EL

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CORPORATE FINANCE

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ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 06: Time Value of Money

CONCEPTS COVERED

⮚ Time value of money and its applications

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⮚ Future value: The concept of compounding

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⮚ Present value: The concept of discounting

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KEY POINTS

⮚ A rupee today is not equal to a rupee tomorrow!

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⮚ Compounding effect

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⮚ Discounting effect

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Cost-Benefit Analysis
An aid to decision making
The first step in decision-making: Identify the costs and the benefits of a decision.
• ‘Benefits’ > ‘Costs’: Take the decision
• ‘Benefits’ < ‘Costs’: Hold on!
As financial manager, we might take several decisions:

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• Marketing: To determine the incremental revenue as a result of an advertising campaign
• Operations: To determine production costs after significantly revamping the production facility

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• Human Resources: To recruit full-time or on contract
• Strategy: To determine a competitor’s response to a price increase

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Mostly, in business, costs and benefits occur at different points in time!
• Invest today to earn an income tomorrow!
Today One Year

– Rs. 1,00,000 + Rs. 1,05,000

The Time Value of Money
Converting values across time
As we know, most of the time, costs and benefits occur at different points in time, thus not comparable!
• Invest today in a project → Earn profits in future!
Today One Year

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– Rs. 1,00,000 + Rs. 1,05,000

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If we compare the above cash flows, we find a net (positive) value of Rs. 5,000, but it ignores the
timing of costs and benefits.

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In general, a rupee (received) today is worth more than a rupee (received) in one
year. Why?

The difference in value between money today and money in the future is called the
TIME VALUE OF MONEY.
 The Time Value of Money (cont.)
Converting values across time: Future Value
By depositing money into savings bank account, we can convert money today into money in future
(with no risk).
Deposit money today Receive money in future
One Year

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– Rs. 1,00,000 + Rs. 1,10,000

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Converting values across time: Present Value

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By borrowing money from bank, we can exchange future money for money today.

Borrow money today Pay money in future

One Year

+ Rs. 1,00,000 – Rs. 1,10,000

Time Value of Money: Future Value
Converting values across time: Future Value
● Future value (FV) is the value of a current asset at a future date based on an assumed
rate of growth.
● The rate of growth is the interest rate applicable to the cash flows.
● FV = PV*(1+r)t

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○ FV = future value
○ PV = present value

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○ r = interest rate applicable per period
○ t = number of periods

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● Future value interest factor = (1+r)t
Time Value of Money: Future Value
Converting values across time: Compounding Effect
● Compounding is the process whereby interest is earned on an the original principal
amount as well as to interest earned in the previous periods.
● It can be interpreted as “Interest on Interest” and results in magnification of returns
over time.

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● “Magic of Compounding”: Simple Interest vs Compound Interest

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Time Value of Money: Future Value
Example of Future Value
● Suppose you invest $1,000 for one year at 5% per year. What is the future
value in one year?
○ Value in 1 year = Interest + Principal = 1000*0.05 + 1000 = 1050
○ Using formula, FV = 1000*(1+0.05)1 = 1050

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● What is the future value if you leave it invested for two more years? What is
the future value three years from now?

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○ FV = 1000*(1+0.05)3 = 1157.63
● If you invest with simple interest for 3 years,

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○ FV with simple interest = 1000 + 50 + 50 + 50 = 1150
○ FV with compound interest = 1157.63
○ The extra 7.63 comes from interest earned on the two previous interest
payments.
Time Value of Money: Present Value
Converting values across time: Present Value

● Present value (PV) is the current value of a future sum of money or stream of
cash flows given a specified rate of return.
● The rate of return used for discounting is key to properly valuing future cash
flows.

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● PV = FV/(1+r)t

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○ FV = future value
○ PV = present value

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○ r = interest rate applicable per period
○ t = number of periods
● Present value interest factor = 1/(1+r)t
Time Value of Money: Present Value
Examples of Present Value
● You want to begin saving for your daughter’s college education and you estimate
that she will need $150,000 in 17 years. If you feel confident that you can earn 8%
per year, how much do you need to invest today?

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○ PV = 150000/(1+0.08)17 = $40540

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● Your parents set up a trust fund for you 10 years ago that is now worth $19,671.51.

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If the fund earned 7% per year, how much did your parents invest?

○ PV 10 years ago = 19671.51/(1+0.07)10 = $10000

Time Value of Money: Present Value
Some key inferences

● For a given interest rate – the further out the cash flow, the lower it’s present
value
○ Example: What is the present value of $500 to be received in 5 years? 10
years? The discount rate is 10%.

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○ 5 years: PV = 500/(1.1)5 = 310.46

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○ 10 years: PV = 500/(1.1)10 = 192.77
● For a given time period – the higher the interest rate, the smaller the present

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value
○ Example: What is the present value of $500 received in 5 years if the interest
rate is 10%? 15%?
○ Rate = 10%: PV = 500/(1.1)5 = 310.46
○ Rate = 15%; PV = 500/(1.15)5 = 248.59
Time Value of Money: Applications
Financial decision making

Corporate finance decisions:

● Invest in a new project requiring substantial amount of investment
● Research & development decisions
● Launching a new product or in a new market

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PT
Personal finance decisions:
● Make an investment for future, e.g., education

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● Buy an insurance policy
● Live in a rented house or buy own house?
Time Value of Money: Applications
Annual Percentage Rate (APR)
● APR is the annual rate that is quoted by law.
● APR = Period rate times number of periods per year.
● APR becomes relevant only if the compounding interval is taken into

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account. By contrast EAR is meaningful even without compounding effect.
● Example:- Calculate APR if the semi-annual rate of interest rate is 7%.

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○ APR = Period rate * Period Per Year
○ Here, APR = 0.07*2 = 1.4%

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Time Value of Money: Applications
Effective Annual Rate (EAR)
● EAR is the actual rate of Interest paid or received during the year after
adjusting the compounding effects. If we want to compare two alternative
investment proposals with different compounding periods, we need EAR for
comparison.
● EAR = [1+APR/m]m-1

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○ m: number of compounding periods

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○ APR: Annual Percentage Rate (quoted)
● Example:- There are two investment options available, one pays 6.25% with

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daily compounding and the other pays 6.3% with semi annual compounding.
Which option should an investor choose?
○ CASE 1: EAR = [1+0.0625/365]365-1 = 6.44%
○ CASE 2: EAR = [1+0.063/2]2-1 = 6.39%
○ Clearly, investment 1 will give better returns than 2.
CONCLUSION

⮚ The difference in value of money today and that of money in future: Time Value

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of Money

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⮚ A rupee received today is far more worth than a rupee received one year hence.
⮚ Compounding: Computing the future value of an investment made today

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⮚ Discounting: Computing the present value of cash to be received at some future
date
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PT
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 EL
PT
CORPORATE FINANCE

N
ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 07: Valuation of Future Cash Flows

CONCEPTS COVERED

⮚ Future value and present value calculations

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⮚ Discounting of cash flows: Annuity

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⮚ Discounting of cash flows: Perpetuity

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 KEY POINTS

⮚ In general, we have multiple cash flows (both inflows and, sometimes,

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outflows) in a business decision.

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⮚ These cash flows occur at different points in time.
⮚ We find present value of these cash flows to compare with initial

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costs/investments and make decision.
⮚ If present value of cash inflows > the present value of cash outflows, then GO
AHEAD with the decision.
Present Value: Multiple cash flows

● PV of multiple cash flows is calculated by adding up the individual PVs

of each future cash flow. Similar method is applicable for calculating
FV.
● Example: Suppose you are going to receive $200 in an year, $400 in

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two years, $600 in 3 years and $800 in 4 years. The discount rate is
12%. Find the PV of the cash flows.

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○ Find the PV of each cash flows and add them:
○ Year 1 PV: 200/(1.12)1 = 178.57

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○ Year 2 PV: 400/(1.12)2 = 318.88
○ Year 3 PV: 600/(1.12)3 = 427.07
○ Year 4 PV: 800/(1.12)4 = 508.41
○ Total PV = 178.57 + 318.88 + 427.07 + 508.41 = 1432.93
Present Value: Multiple cash flows
Timeline
● Drawing a timeline for cash flows helps in visualising and solving the problem.
● For the example in previous slide,

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PT
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Present Value: Annuity
● Annuity is a finite series of regular payments that occur at regular
intervals.
○ If the first payment occurs at the end of the period it is termed as
an Ordinary Annuity.
○ If the payment occurs on the beginning of the period it is termed

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as Annuity Due.
● Some examples of Annuities:

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○ Regular deposits to a savings account
○ Monthly home mortgage payments

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○ Monthly insurance payments
○ Pension payments.
Present Value: Annuity
Annuity formulae

PVA (Present Value of Annuity) FVA (Future Value of Annuity) PV of Growing Annuity

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PT
● Here,

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○ PMT: annual equal cash flow
○ r: discounting rate per period
○ g: rate of growth of annuity payments
○ t: number of periods
Present Value: Annuity
Examples of Annuities

● While planning for the future, you put $4000 per year in an Investment
fund. The account pays you 5 % interest per year. How much will you
have while you retire after 25 Years.

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○ PMT = 4000, t=25, r=0.05
○ FVA = 4000*[(1+0.05)25-1/0.05] = $190908.4

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● Rahul won a jackpot after after paying $90,000 per year for 30 years. If
the rate of interest is 9 % and the first payment is to be received a year

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from now, calculate the Present value of the jackpot.
○ PMT = 90000, t=30, r=0.09
○ PVA = 90000*[(1-1/(1+0.09)30)/0.09] = $924628.9
Present Value: Growing Annuity
Examples of Growing Annuity
● A person recruited by a MNC with a package of $95,000 per year
anticipates a growth of 7% until his retirement in 35 Years. With a
interest rate of 25%, what is the present value of his lifetime salary.

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○ PMT = 95000, t=35, r=0.25, g=0.07
○ PVGA = 95000*[1-(1+0.07/1+0.25)35/0.25-0.07] = $525492

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● A defined-benefit retirement plan offers to pay $20,000 per year for 40
years and increase the annual payment by three-percent each year.

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What is the present value at retirement if the discount rate is 10
percent?
○ PMT = 20000, t=40, r=0.10, g=0.03
○ PVGA = 20000*[1-(1+0.03/1+0.1)40/0.1-0.03] = $265121
Present Value: Perpetuity
● Perpetuity - Perpetual Annuity
● Infinite series of equal payments separated by equal intervals of time.
● Present value of Perpetuity = PMT/r (infinite GP sum)
○ PMT: annual equal cash flow
○ r: discounting rate applicable

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● Growing perpetuity: If the payments comprising the perpetuity grow at
a rate g,

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○ Perpetuity PV = PMT/(r-g)
○ Assuming g<r

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Present Value: Perpetuity
Example of Perpetuity

● A government wants to set up an endowment that will offer $1 million each year
in scholarship forever. If the rate of return is 8%, find out the endowment value
that can support $1 million payments each year.

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○ PV of Perpetuity = $1,000,000/0.08 = $12,500,000

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● If the scholarship requirements grow at 4%,
○ PV of Perpetuity = $1,000,000/(0.08-0.04) = $25,000,000

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CONCLUSION

• Typical business decisions involves multiple cash flows, occurring

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at different points in time.

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• These cash flows might be annuity, perpetuity, growing annuity,
and growing perpetuity in nature.

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• We calculate Net Present Value (NPV): the difference of the
present value of all cash inflows and cash outflows.
• If NPV > 0, go ahead, otherwise NO.
REFERENCES

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⮚ Corporate finance / Stephen A. Ross, Randolph W. Westerfield, Jeffrey Jaffe. -- 9th ed. p.

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cm. -- (The McGraw-Hill/Irwin series in finance, insurance and real estate)

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PT
EL
 EL
PT
CORPORATE FINANCE

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ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 08: Valuation of Future Cash Flows (cont.)

CONCEPTS COVERED

⮚ Using NPV for Valuation of cash flows

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⮚ Valuation of for non-annual cash flows

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⮚ Calculating other variables: interest rate and number of periods

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Valuation of Cash Flows
The Three Rules
1. Only values at the same point in time can be compared or combined for decision making.

Bring all cash flows at the same point in time to make decisions.

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2. To calculate future value, we compound cash flows.

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Baseline formula: 𝑭𝑽𝒏 = 𝑪 × 𝟏 + 𝒓 𝒏

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3. To calculate present value, we discount cash flows.

𝑪
Baseline formula: 𝑷𝑽 =
𝟏+𝒓 𝒏
Valuation of Cash Flows
Using the formula for calculating other variables: Loan repayment
Present value of a constant annuity:

𝑪 𝟏
𝑷𝑽 =
𝒓
𝟏−
(𝟏+𝒓)𝒏
, where C = annuity cash flows, r = discounting rate, n = no. of years

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Tweak the above formula to calculate the equal repayment amount for a loan:

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Loan Amount C1 C2 C3 Cn

Here, C1 = C2 = … = Cn

𝑃𝑉
Then, the formula for annuity will be: 𝐶=1 1
𝑟
1− 1+𝑟 𝑛
Valuation of Cash Flows
Using the formula for calculating other variables: Loan repayment (cont.)
Example 1: Suppose your firm plans to buy a machinery for Rs. 100,000. The bank offers you a 30-year
loan with equal annual payments and an interest rate of 8% per year. However, the bank requires that
you pay 20% of the purchase price as a down payment, so you can borrow only Rs. 80,000. What should
be the annual loan payment?

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PT
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Valuation of Cash Flows
Using the formula for calculating other variables: Monthly cashflows (cont.)
Example 2: Suppose you want to purchase a new laptop and are offered two payment plans. You can
either pay Rs. 20,000 in cash immediately, or get a loan that requires you to pay Rs. 500 each month for
the next four years. If the interest rate you can earn on your cash is 6%, which option should you choose?

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PT
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Valuation of Cash Flows
Using the formula for calculating other variables: Number of periods
Suppose we deposit Rs. 10,000 in a bank account that pays 10% interest.

We want to know after how much time, the amount will grow to Rs. 20,000.

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The cash flows on the timeline will look like this:
tn

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t0 t1 t2 t3

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Rs. 20,000
– Rs. 10,000

We need to find n (number of years) s.t. the FV of our investment equals Rs. 20,000

FV = Rs. 10,000 x (1+10%)^n = Rs. 20,000

Using a financial calculator, we get n = 7.27 years. (Use Excel function for n)
Valuation of Cash Flows
Using the formula for calculating other variables: Number of periods
Example 3: Let’s suppose that you are planning to save to buy a motorcycle costing Rs. 60,000. Currently
you have a saving of Rs. 10,050, and you hope to save Rs. 5,000 every year at the end of the year. The
prevailing interest rate is 7.5% per year on your savings. How long should it take to reach your goal?

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PT
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CONCLUSION

• With the help of time value of money concept, we develop tools that a financial

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manager can use to value costs and benefits of a decision.
• Given the data on discounting rate, cash flows (both inflows and outflows), and

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time period, we can find the present value to make decisions.
• The formula can be used to calculate other variables, such as annuity cash flows,

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interest rate, number of periods, and equal monthly installments.
• These tools are frequently applied in long-term investment decision making in
corporations.
REFERENCES

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⮚ Principles of Corporate Finance, Brealey et al. (2018), McGraw Hill.

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PT
EL
 EL
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CORPORATE FINANCE

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ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 09: Valuation of Bonds

CONCEPTS COVERED

⮚ Bonds as debt instrument, its salient characteristics

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⮚ Zero coupon bonds

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⮚ Yield to maturity (YTM)

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⮚ Pricing of bonds
Valuation Principles
Valuation of Financial Securities
• Tools for valuing cash flows (e.g., NPV method): to be used to do valuation of financial
securities that have cash flows.
• Financial securities have unique characteristics, however, should have associated cash flows.
• The basic rule: ascertain cash flows (both inflows and outflows), determine discounting rate,

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figure out period, and calculate value.

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Example of financial securities for valuation:
• Zero-coupon Bonds: no coupon, only face value and maturity period.

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• Coupon-bearing Bonds: have face value, coupon, frequency, and maturity period.
• Shares: have dividends, but generally no maturity period.
Valuation Principles
Valuation of Financial Securities: Zero-coupon Bond (ZCB)
• A bond that makes only one payment at maturity; also known as pure-discount bond.
• The only cash flow that an investor receives in a ZCB is the face value of the bond at the maturity date.
t0 t1

Purchase Price Face Value payable at maturity

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Yield-to-Maturity (YTM) of a ZCB:

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The discounting rate that sets the present value of the promised bond payments equal to
the current market price of the bond.

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t0 t1

–Rs. 96.62 Rs.100

Using the formula PV = FV/(1+r)n

We obtain YTM as the discounting rate, r as following: 96.62 = 100/(1+YTM)1
Thus, YTM = 0.0349 or 3,5%
Valuation Principles
Valuation of Financial Securities: Zero-coupon Bond (ZCB)
𝑭𝒂𝒄𝒆 𝑽𝒂𝒍𝒖𝒆 𝟏/𝒏
• Yield-to-Maturity of an n-year ZCB: 𝟏 + 𝒀𝑻𝑴𝒏 =
𝑷𝒓𝒊𝒄𝒆

Yield-to-Maturity (YTM) of ZCBs with different maturities:

Suppose we have the four ZCBs each of Rs. 100 face value, but trading at following prices:

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Maturity 1-year ZCB 2-year ZCB 3-year ZCB 4-year ZCB

Price Rs. 96.62 Rs. 92.45 Rs. 87.63 Rs. 83.06

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Using the above formula, we can calculate the YTM for these bonds:

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Valuation Principles
Valuation of Financial Securities: Zero-coupon Bond (ZCB)
Pricing of ZCB: Suppose we have the following yield-to-maturity curve of a given bond (FV = Rs. 100):
Yield Curve
5.5
Yield to Maturity (%)

4.5

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4

3.5

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0 1 2 3 4 5 6 7
Maturity (in Years)

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Using the formula, we can calculate the price of this bond:
Valuation Principles
Valuation of Financial Securities: Coupon Bond
Coupon bonds pay investors their face value at maturity. Additionally, it pays regular coupon interest
payments. Similar securities are: treasury notes, treasury bonds, and treasury bills.

Cash flow structure of a coupon bond:

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PT
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𝑪 𝟏 𝑭𝑽
Yield-to-Maturity of an n-year coupon bond: 𝑷𝑽 = 𝟏− +
𝒀𝑻𝑴 𝟏+𝒀𝑻𝑴 𝒏 𝟏+𝒀𝑻𝑴 𝒏
Valuation Principles
Valuation of Financial Securities: Pricing a Coupon Bond
There is a five-year Rs.1,000 bond with a 2.2% coupon rate, due semi-annually. Suppose interest rate
drops and the bond’s yield to maturity decreases to 2% (expressed as an APR with semi-annual
compounding). What should be the price of this bond?
𝑪 𝟏 𝑭𝑽
Using this formula: 𝑷𝑽 = 𝟏− +
𝒀𝑻𝑴 𝟏+𝒀𝑻𝑴 𝒏 𝟏+𝒀𝑻𝑴 𝒏

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PT
N
Valuation Principles
Valuation of Financial Securities: Bonds
• A bond will trade at premium if its coupon rate exceeds its yield to maturity (YTM). It will trade at
discount if its coupon rate is less than its YTM. If a bond’s coupon rate is equal to its YTM, it trades
at par.
• As a bond approaches maturity, the price of the bond approaches its face value.
• Bond price changes as interest rates change. When interest rate rise, bond prices fall, and vice

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versa.
• Long-term ZCBs are more sensitive to changes in interest rates than are short-term ZCBs.

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• Bonds with low coupon rates are more sensitive to changes in interest rates than are similar
maturity bonds with high coupon rates.

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CONCLUSION

• Bonds, like a loan, require the borrower to pay periodical coupon

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payments.
• There are zero coupon bonds that do not pay any coupon, but only face

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value at maturity.
• Using discounting method, we can calculate bonds’ prices, yield, and

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maturity in certain cases.
REFERENCES

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⮚ Fundamentals of Corporate Finance, 3rd ed. (2019), Berk et al. Pearson

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PT
EL
 EL
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CORPORATE FINANCE

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ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 10: Valuation of Stocks

CONCEPTS COVERED

⮚ Stocks as securitized ownership

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⮚ Valuation of stocks

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⮚ Dividend Discount Model

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Valuation Principles
Valuation of Financial Securities: Stocks
Common stock
• A form of securitized ownership – a share – in the corporation
• It confers rights to any common dividends as well as rights to vote for major decisions
• Voting rights for election of directors, mergers, and other major events

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Preferred stock
• Stock with preference over common shares in payment of dividends and in liquidation

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• Cumulative versus non-cumulative preferred stock: In cumulative preferred stock, all
preferred dividends must be paid before any common dividend can be paid; dividends do

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not accumulate in case of non-cumulative preferred stocks.

For an investor, the value of a stock today shall be:

• One-year investor: Present value of dividend received, if any, and capital gains
• Multi-year investor: Present value of all dividends expected to be received by the
investor in future
Valuation Principles
Stock Valuation: Dividend Discount Model (One-year Investor)
For an investor:
• There are two potential sources of cash flows from owning a stock:
• Cash dividend that the firm might pay to its shareholders during the holding period, and
• Any capital appreciation in the form of a price increase at some future date

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t0 t1

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Purchase Price Dividend + Selling Price

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t0 t1

–P0 Div1 + P1

Using the formula PV = FV/(1+r)n

𝑫𝒊𝒗𝟏 + 𝑷𝟏
We obtain today’s price as following: 𝑷𝟎 = Decision??
𝟏 + 𝒓𝑬
Valuation Principles
Stock Valuation: Dividend Discount Model (One-year Investor)
𝑫𝒊𝒗𝟏 + 𝑷𝟏
To find the stock price, we use this formula: 𝑷𝟎 =
𝟏 + 𝒓𝑬

Return on the stock can be derived as following:

𝑫𝒊𝒗𝟏 + 𝑷𝟏 𝑫𝒊𝒗𝟏 𝑷𝟏 − 𝑷𝟎

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𝒓𝑬 = −𝟏 or, 𝒓𝑬 = +
𝑷𝟎 𝑷𝟎 𝑷𝟎

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Recall: Total return = Dividend Yield + Capital Gain Rate

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Now, consider the following example:
t0 t1

–P0 Div1 = Rs. 5.60

P1= Rs. 455.00
Given that expected return = 6.80%, what should be the price today?
Valuation Principles
Stock Valuation: Dividend Discount Model (Multi-year Investor)
For an investor:
• There are two potential sources of cash flows from owning a stock:
• Cash dividends that the firm might pay to its shareholders, for more than once, and
• Any capital appreciation in the form of a price increase at some future date

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t0 t1 t2

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Purchase Price Dividend (t1) Dividend (t2) + Selling Price (t2)

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Extending the formula for multi-period, we obtain today’s price as following:

𝑫𝒊𝒗𝟏 + 𝑷𝟏 𝑫𝒊𝒗𝟐 + 𝑷𝟐 𝑫𝒊𝒗𝟏 𝟏 𝑫𝒊𝒗𝟐 + 𝑷𝟐

𝑷𝟎 = , 𝐰𝐡𝐞𝐫𝐞 𝑷𝟏 = , 𝐬𝐮𝐛𝐬𝐭𝐢𝐭𝐮𝐭𝐢𝐧𝐠 𝐭𝐡𝐢𝐬, 𝐰𝐞 𝐠𝐞𝐭 𝑷𝟎 = +
𝟏 + 𝒓𝑬 𝟏 + 𝒓𝑬 𝟏 + 𝒓𝑬 𝟏 + 𝒓𝑬 𝟏 + 𝒓𝑬

𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝟐 + 𝑷𝟐
𝑷𝟎 = +
𝟏 + 𝒓𝑬 (𝟏 + 𝒓𝑬)𝟐
 Valuation Principles
Stock Valuation: Dividend Discount Model (Multi-year Investor)
When we generalize the Dividend Discount Model for multiple years in future with terminal year ‘n’:
t0 t1 t2 tn

Purchase Price Dividend (t1) Dividend (t2) Dividend (tn) + Selling Price (tn)

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The formula to obtain today’s stock price will be as following:

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𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝟐 𝑫𝒊𝒗𝒏 𝑷𝒏
𝑷𝟎 = + + ⋯+ +
𝟏 + 𝒓𝑬 (𝟏 + 𝒓𝑬 )𝟐 (𝟏 + 𝒓𝑬 )𝒏 (𝟏 + 𝒓𝑬 )𝒏

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For a special case, where the firm keeps on paying dividends year after year and is never
liquidated, it is possible to hold the share forever:

𝑫𝒊𝒗𝟏 𝑫𝒊𝒗𝟐 𝑫𝒊𝒗𝟑

𝑷𝟎 = + 𝟐
+ 𝟑
+⋯
𝟏 + 𝒓𝑬 (𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )
Valuation Principles
Stock Valuation: Dividend Discount Model (Multi-year Investor)
When the firm pays a constant dividend every year and the investor holds the share forever:
𝑫𝒊𝒗𝒊
𝑷𝟎 = Recall: How to calculate the present value of constant perpetuity?
𝒓𝑬
What about the dividend grows at a constant rate of growth, g (Constant Dividend Growth Model)?

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t0 t1 t2 t3 ∞

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Purchase Price Div1 Div2 (1+g) Div3 (1+g)2

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Recall: How to calculate the present value of a growing perpetual cash flow?
The share price will be the present value of all future dividends (given rE > g):

𝑫𝒊𝒗𝒊
𝑷𝟎 =
𝒓𝑬 − 𝒈
Valuation Principles
Stock Valuation: Dividend Discount Model (Multi-year Investor)
Suppose a firm, Sinfosys Ltd., plans to pay Rs. 2.30 per share in dividends in the coming year. If its equity
cost of capital (rE) is 7% and dividends are expected to grow by 2% per year in future, what shall be the
value of the Sinfosys Ltd.’s stock today?
𝑫𝒊𝒗𝒊
𝑷𝟎 =
𝒓𝑬 − 𝒈

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t0 t1 t2 t3 ∞

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Purchase Price Div1 Div2 (1+g) Div3 (1+g)2

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Valuation Principles
Stock Valuation: Dividends and Growth in Earnings
• Dividend payout (Divi) is calculated as “Earnings per share (EPS) X Dividend payout rate)
• Here, EPS = Earnings for the year ÷ No. of shares outstanding

The firm can increase the dividends in three ways:

• It can increase its earnings (net income);

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• It can increase its dividend payout rate;
• It can decrease its number of shares outstanding.

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Earnings growth rate can be determined as following:

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• Earnings Growth Rate (g) = Retention Rate × Return on New Investments
• Here, Retention Rate is the fraction of current earnings that the firm retains
within the business (for future investments, usages, etc.).
Valuation Principles
Stock Valuation: Dividends and Growth in Earnings
Example:
Suppose India Sporting Goods Ltd. decides to cut its dividend payout rate to 75% to invest in
new stores as part of its expansion plans. The return on these new investments will be 8%. The
expected earnings per share (EPS) this year is Rs. 6 and the cost of equity capital is 10%. Given
this information, what shall be the current share price of the company?

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• Divi = EPS x Dividend Payout Rate
• Earnings Growth Rate (g) = Retention Rate × Return on New Investments

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• P0 = Divi ÷ (rE – g)

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CONCLUSION

• Ownership in a firm is distributed into shares of stock. These shares carry

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rights to share in the profits of the firm by way of future dividends.
• These shares also come with rights to vote to make major decisions in the

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firm.
• Based on the valuation principles, we can determine the current price of a

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stock using discounting of (expected) dividends.
• Dividend Discount Model is mostly used to calculate the price of a share
given its dividends, growth in dividend (if any), and cost of equity capital.
REFERENCES

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⮚ Fundamentals of Corporate Finance, 3rd ed. (2019), Berk et al. Pearson

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