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Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Time Value of Money
Time Line
Cash Flows at-the-end of period
Cash Flows at-the-beginning of period
0 4 3 2 1
1000 1000 1000 1000
Period 1
Period 2 Period 3 Period 4
Cash Flows of Rs 1000/- each at Year-end for 4 years
Cash Flows of Rs 1000/- each at Year-beginning for 4 years
0 4 3 2 1
1000 1000 1000 1000
Period 1 Period 2 Period 3 Period 4
2
2 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Time Value of Money
Cash flow occurring at the end of 2
nd
year is not equal
to the cash flow occurring now because of Time Value
of Money (TVM).
Why TVM?
Inflation - value of currency decreases over time.
Preference for present consumption over future
consumption- to induce people to give up present
consumption, you have to offer them more in the
future.
Uncertainty about the future - higher uncertainty (risk)
means less valuable the future cash flow.
Thus, the cash flows occurring in different time periods
have to be made comparable.
3
Time Value of Money
Take todays cash flows into the future : Future Value
Bring future cash flows to todays value: Present Value
4
0
4 3 2 1
P
FV
5
@ r%
0
4 3 2 1
P
FV
5
@ r%
3 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Future Value
Future Value of amount P , after n years would be:
FV
n
= P*(1+r)
n
5
Future Value Interest Factor
[FVIF (n,r)]
0
4 3 2 1
P = 1,000
FV = 1,276.28
5
@ 5%
1000*(1.05)
5
0
4 3 2 1
P
FV
5
@ r%
Future Value
6
FVIF (6 yrs,5%)
Values of FVIF for various combinations of r and n are
given in Future Value Interest Factor tables.
4 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Future Value (Contd.)
If you invest Rs.80,000/- @ 14%p.a., how much would it amount to
in 5 years?
0
4
3 2 1
80,000
1,54,033
5
7
Future Value of Rs. 80,000/- @14% after 5 years would
be: 80,000*(1+0.14)
5
or 80,000*FVIF (5 years,14%)
= 80,000*1.9254 = Rs 1,54,033/-
Future Value (Contd.)
8
5 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Future Value
9
Compounding Rate (r)
Present Value (PV
N
)
Time Period (N)
Returns the Future Value
=FV(Interest Rate, Time,, Present
Value,0(or1))
Future value
10
5%
8%
10%
12%
15%
18%
900
1400
1900
2400
2900
3400
3900
4400
4900
5400
5900
1 2 3 4 5 6 7 8 9 10
F
u
t
u
r
e
V
a
l
u
e
Years
Higher the interest rate, faster the savings grow
6 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Compounding more than once a year
n*m
n
r
FV = P*(1+ )
m
Interest may be paid more than once a year.
Future Value is :
where m is no. of times interest is paid.
11
If you invest Rs.80,000/- @ 14%p.a., how much would it amount to
in 5 years, if interest is compounded (a)semi-annually, (b) quarterly?
Frequency Future Value
Semi-Annually (2) 80000*(1+0.14/2)
(5*2)
= 80000*(1.07)
(10)
= 80000*1.9672 = 1,57,372/-
Quarterly (4) 80000*(1+0.14/4)
(5*4)
= 80000*(1.035)
(20)
= 80000*1.9898 = 1,59,183/-
Compounding more than once a year
12
If you invest Rs.80,000/- @ 14%p.a., how much would it amount
to in 5 years, if interest is continuously compounded?
Future Value on continuous compounding would be:
80000*e
0.14*5
= 80000*2.0138 = 1,61,100/-
As m approaches infinity, the term (1+r/m)
n*m
approaches e
r*n
,
where e is approx. 2.71828 and is defined as
m
m
1
e=limit(1+ )
m
3
46
Present Value of a Perpetuity:
A
PVP=
r
24 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Perpetuity
You want to endow an annual MBA graduation party at your alma
amter. The event would cost Rs.50,000/- each year forever. If the
business school earns @ 8%p.a. on its investments and the first
party is in one years time, how much will you need to donate to
endow the party?
50,000
PVGP= =Rs.6,25,000/-
0.08
1 2 3
50,000 50,000 50,000
PVGP= + + +......
(1.08) (1.08) (1.08)
47
Growing Perpetuity
Growing Perpetuity is a stream of cash flows at regular
intervals and grows at a constant rate forever.
2 3
1 2 3 4
A A(1+g) A(1+g) A(1+g)
PVGP= + + + ......
(1+r) (1+r) (1+r) (1+r)
A(1+g)
2
0
2
1
A
A(1+g)
3
A(1+g)
3
4
48
Present Value of a Growing Perpetuity:
A
PVGP=
r-g
25 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Growing Perpetuity
But then you are informed that the cost of the party would increase
by 4% per year, (after the first year).How much will you now need
to donate to endow the party?
50,000
PV= =Rs.12,50,000/-
0.08 - 0.04
2
1 2 3
50,000 50,000(1.04) 50,000(1.04)
PV= + + +......
(1.08) (1.08) (1.08)
You need to double the amount of your gift !!!
49
Summary
50
Present Value Future Value
Single Cash Flow
Annuity
(Regular Annuity)
Annuity
(Annuity Due)
Growing Annuity
(Regular Annuity)
Growing Annuity
(Annuity Due)
Perpetuity
Growing Perpetuity
n
1 1
A -
r r(1+r)
| |
|
\
n
1
C
(1+r)
n
A 1+g
1-
r-g 1+r
| |
| |
|
|
|
\
\
A
r
A
r - g
n
1 1
A - (1+r)
r r(1+r)
| |
|
\
n
(1+r) -1
A
r
| |
|
\
n
(1+r) -1
A (1+r)
r
| |
|
\
n
n
A 1+g
1- (1+r)
r-g 1+r
| |
| |
|
|
|
\
\
n
A 1+g
1- (1+r)
r-g 1+r
| |
| |
|
|
|
\
\
n
n
A(1+r) 1+g
1- (1+r)
r-g 1+r
| |
| |
|
|
|
\
\
n
C(1+r)
26 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Where to Invest ?
Atul want to invest Rs. 10 Lac for a period of 10 years. He can invest in
Government bonds which mature in 6 years and earn interest @ 8%
pa. The expected fixed deposit rate for 6 years hence, given by a local
bank is 3.5% pa, with half yearly compounding. Meanwhile, Yep Bank
has offered an investment proposal offering 6.5% pa with quarterly
compounding for 10 years. Which proposal is better for Atul?
Option 1: Invest in Government Bonds @ 8% pa for 6 years & @ 3.5%
pa (half yearly compounding) in bank fixed deposit for next 4 years
thereafter.
51
10,00,000 * (1.08)
6
= Rs. 15,86,874.32
15,86,874.32 * (1.0175)
8
= Rs. 15,86,874.32 *1.14888 = Rs. 18,23,131/-
Option 2: Invest in Yep Bank 10-year Fixed deposit @ 6.5% pa
(quarterly compounding) for 10 years.
10,00,000 * (1.01625)
40
= 10,00,000* 1.90556 = Rs. 19,05,560/-
Better to deposit with Yep Bank.
The MBA Decision
52
27 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
Valuation of Securities
54
Valuing a Zero-coupon Bond
Consider a Zero-coupon Bond with face value of Rs. 5,000/- payable
at the end of 3 years. What should be the price of the bond today,
if the required rate of return is 5%?
n
n
F
Value of ZCB =
(1+r)
0 3
5,000
V = = Rs.4,319.19
(1.05)
0
3
2
1
5,000
??
28 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
55
Valuing a Coupon Bond
n
0 1 2 3 n n
F A A A A
V = + + +.....+ +
(1+r) (1+r) (1+r) (1+r) (1+r)
NTPC issues 14% bonds of Rs.10,000/- face value, redeemable after 5
years. Assuming the required rate of return is 10%, what should be
the price of the bond today?
0 1
5 4
A
2
A A
3
A/(1+r)
1
A+F A
A/(1+r)
3
A/(1+r)
2
A/(1+r)
4
A+F/(1+r)
5
n
t n
t=1
Coupon Interest Face Value of Bond
Value of Coupon Bond = +
(1+r) (1+r)
56
Valuing a Coupon Bond
5
t 5
t=1
1,400 10,000
= +
(1.10) (1.10)
Face Value = Rs.10,000 ; Coupon rate = 14% pa;
Tenure = 5 Years; Required rate of return = 10%;
Value of Bond= ??
5
t
0 t 5
t=1
A F
V = +
(1+r) (1+r)
=1,400*PVIFA(5yrs, 10%) + 10,000*PVIF(5 yrs, 10%)
=1,400*3.79079 + 10,000*0.62092
= 5,307.10 + 6,209.21 = Rs.11,516.31
29 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
57
Valuing Equity : Dividend Discount Model (DDM)
Value of an equity share is the present value of the stream of
expected future dividends discounted at an appropriate discount
rate.
3 1 2
1 2 3
D D D D
Value = + + +..........+
(1+r) (1+r) (1+r) (1+r)
t
t
t=1
D
Value =
(1+r)
General Form of DDM
Value of a stock = PV(expected future dividends)
58
DDM - Constant Growth
If the dividends are expected to grow at a constant rate g,
and r > g, then,
Assumptions:
D
1
> 0
Dividends grow at a constant growth rate g =ROE*b
Dividend Payout ratio (1-b) is constant
1 2 3
1 1 1 1
0 1 2 3 4
D D (1+g) D (1+g) D (1+g)
V = + + + +..........+
(1+r) (1+r) (1+r) (1+r)
1
0
D
V =
(r - g)
30 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
59
DDM - Constant Growth
D
1
=Rs.3/- ; g= 7% forever, r = 13%, what should be the
Value of the equity share?
1
D 3.00
Value = = = Rs.50/-
(r - g) (0.13 - 0.07)
60
DDM - Multiple Growth Rate
n
t-1 t n n+1
0 n t n
t=1
n
D (1+g ) V D
V = + where V =
(1+r) (1+r) r - g
n
t-1 t n+1
0 t n
t=1
n
D (1+g ) D 1
V= +
(1+r) (1+r) r - g
`
)
1 2
1 1 1 2 2 2 2
0 1 2 3 4
D D (1+g ) D (1+g ) D (1+g )
V = + + + +..........+
(1+r) (1+r) (1+r) (1+r)
31 Dr. Pankaj Varshney
04-Oct-2013 LBSIM-PGDM(General)-Sec-A & C Batch
2013-15
61
DDM - Multiple Growth Rate -Illustration
D
0
= 3.50; g
1-3
=15% g
4-6
=12% g
7+
=8% ; r = 12% ; Value = ??
D
1
= 4.03; D
2
= 4.63; D
3
= 5.32; D
4
= 5.96; D
5
= 6.68; D
6
= 7.48; D
7
= 8.08
0 1 2 3 4 5 6 6
4.03 4.63 5.32 5.96 6.68 7.48 8.08 1
V = + + + + + +
(1.12) (1.12) (1.12) (1.12) (1.12) (1.12) (0.12 - 0.08) (1.12)
` `
) )
0
P = 124.78 Rs. 125/-
62
Value of a Business
= Rs.23,92,380/-
Case-1 Growing Regular Annuity:
Case-2 Growing Annuity Due:
50
RA
3,00,000 1.025
PVGA = 1-
0.15 - 0.025 1.15
| |
| |
|
|
|
\
\
50
RA
3,00,000 1.025
PVGA = 1- (1.15)
0.15 - 0.025 1.15
| |
| |
|
|
|
\
\
= Rs.27,51,245/-
Indicoffee, a popular coffee shop located in a busy shopping mall, is
expected to generate net cash flows of Rs 3 Lacs a year. If the
cash flows increase @ 2.5% pa for the next 50 years, what is the
worth of the coffee shop? (assume discount rate of 15%)