Module III: Valuation Concepts

Time Value of Money

If an individual behaves rationally, then he would not equate money in hand today with the
same value a year from now. In fact, he would prefer to receive today than receive after one
year. The reasons sited by him for preferring to have the money today include:
1. Uncertainty of receiving the money later.
2. Preference for consumption today.
3. Loss of investment opportunities.
4. Loss in value because of inflation.
The last two reasons are the most sensible ones for looking at the time value of money.
There is a 'risk free rate of return' (also called the time preference rate) which is used to
compensate for the loss of not being able to invest at any other place. To this a 'risk premium'
is added to compensate for the uncertainty of receiving the cash flows.

Required rate of return = Risk free rate + Risk premium

The risk free rate compensates for opportunity lost and the risk premium compensates for
risk. It can also be called as the 'opportunity cost of capital' for investments of comparable
risk.
To calculate how the firm is going to benefit from the project we need to calculate whether
the firm is earning the required rate of return or not. But the problem is that the projects would
have different time frames of giving returns. One project may be giving returns in just two
months, another may take two years to start yielding returns. If both the projects are offering
the same %age of returns when they start giving returns, one which gives the earnings earlier
is preferred.
This is a simple case and is easy to solve where both the projects require the same capital
investment, but what if the projects required different investments and would give returns
over a different period of time? How do we compare them? The solution is not that simple.
What we do in this case is bring down the returns of both the projects to the present value
and then compare. Before we learn about present values, we have to first understand future
value.

Future Value:

If we are getting a return of 10 % in one year what is the return we are going to get inbtwo
years? 20 %, right. What about the return on 10 % that you are going to get at the end of one
year? If we also take that into consideration the interest that we get on this 10 % then we get
a return of 10 + 1 = 11 % in the second year making for a total return of 21 %. This is the
same as the compound value calculations that you must have learned earlier

Future Value = (Investment or Present Value) * (1 + Interest) No. of time Periods

The compound values can be calculated on a yearly basis, or on a half-yearly basis, or on a

monthly basis or on continuous basis or on any other basis you may so desire. This is
because the formula takes into consideration a specific time period and the interest rate for
that time period only.
To calculate these values would be very tedious and would require scientific calculators. To
ease our jobs there are tables developed which can take care of the interest
factorcalculations so that our formulas can be written as:

Future Value = (Investment or Present Value) * (Future Value Interest Factor n,i)

where n = no of time periods and i = is the interest rate.

Let us look at an example of how we calculate the future value:

Example:

Rs 7000 are invested at 5% per annum compound interest compounded annually. What
will be the amount after 20 years?

Solution:
Here i = 0.05, P = 7000, and n = 20. Putting it in the formula we get:
FV = 7000 x (1+0.05)20
FV = 7000 x 2.6533
= Rs 18573.1

Future Value of an Annuity:

Annuity is defined as periodic payment every period for a number of periods. This periodic
payment is the same every year only then it could be called an annuity. The compound value
(future value) of this annuity can be calculated using a different formula:

Here A is the constant periodic cash flow (annuity), i is the rate of return for one period and n
is the number of time periods. The term within the brackets is the compound value factor of
an annuity. We can also use the tables given at the end of the text book to calculate the
compound values of the cash flows and the formula would change to:

Future Value = Annuity * (Future Value Annuity Factorn,i)

Extending the same example we used above, if we were going to pay Rs 7000 every year for
the next 20 years what is the value at the end of 20 years if the interest rate was 5 %
compounded annually.
Present Value:

When we solve for the present value, instead of compounding the cash flows to the future,
we discount the future cash flows to the present value to match with the investments that we
are making today. Bringing the values to present serves two purposes:
1. The comparison between the projects become easier as the values of returns of both are
as of today, and
2. We can compare the earnings from the future with the investment we are making today to
get an idea of whether we are making any profit from the investment or not.
For calculating the present value we need two things, one, the discount rate (or the
opportunity cost of capital) and two, the formula.
The present value of a lump sum is just the reverse of the formula of the compound value of
the lump sum:

Or to use the tables the change would be:

Present Value = Future Value * (Present Value Interest Factor n,i)

where n = no of time periods and i is the interest rate.

Let us look at an example of how we calculate the future value:
Solve this or use the present value table.
Using the present value interest factor table we find that present value of Rs 1 of 20 years
from now at 5% interest is 0.3769. Multiplying it with the future value Rs 2,00,000 we get:

PV = 2,00,000 x 0.3769 = Rs 75,380

Present Value of an Annuity

The present value of an annuity can be calculated by:

Or to use the tables the change would be:

Present Value = Annuity * (Present Value Annuity Factor n,i)

Example
You have been promised an annual grant of Rs 7000 every year for the next 20 years If you
can invest the amount at 5% per annum compounded annually what will be the amount you
would require today to land up with the same position?
Perpetuity:
If the annuity is expected to go on forever then it is called a perpetuity and then the above
formula reduces to:

Perpetuities are not very common in financial decision making as no project is expected to
last forever but there could be a few instances where the returns are expected to be for a
long indeterminable period. Especially when calculating the cost of equity perpetuity concept
is very useful.

For a growing perpetuity the formula changes to:

All these calculations take into consideration that the cash flow is coming at the end of the
period.

Valuing Securities:

The objective of any investor is to maximise expected returns from his investments, subject
to various constraints, primarily risk. Return is the motivating force, inspiring the investor in
the form of rewards, for undertaking the investment. The importance of returns in any
investment decision can be traced to the following factors:
 It enables investors to compare alternative investments in terms of what they have to
offer the investor.
 Measurement of past returns enables the investors to assess how well they have
done.
 Measurement of historical returns also helps in estimation of future returns.

Why are we discussing the return so much? The value of the security to an investor is directly
proportional to the return that he is expected to get from that security. Higher the return
expected, higher is the value. But what are we going to do with the value of the security?
Well, value of the security is the price that you are going to pay for that security. This means
that the present value of the security is that value which is dependent on the return from the
security and the risk profile of that security. Now let us go further on return.

The Components of Return:

Return is basically made up of two components:

 The periodic cash receipts or income on the investment in the form of interest,
dividends, etc. The term yield is often used in connection with the component of
return. Yield refers to the income derived from a security in relation to its price, usually
its purchase price.
  The appreciation (depreciation) in the price of the asset is referred to as capital gain
(loss). This is the difference between the purchase price and the price at which the
asset can be, or is, sold.

Measuring the Rate of Return:

The rate of return is the total return the investor receives during the holding period (the period
when the security is owned or held by the investor) stated as a %age of the purchase price of
the investment at the beginning of the holding period. In other words it is the income from the
security in the form of cash flows and the difference in price of the security between and the
end of the holding period expressed as a %age of the purchase price of the security at the
beginning of the holding period. Hence, total return can be defined as:

The price change over the period, is the difference between the beginning (or purchase) price
and the ending (or sales) price. This can be either positive (sales price exceeds purchase
price) or negative (purchase price exceeds sales price).
The general equation for calculating the rate of return for one year is shown below: