -$9.4 ($990.6－$1,000) is his NPV.

• Note that in accounting the profit is $50 ($1,050－

$1,000) for Mr. B also.

• However, Mr. B would not buy the bond because the

bond has negative value for him.
 Exhibit 5-2. Comparison of Present Value (1)
Investor Required Rate Initial Cash Inflow PV NPV
of Return Investment in Year 1

You 4% $1,000 $1,050 $1,009.60 $9.60

Mr. B 6% $1,000 $1,050 $990.60 -$9.40

 To Value a Bond with Multiple-Year Maturity

1) Present value of a bond

• You can buy a corporate bond at the price of $1,000

now.

• If you buy the bond, you will receive $50 one year
later, $50 two years later and $1,050 three years later.

• Is the bond worth investing?

 Present Value ＝ Future Value ÷（1＋Required Rate of Return）years of investment

Exhibit 5-3. Cash Flow of Multiple Years

Now Year 1 Year 2 Year 3

（Required Rate of Return : 4％）

50 50 1,050

Present Value
-1,000 50÷ (1+.04) 50÷ (1+.04)2 1,050÷ (1+.04) 3
=48.08 =46.23 =933.45
• The PV (present value) for the bond is $1,027.8
(i.e. $48.08＋$46.23＋$933.45)

• You can buy the bond at the amount of $1,000

although you are willing to pay up to $1,027.8.

• Therefore, in corporate finance theory $27.8

($1,027.86－$1,000) is regarded as your true value
and it is called as your Net Present Value (NPV).
On the other hand, for the person with 6% required rate
of return, the present value of the bond is $973.3 as
shown in Exhibit 5-4 and net present value (NPV) is
-$26.7.
 Exhibit 5-4. Comparison of Present Value (2)

Now Year 1 Year 2 Year 3 PV NPV

Cash outflow -1,000

Cash inflow 50 50 1,050

PV at 4% of Required 48.08 46.23 933.45 1027.8 27.8

Rate of Return =50÷1.04 =50÷1.042 =1,050÷1.043

PV at 6% of Required 47.17 44.50 881.60 973.3 -26.7

Rate of Return =50÷1.06 =50÷1.062 =1,050÷1.063
2) Interest rate change and its impact on bond price

Assume you bought a bond yesterday by paying $1,000.

The bond gives you 5% interest once at the end of every
year and gives you back the principal after three years.

This means you can get $50 as an interest every year and
$1,000 three years later.
【Question 5-1】 Suppose Mr. X buys your bond today,
what will be his cash flow in year 1, year 2 and year 3? In
other word, how much can he receive every year?

【Question 5-2】 Suppose the market interest rate

declines to 4% today, at what price can you sell your
bond now? It means that everybody’s required rate of
return is 4% today.

【Question 5-3】 If the market interest rate goes up to

6% tomorrow, at what price can you sell your bond
tomorrow? It means that everybody’s required rate of
return will be 6% tomorrow.
 Impact of Timing Difference on Present Value
Assuming that you want to buy somewhat irregular
type of bonds, which bond would you buy?

Bond X Bond Y

Requied Rate of Return 10%

Initial Investment 1,000

Cash Inflow
Year 1 300 500
Year 2 400 400
Year 3 500 300
 Exhibit 5-5. Impact of Timing Difference
Now Year 1 Year 2 Year 3

Bond X 300 400 500

Bond Y 500 400 300

-1,000

PV Bond X 300÷1.1 400÷1.12 500÷1.13

（Required Rate of Return 10％） = 272.73 = 330.58 = 375.66

PV Bond Y 500÷1.1 400÷1.12 300÷1.13

（Required Rate of Return 10％） = 454.55 = 330.58 = 225.39
 Bond X
Present value (PV) ＝ $300÷1.1 + $400÷1.12 + $500÷1.13
＝ $272.73 + $330.58 + $375.66
＝ $978.96
Net present value ＝ PV ($978.96)－Initial investment ($1,000)＝-$21.04

Bond Y
Present value (PV) ＝ $500÷1.1 + $400÷1.12 + $300÷1.13
＝ $454.55 +$ 330.58 + $225.39
＝ $1,010.52
Net present value ＝ PV ($1,010.52)－Initial investment ($1,000)＝$10.52

• Even if you receive the same total amount, timing

difference of cash inflow causes different present value
which affects your investment judgment.
Formula of Present Value and Net Present Value

You can calculate present value and net present value if

you can determine the following two items.

(1) Forecast of cash outflow and inflow:

• When is cash flowing out and how much?
• When is cash flowing in and how much?
(2) Determination of your required rate of return:

You need to determine your required rate of return when you

invest your money.
Exhibit 5-6. Future Cash Flow and Present Value

Year 1 Year 2 Year 3 ・・・・ Year n

(A) Cash Inflow C1 C2 C3 ・・・・ Cn

(B) PV at r% of Required C1 C2 C3 Cn
2 3
・・・・
Rate of Return 1+r (1+r) (1+r) (1+r)n
If you can receive cash as shown in Exhibit 5-6 row (A) and
your required rate of return is r, present value for you can be
shown by the following formula

C1 C2 C3 Cn
PV = +
2
+
3
+ ・・・・・・ +
1+ r (1+r) (1+r) (1+r)n

Taking “I” as “initial investment”, the formula for NPV is

C1 C2 C3 Cn
NPV = + 2
+ 3
+ ・・・・・・ + n
－ I
1+r (1+r) (1+r) (1+r)

This portion is PV
 Calculation of PV by Excel
Assume that required rate of return, initial investment,
and cash flow are as shown below.

Requied Rate of Return 10%

Initial Investment 1,000

Cash Inflow
Year 1 300
Year 2 400
Year 3 500
The way to calculate Present Value by using Excel is as
follows.

(1) Make a table as above in the Excel sheet.

(2) Put the cursor at one of the cells in Excel
(3) Then, =NPV(
(4) Then, 10%, (Do not forget “comma” after 10% )
(5) Then, drag the column of 300, 400, 500
(6) Then, “Enter”
(7) Answer 978.96 is shown in the column. Note this
is Present value, not Net present value.
 【Answer to Questions 5-1 to 5-3】

If Mr. X buys the bond from you today, what will be the
cash flow for Mr. X?

• There is no change!

• Under the contract the interest payment is $50 every

year and repayment of principal is $1,000 at the end
of the third year.
If market interest rate is now 4%,

• everybody must accept this 4% as his new required

rate of return

• this 4% must be used to calculate present value

• Calculation is the same as PV at 4% required rate of

return shown in the table on page 85 of the textbook

• Present Value at 4% required rate of return is

$1,027.8 meaning that you can sell the bond at
$1,027.8 now.
On the other hand, if market interest rate is 6%
tomorrow,

• present value will become $973.3 (See page 85 of

textbook)

• Therefore, you can sell the bond at only $973.3

tomorrow.
These calculations explain the following relationship.

• Decline in interest rate ⇒ Rise in bond price

• Rise in interest rate ⇒ Decline in bond price

 SECTION 2

INTERNAL RATE OF RETURN METHOD

 To Value a Bond with 1-Year Maturity

• There is another method which is called Internal Rate

of Return (IRR) to evaluate investment opportunities.

• The return (interest rate) of the bond is calculated by

the following formula.

years of investment
（1＋interest rate） ＝ Principal and Interest ÷Principal
• Assume there is a bond which requires an initial
investment of $1,000 and offers $1,050 after one
year.

If you input
1,050 at <Principal and interest>,
1,000 at <Principal> and
1 at <years of investment>, (into the formula)
it becomes 1,050 ÷ 1,000 = 1.05.

Therefore, interest rate is 0.05 = 5%.

• In corporate finance theory, the (5%) return is called

“internal rate of return (IRR)”.
• The equation above means that the factor (=discount
factor) which makes $1,050 equal to $1,000 is 1+r.

• In this case r = 0.05 = 5% which is the internal rate of

return (IRR).

• In other word, internal rate of return is the rate to

equalize $1,050 and $1,000.
Next step is to compare the IRR of the project with investor’s
required rate of return(RRR).
Which is higher, IRR or RRR?
If IRR > RRR ⇒ Good
If IRR < RRR ⇒ Not Good

In case of 5% Internal Rate of Return

Required rate of Satisfaction/ Decision

return dissatisfaction
4% satisfied to invest

6% dissatisfied not to invest

 Cash Flow with Multiple Years

• You are considering to buy somewhat irregular type of

bonds to which you need to pay $1,000. The bond will
pay you $300 at year 1, $400 at year 2 and $500 at
year 3. If your required rate of return is 10%, would
you buy the bond?

• Let’s evaluate this bond based on the internal rate of

return method.
• Internal rate of return has been previously defined as
the rate to equalize $1,050 and $1,000.

• By extension, internal rate of return is the discount

factor which equalizes initial investment and cash
inflows of the following years.

300 400 500

1,000 = + +
1+ i (1+i )2 (1+i )3
 Formula of IRR

If an initial investment and cash flow are expressed as

“I” and Cn respectively, the formula of IRR is expressed
as;

The “ i ” which equalizes both sides of the equation is

IRR.
 Question 5-4

• If you invest ¥10,000 now, you will get ¥10,300 one

year later. What is the internal rate of return of this
investment opportunity?

• If you invest ¥10,000 now, you will receive ¥300 in year

1 and in year 2, then ¥10,300 in year3. What is the
internal rate of return of this investment opportunity?

• If you invest ¥9,800 now, you will receive ¥300 in year

1 and in year 2, then ¥10,300 in year 3. Is the internal
rate of return of this investment opportunity higher
than 3% or lower than 3%?
 Calculation of IRR by Excel
• It is troublesome but not impossible to calculate IRR if
the cash inflows are in multiple years. Calculators or
Excel can be used.

• Using the previous example where,

Initial investment $1,000
Cash inflow
Year 1 300
Year 2 400
Year 3 500
• When using EXCEL,
Step 1 Input the following 4 numbers in the cells.
-1,000 [Do not forget minus(-) in front of 1,000]
300
400
500
Step 2 =IRR( [At this point, do not press ENTER]
Step 3 Drag 4 numbers above and press ENTER key.

• Here, the answer 8.8963%, which is the IRR of this

cash flow, is shown.
When initial investment is $1,000 and cash inflows from
year 1 to year 5 are as follows,

<Case 1> 200、300、400、500、600

<Case 2> 600、500、400、300、200

Calculate IRR of both Case 1 and Case 2 in Excel and

confirm the answers.

<Case 1> IRR＝23.29%

<Case 2> IRR＝36.08%
Discounted Cash Flow Method (or DCF Method)

• The common feature of PV and IRR is the process

called “discounting”.

• In both methods, future cash flows are discounted in

order to make figures comparable .

• Therefore, these two methods are called Discounted

Cash Flow Method.
 • judgment is based on the
PV value or amount i.e. the
amount of PV or NPV

• the focus is on percentage

IRR i.e. how much the return is
in percentage
 SECTION 3

DIVIDEND DISCOUNT MODEL

• In this section, we will study an evaluation method of
stocks.

• Assume that you plan to buy CANON’s stock at the price of

3,600 yen and hold it for life from now. The price 3,600 yen
is cash outflow as you pay the amount now.

• As long as CANON exists, you would probably receive

dividends for life. Let’s assume that you receive dividends
once a year. They are considered as future cash inflow.
• How would you calculate the Present Value of your future
dividend income?

• One of the methods to calculate the Present Value is called

dividend discount model.
 Formula of Present Value
• Assume you have an investment opportunity which
produces cash inflow every year and continue forever;
D1 , D2 , D3 , ...

• Taking r as your required rate of return, the PV of

individual year’s cash inflow will be;

PV of year 1’s cash inflow: D1 / (1+r)

PV of year 1’s cash inflow: D2 / (1+r)2
PV of year 1’s cash inflow: D3 / (1+r)3
• By adding up PV of each individual year, you can find
the PV of this investment opportunity.

D1 D2 D3
PV = + 2
+ 3
+ ･･･････････
1+r (1 + r) (1 + r) 【Formula A】

• This shows the present value of the future cash inflow

assuming the required rate of return is r.
 Dividend is Constant Forever

If dividend is constant forever, formula A can be

rewritten as below.

D1 D1 D1
PV = + 2
+ 3
+ ･･･････････ (1)
1+r (1 + r) (1 + r)
This can be simply expressed as;

D1
PV =
r 【Formula B】

• Formula B means that if the dividend is constant

forever, the stock price is expressed as
dividend/required rate of return.
【Question 5-3】

• CANON’s current stock price is ¥3,900.

• Assume that the company’s dividend next year is

¥120 and the dividend remains the same forever.

• If your required rate of return is 2.5%, would you buy

the stock?

• If your required rate of return is 3.5%, would you buy

the stock?
 Dividend Grows at g% Forever

D1 D2 D3
PV = + 2
+ 3
+ ･･･････････
1+r (1 + r) (1 + r)
If the dividend is assumed to grow constantly forever at
the rate of g, the formula is expressed as;

2
D1 D1（1 + g） D1（1 + g）
PV = + + + ･･･････････ (3)
1+r 2 3
(1 + r) (1 + r)
• In the equation above, D2 is shown as D1(1+g)
because D1 grows at the rate of g and becomes D2.

• Similarly, D3 is shown as D1(1+g)2 because

D3 = D2(1+g) = D1 x (1+g) x (1+g) = D1(1+g)2

• In this case,

D1
PV =
r－g
【Formula C】
 【Question 5-4】

• Toyota’s current stock price is ¥6,000.

• Assume that the company’s dividend next year is

¥200 and the dividend grows by 2% annually forever.

• If your required rate of return is 5%, would you buy

the stock?

• If your required rate of return is 6%, would you buy

the stock?
 Summary of Dividend Discount Model

• Dividend discount model is used to calculate PV of

future dividend.

• The formula is expressed as;

D1 D2 D3
P0 = + 2
+ 3
+ ･･･････････
1+r (1 + r) (1 + r)
• If your view on future dividends and required rate of
return are the same with other investors, it means
both numerators (D1, D2, or D3･･･) and denominators
(r) in the formula are the same, and P0 is the same to
you and other investors in such a situation.

• Therefore, current stock price is assumed to reflect

investors’ average required rate of return and average
view on the future dividends.
However, if you have a different required rate of return
or different view on the future dividends, it means that
you have different r or D1, D2, or D3 … in the formula.

In such a case, your calculation of P0 should be different

from that of the current stock price.

Therefore,
i. Buy the stock if your P0 < current stock price
ii. Do not buy the stock if your P0 > current stock price