Valuation Concepts: Time Value of Money

Lesson Objectives:
 To have a clear concept on time value of money and other relevant values;
 To know the tools and techniques involved in determining present, future or terminal
values and
 To solve for time and interest rates for present and future values.

Concept of Time Value of Money and other Relevant Values

 In the literature of Finance and Mathematics, time value of money concept has been
recognized. The concept signifies that money has time value. That is, the value of
money varies in terms of time.
 According to this concept, a dollar received today is worth more than a dollar expected
to be received in the future. This is because of the fact that the sooner a dollar is
received, the quicker it can be invested to earn a positive return.
 Therefore, it is true that one dollar in the future is less valuable than one dollar of today.
The relationship between one dollar in the future and one dollar of today is known as
the time value of money. This present value concept of time value of money should be
clearly understood by the investors as well as financial managers in order to examine
its impact on the value of an asset.
Future Value or Terminal Value
 Future value is the value of a cash flow or a series of cash flows at some time of a
present amount of money. That is, future value refers to the to which a cash flow or a
series of cash flows will grow over a given period of time. Therefore, the future value
is dependent on three things:
(i) present value;
(ii) period and
(iii) rate of interest.
 Thus, the future value at the end of one year equals the present value multiplied by one
plus interest rate.
 As for example, if present value equals to Tk. 100, period is 1 year and rate of interest
is 10 percent; then future value will be Tk. 110.
Present Value
 Present value is the value today of a future cash flow or series of cash flows. That is,
present value is a future amount discounted to the present by some required rate. The
present value is dependent on three things: (i) future value, (ii) period and rate of
interest.
 As for example, if future value is Tk.115, period is one year and rate of interest is 15
percent; then present value will be Tk. 100 only.
 Since, cash flow is involved in both the future value and present value; it needs
clarification. Cash flow embraces both cash outflow and cash inflow. Cash outflow is a
payment or disbursement of cash for expenses, investments and so on.
On the other hand, cash inflow is a receipt of cash from an investment, an employer, a
banker or from any other sources.
 Tools and Techniques of Time Value of Money
Tools used in Time Value of Money
 One of the most important tools in time value of money analysis is the cash flow time
line. It is a graphical representation used to show the timing of cash flows. Such line is
used helping us visualizing when the cash flows associated with a particular situation.
Constructing a cash flow time line will help us to solve problems related to the time
value of money.
 To illustrate the time line concept, let us consider the following diagram.

Techniques of Time Value of Money

 The following two techniques are generally used in time value money: (i) compounding
and (ii) discounting. The following paragraphs deal with each of the techniques.
Compounding Technique
 A Taka in hand today is worth more than a Taka to be received in the future. This is
because of the fact that if you had it now, you could invest it, earn interest and end up
with more than one Taka.
 The process of going from today’s values which are termed as present values (PV), to
future values (FV) is called compounding.
 That is, the process of determining the value of a cash flow sometime in the future, by
applying compound interest rate is known as compounding. By compound interest we
mean interest earned on interest.
Compound Interest vs. Simple Interest
 Compound interest refers to the interest earned on both the initial principal and the
interest reinvested from prior periods, while simple interest refers to the interest earned
only on the original principal amount invested.
 Let us clear these with examples. Suppose your principal amount is Tk. 1000 and the
rate of interest is 10% and the period is 3 years. In the example, compound interest
comes to Tk. 331 (100+110+121); whereas, simple interest comes to Tk. 300
(100+100+100) only at the end of 3 years.
 Now, the question arises how the FVs are determined. There are two approaches to
determine FVs: one is Equation approach and the other is Tabular approach.
Terms of Interest and Future Values
 Interest may be paid annually, semiannually, quarterly, monthly, even daily and even
continuously or infinitely and such mode of payment of interest is known as terms of
interest.
 Interest may be paid annually, semiannually, quarterly, monthly, even daily and even
continuously or infinitely and such mode of payment of interest is known as terms of
interest. Such terms of interest have impact on the FVs.
 In the above Equation and Tabular Approaches of calculating FVs, we have assumed
that interest is paid annually. Now, let us consider the relationship between FVs and
interest rates for different periods of compounding.
 FVs and terms of interest have direct relationship, implying that the number of times
interest paid in a year (m) is increased, the FV also increases. For different terms of
interest, the formula for finding out FVs under both the Equation and Tabular
Approaches need to be adjusted as follows :
 Future Value Interest Factor for i and n (FVIF i, n)
FVIFi,n refers to the future value of Tk. 1 left on deposit for n periods at a rate of i percent
per period that is, the multiplier by which an initial investment grows because of the interest
earned. In order to find out IF from Future Value Table, time period (n) and rate of interest
(i) should be considered simultaneously. In the Table, the vertical column represent n;
whereas, the horizontal columns represent rates of interest.

Problem – 1
Find out the future values (FV) in the following situations:
a) At the end of 3 years, how much is an initial deposit of Taka 1,000 worth, assuming a
quarterly compounded interest rate of (i) 10% and (ii) 100%.

b) At the end of 10 years, how much is an initial investment of Taka 1,000 worth, assuming an
interest rate of 10% compounded : (i) annually; (ii) semiannually; (iii) quarterly, (iv)monthly
and (v)continuously ?
Problem – 2:
Assume that it is now January 1, 2000. On January 1, 2001, you will deposit Tk. 1000
into Savings Account of Janata Bank that pays 12 percent interest per annum.

Required:
(a) If the bank compounds interest annually how much will you have in your account on
January-1, 2006?
(b) What would your January-1, 2005 balance be if the bank used quarterly compound?
(c) Suppose you deposited Tk. 1000 in payments of Tk. 200 each on January 1, 2001, 2002,
2003, 2004 and 2005. How much would you have in account on January-1, 2005, based on
10 percent annual compounding?

Discounting Technique
 Discounting refers to the process of determining the present value of a cash flow or a
series of cash flows. It is the reverse of compounding. That is, the process of finding
present values from future values is called discounting. If you know the FVs, you can
discount the PVs.
 At the time of discounting you would follow these steps.
Present Value Interest Factor (PVIF)
Present value interest factor for i and n (PVIFi, n) refers to the present value of Tk. 1 due
n periods in the future discounted at i percent per period. In order to find out IF from
Present Value Table, time period (n) and rate of interest (i) should be considered
simultaneously. In the Table, the vertical column represents n; whereas, the horizontal
column represent rates of interest.
Problem - 3
Determine the Present Values (PVs) in the following cases : a) Taka 1,000 at the end of 5 years
is worth how much today, assuming a discount rate of : (i) 10 percent and (ii) 100 percent;
b) What is the aggregate PVs of the following receipts, assuming a discount rate of 15 percent:
i) Taka 1,000 at the end of 1 year;
ii) Taka 1,500 at the end of 2 years;
iii) Taka 1,800 at the end of 3 years;
iv) Taka 2,200 at the end of 4 years and

v) Taka 2,500 at the end of 5 years?

Problem - 4
Find the present values of the following amount due :
a) Taka 6,600 due in 10 years at a 6 percent discount rate, calculating annually;
b) Taka 9,000 due in 8 years at a 12 percent discount rate, calculated semiannually;
c) Taka12,000 due in 6 years at a 18 percent discount rate, calculated quarterly and
d) Taka 15,000 due in 3 years at a 12 percent discount rate, calculated monthly.
e) Taka 18,000 due in 5 years at a 15 percent discount rate, calculated continuously.

Solving Time and Interest Rates

 Suppose, you can buy a security at a price of Tk. 78.35 that will pay you Tk. 100 after
5years. In this case, PV, FV, and n are given; we are to find out i, the interest rate you will
earn on your investment. Value of i is found out by applying the following formula :
FVn = PV (1 + i)n = PV (FVIFi, n)
Hence, Tk. 100 = Tk. 78.35 (1 + i)5 = (FVIFi, n)
 Annuity: Time Value of Money
Lesson Objectives:
• To know about concept of annuity;
• To know how to determine future value of an ordinary annuity and future value of an
annuity due;
• To know how to determine of present value of an ordinary annuity and present value
of an annuity due;
• To understand how to determine payments and
• To solve time and interest rates for annuities, ordinary and due.
Concept of Annuity
• An annuity is a series of equal payments known as installments at fixed intervals for
specified number of periods. As for instance Tk. 100 paid as an installment at the end
of the each of the next five years is a five year annuity.
• The installment payments are symbolized as PMT and they can occur at either the
beginning or the end of each year. If the installment payments occur at the end of each
period, as they typically do in business transactions, the annuity is known as ordinary/
deferred annuity.
 • If installment payments are made at the beginning of each period, the annuity is called
an annuity due.
• Since ordinary annuities are more common in Finance, when the annuities are used in
this book, you should assume that the installment payments occur at the end of each
period values otherwise mentioned.
Future Value of an Ordinary Annuity
• Future value of an ordinary annuity depends on three things namely : (i) amount of
PMT; (ii) rate of interest and (iii) period. The more the amount of PMT, rate of interest
and the period, the higher will be the amount of FV of an annuity.
• Let us take an example. If you deposit Taka 100 at the end of each of three years in a
Savings A/C that pays 5% interest per year; how much will you have at the end of 3
years ?
• To answer this question, we must find out FV of an ordinary annuity (FVAn). Hence,
FVAn represents the FV of an ordinary annuity over periods. Each payment is
compounded out to the end of period n and he sum of the compounded payments is the
FVAn.
• There are two approaches of determining FVAn viz. (i) Equation Approach and (ii)
Tabular Approach.
i) Under Equation Approach
ii) Under Tabular Approach
Future Value of an Annuity Due
• Like future value of an ordinary annuity, future value of an annuity due also depends
on the : (i) amount of payments; (ii) rate of interest and (iii) number of periods.
• The more the amount of PMT, rate of interest and the number of periods; the higher
will be future value of annuity due. Had there been Tk. 100 payments in the previous
example being made at the beginning of each year, the annuity would have been known
as an annuity due.
• Future value of an annuity due FVA (DUE) can also be found out in two approaches
viz.: (i) Equation Approach and (ii) Tabular Approach.
• Determination of Payments (PMT)
In this sub-section, we shall examine how payments (PMT) are determined in cases of
both types of annuities viz. ordinary annuity and annuity due; where the values of
annuities, rate of interest i and period n are given.
 Solving Time and Interest Rates
In the determination of annuities, time factor and interest or discount factor have
been worth-mentioning. While determining annuities, either ordinary or due;
payment, time factor and interest factor must exist. It is evident that in each of these
cases, the values of any three are given. The value of the fourth one can be found
out. In such a context the necessity of determining the value of either interest (i) or
period (n) has arisen.
Solving period n in cases of Annuities, Ordinary and Due
• In case of either ordinary annuity or annuity due, period n can be found out if values
of ordinary annuity or annuity due, PMT and i are given.
The following examples will clear the matter.
Examples
• Suppose you borrow Taka 15,000 and promise to make equal installment payments of Taka
2,604.62 at the end each of the requisite years at 10 percent.. In this case, you know the
value of ordinary annuity, PMT and i; you are to determine period n. The solution goes as
follows :
Valuation of Long-term Securities
Lesson Objectives:
• To form a clear concept on the fundamental valuation Concepts
• To know about the techniques of valuation of long-term securities viz., bond and stock.

Fundamental Valuation Concepts

Book Value
Book value reflects historical cost, rather than value. It is an accounting concept; but not
financial one. Assets are recorded at historical cost and they are depreciated over years.
Therefore, book value may include intangible assets at acquisition cost minus amortized value.
The book value per share is found out as net worth divided by the number of shares outstanding.
Replacement Value
Replacement value is the amount that a firm would be required to spend if it were to replace
its existing assets in the current condition. It is difficult to find cost of assets currently being
used by the firm. It is likely to ignore the benefits of intangibles and the utility of existing
assets.
Liquidation Value
Liquidation value is the amount that a firm could realize if it sold its assets after having
liquidated or terminated its business. It would not include the value of intangibles since the
operations of the firm are assumed to cease.
Going Concern Value
It is the amount that a firm could realize if it sold its business as an operating business. Such
value would always be higher than the liquidation value.
Market Value
Market value of an asset or security is the current price at which the asset or the security is
being sold or bought in the market. Market value per share is expected to be higher than the
book value per share. A number of factors influence the market value per share; and, therefore,
it shows wide fluctuations.

• The value of any asset can be expressed in general form in the following equation:
• According to the Equation, the value of an asset is affected by expected cash flows
(CF1) and the return required by the investors (k). As you can see, the higher the
expected CF, the greater the asset’s value; also the lower the required return, the greater
the asset’s value.

Valuation of Bonds
• A bond or debenture is a long-term debt instrument. Bonds issued by the government
or the public sector companies in Bangladesh are generally secured. But, the bonds
issued by the private sector companies may be either secured or unsecured. A bond
possess some features of which the following are the main :
(i) Face value: It is also called per value. A bond is generally issued at a par value and
interest is paid on face value.
(ii) Interest rate: It is fixed and known to bondholders. It is also called coupon rate. It
is a rate mentioned on the certificate on the bond.
(iii)Maturity: A bond issued for a specified period of time. It is repaid on maturity date.
(iv) Redemption Value: The value which a bondholder will get on maturity is called
redemption value. A bond may be redeemed at par or at a premium (more than par
value) or at a discount (less than par value).
 (v) Market Value: A bond may be traded in a stock exchange. The price at which
currently sold or bought is called the market value. Market value may be different from
par value or redemption value.

 Bonds may be of two types viz., (a) bonds with maturity and (b) bonds without maturity.
(a) Bond with a Maturity Period : When a bond or a debenture has a finite maturity, to
determine its par value, we shall consider annual interest payments plus its terminal or
maturity value. Using the present value concept, the discounted value of these flows
will be calculated. By comparing the PV of a bond with its market value; it can be
determined if the bond is overvalued or undervalued. Bond value (Vd) can be found out
using the following formula :

(b) Perpetual Bond

Bonds which will never mature are known as perpetual bonds. Such bonds are rarely found in
practice. Since perpetual bonds have no maturity; so there is no terminal value. Therefore, the
value of the bonds would simply be discounted value of the infinite stream of interest flows.
• Therefore, to find value of a perpetual bond is too easy which goes as follows :

INT
Vd = ----------
Kd
Problem - 1
The Beta Corporation issued a new series of bonds on January 1, 1980. The bonds were sold at
par value of Taka 1,000, have a 12 percent coupon and would mature on December 31, 2009.
Coupon payments are made semiannually i.e. on June 30 and December 31. What was the price
of the bond on January 1, 1985 assuming that the level of interest rates had fallen to 10 percent

Problem - 2
The bonds of Leema Corporation are perpetuities with a 10% coupon. Bonds of such type are
currently yield 8% and their par value is Tk. 1,000.
a) What is the price of the coupon ?
b) Suppose interest rate levels rise to the point where such bonds now yield 12%. What would
be the price of bonds ?
c) At what price would the Leema Corporation sell if the yield on those bonds was 10% ? and
d) How would your answers to parts a, b and c change if the bonds were not perpetuities but
had a maturity of 20 years ?
Valuation of Common Stocks
• Stock prices are determined at the equation similar to the bond valuation equation,
explained in earlier.

• The valuation of stocks may relate to the three situations as follows :

(i) valuating stocks with zero growth of dividend;
(ii) valuating stocks with constant growth and
(iii) valuating stocks with non-constant growth.
Measurement of Returns from Long-term Securities

Lesson Objectives:
• To study the techniques of measuring returns from bonds;
• To study the techniques of measuring stock return and
• To examine the criteria used in measuring financial risk involved in these returns.

Techniques of Measuring Returns

We know that long-term securities consist of long-term bond and stock, common and preferred.
The return from such securities is also known as yield, which refers to the internal rate of return
(IRR). IRR or yield for an investment is the discount rate that equates the present value of the
expected cash outflows with the present value of the expected cash inflows. IRR can be found
out by applying the following equation:

 Bond Returns
Bond return or bond yield is simply a bond’s internal rate of return (IRR). While valuing bonds,
we have mentioned that bonds are of two types namely:
(a) Maturity Bond and
(b) Perpetual Bond.
So, bond return as follows:
(a) Returns from Maturity Bonds
• In case of maturity bonds, yield to maturity (YTM) is applicable which is the average
rate of return earned on a bond, if it is held to maturity. In case of maturity bonds, there
are two discounts or coupon bonds viz., (i) Pure discount (zero coupon bonds) and (ii)
Coupon bonds.
(i) Zero Coupon Bonds: It is one where the issuer promises to make a single payment
at a specified future date. The single payment is the same as the face value of the bond.
In case of zero coupon bonds, YTM is found out as follows :
 Dividend Discount Models
Dividend discount models are designed to measure the implied stock return under the specific
assumptions as to the expected growth pattern of the future dividends.
Market Risk and Return (MRR)
Lesson Objectives:
 To have an idea on the concepts of market risk and return and market efficiency;
 To understand the techniques of portfolio security analysis and selection;
Concepts of Market Risk and Return Market Efficiency
a) Concept of Return: Simply stated, return means outcome of an investment. If an
investor invests money in real assets or financial assets; then he may get return from
real assets or from financial assets. Again return may be actual or expected. Return is
the reward from undertaking the investment. Return on a typical investment consists of
two components viz., yield and capital gain. Yield is the income component of a
security’s returns. Capital gain is the change in price on a security over some period of
time.
b) Concept of Risk and Market Risk :
• Risk can be defined as the chance that some event other than expected will occur. That
is, risk is the chance of occurrence of the deviation between the expected and actual
event.
• The risk associated with the investment in securities is known as investment risk. The
investment risk, is, thus related to the possibility of actually earning a return other than
expected – the greater the variability of the possible outcomes, the riskier the
investment.
• The portion of a security’s risk that can be eliminated is called diversifiable or firm
specific or unsystematic risk; whereas, that portion of a security’s risk that cannot be
eliminated is called non-diversifiable or market or systematic risk.
• Market risks are associated with economic or market factors that systematically affect
most firms.
• As for example, war, inflation, recessions, depressions and high interest rates are known
as the economic or market factors, which affect securities of most of the firms. Because
most securities tend to be affected similarly (negatively) by these market conditions,
systematic risk cannot be eliminated by portfolio diversification.
c) Concept of Market Efficiency:
• Market efficiency means that the market prices of the securities represent the security
market’s consensus estimate of the value of those securities. If the market is efficient,
it uses all information available to it in setting security price.
• Investors who choose to hold a security are doing so because their information lead
them to think that the security is worth at least its current market price. And, the persons
who do not buy the security interpret their information as a lower appraisal.
• An efficient market (EM) is defined as one in which the prices of all securities quickly
and fully reflect all available information about the assets.
• This concept postulated that investors will assimilate all relevant information into
prices in making their buy and sell decisions. Therefore, the current price of a stock
reflects:
1. All known information, including :
• Past information (e.g., last year’s or last quarter’s earnings)
• Current information as well as events that have been announced but are still
forthcoming (such as a stock split)
2. Information that can reasonably be inferred; for example, if many investors believe that
interest rates will decline soon, prices will reflect this belief before that actual decline
occurs.
• An efficient capital market exists when the security market prices reflect all available
public information about the economy, financial/ capital markets and the specific firm
involved. The implication is that the market price of the individual security adjusts very
rapidly to new market information. As a result, security prices are said to fluctuate
randomly about their ‘intrinsic’ values.

Stages of Market Efficiency

• Three stages of market efficiency are there namely weak form of efficiency, semi strong
form of efficiency and strong form of efficiency.
• In the weak form of efficiency, security prices reflect the market information contained
in the record of past prices. In this stage of market efficiency, it is impossible to make
consistently superior profits by studying past prices. Price will follow a random walk.
• In the semi strong form of efficiency, it is required that the security prices reflect not
just the past prices but all other published information. In this case, prices will adjust
immediately to the public information.
• Finally, in the strong form of efficiency, security prices reflect all the available
information, past, present, published and unpublished. Such information can be
acquired by painstaking analysis of the company and the economy. In such a market we
would observe lucky and unlucky investors.
• The hypothesis that the security markets are efficient will be true only if a sufficiently
large number of investors are not in doubt about its efficiency and behave accordingly.
In other words, the theory requires that there be sufficiently a large number of market
participants who, in their attempts, for earnings profits, promptly receive and analyze
all the information that are publicly available relevant to firms whose securities they
follow.

Conditions of Market Efficiency

It can be shown that an efficient market can exist if the following events occur:
1. A large number of rational profit maximizing investors exist who actively participate
in the market by analyzing, valuing and trading stocks. These investors are price takers;
that is, one participate alone cannot affect the price of a security.
2. Information is costless and widely available to market participants at approximately the
same time.
3. Information is generated in a random fashion such that announcements are basically
independent of one another.
4. Investors react quickly and fully to the new information, causing stock prices to adjust
accordingly.
• These conditions may seem strict, and in some sense they are. Nevertheless, consider
how closely they parallel the actual investments environment.
Portfolio Expected Return and Its Measurement
• The expected return for portfolio security is a weighted average of expected returns for
securities making up that portfolio. So, the excepted return on the portfolio security is
easily measured as the weighted average of the individual securities’ expected returns.
The percentages of a portfolio’s total value that are invested in each portfolio asset are
referred to as portfolio weights, which will denote by W. The combined portfolio
weights are assumed to sum to 100 percent of total investible funds or 1-0 indicating
that all the portfolio funds are invested.

Capital Asset Pricing Model (CAPM)

&
Expected Return and Risk (ERR)

Lesson Objectives:
• To grasp the concept of Capital Asset Pricing Model (CAPM);
• To identify the assumptions of CAPM;
• To understand the concept of Beta and Beta Coefficient;
• To know portfolio Beta Coefficient and
• To know how to determine expected return and risk (ERR)

Concept of Capital Asset Pricing Model (CAPM)

• A model used to determine the required return on asset, which is based on the
proposition that any asset’s return should be equal to the risk–free rate of return plus a
risk premium that reflects the asset’s non diversifiable risk.
Assumptions of CAPM
CAPM is based on a number of assumptions. The most important assumptions are:
(1) Market efficiency: The capital markets are efficient. The capital market efficiency
implies that share prices reflect all available information.
(2) Risk aversion: Investors are risk averse. They evaluate a security’s return and risk in
terms of the expected return and variance or standard deviation respectively. They prefer the
highest expected returns for a given level of risk.
(3) Homogeneous expectations: All investors have the same expectations about the expected
return and risk of securities.
(4) Single time-period: All investor’s decisions are based on single time period.
(5) Risk-free rate: All investors can lend or borrow at a risk-free rate of interest.
(6) Individuals seek to minimize the expected utility of their portfolios over a single period
planning horizon.
(7) The market is perfect: There are no taxes. There are no transaction costs. Securities are
completely divisible, the market is competitive.

(8) The quantity of risky securities in the market is given.

Concept of Beta and Beta Co-efficient

• Beta is a measure of the market risk or systematic risk of a security that cannot be
avoided through diversification.
• Beta is a relative measure of risk of an individual stock in relation to the market
portfolio of all stocks.
• Whereas, the measure of a security’s sensitivity to market fluctuations is called Beta
Coefficient and is generally designated with the Greek symbol for β (beta). Beta is the
key element of the CAPM.
• Therefore, Beta Co-efficient (β) is a measure of the extent to which the return on a given
security moves with the capital market. The following Figure presents betas of 1.5(A),
1.0 (B) and 0.6 (C).
• Securities with different slopes have different sensitivities to the returns of the market
index. If the slope of this relationship for a particular security is a 45 degree angle, as
shown for security B in the above figure, the beta is 1.0. This means that for every 1
percent change in the market’s return, on average this security’s returns change 1
percent. The market portfolio has a beta of 1.0.
• In summary, the aggregate market has a beta of 1.0. More volatile (risky) stocks have
betas larger than 1.0, and less volatile (risky) stocks have betas smaller than 1.0. As a
relative measure of risk, beta is very convenient.
• Beta is useful for comparing the relative systematic risk of different stocks and, in
practice, is used by investors to judge a stock’s riskiness. Stocks can be ranked by their
betas.
• Because the variance of the market is a constant across all securities for a particular
period, ranking stocks by beta is the same as ranking them by their absolute systematic
risk. Stock with high (low) betas are said to be high (low) risk securities.

Problems and Solutions

Review Problem