Chapter

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TIME VALUE OF MONEY

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TIME VALUE OF MONEY

LEARNING OBJECTIVES
 Explain the time value of money.  Explain the various valuation concepts  Compute the various values based on different valuation concepts  Understand different valuation models concerned with different securities

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Time Value of Money

Meaning of Time Value of Money Money has time value. i.e, the value of money changes over a period of time The value of a rupee received today is different from the value of a rupee to be received after a year. A rupee today has value than a rupee after a year. Factors contributing to the Time Value of Money Money has a time value because of the following reasons.  individuals generally prefer current consumption to future consumption  an investor can profitably employ a rupee received today to give him a higher value to be received tomorrow or after a certain period.  In an inflationary economy the money received today has more purchasing power than money to be received in future.  A bird in hand is worth two in the bush : This statement implies that people consider a rupee today worth more than a rupee in the future, say, after a year. This is because of the uncertainty connected with the future.
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TIME VALUE OF MONEY

Valuation concepts or Techniques

The Time value of money implies (i) That a person will have to pay in future more for a rupee received today and (ii) a person may accept less today for a rupee to be received in future.  The above statements relate to two different concepts they are I - Compound value Concept II - Discounting or Present Value Concept

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TIME VALUE OF MONEY

Required Rate of Return

 The time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It may be therefore called the risk-free rate.  An investor requires compensation for assuming risk, which is called risk premium.  The investors required rate of return is: Risk-free rate + Risk premium

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TIME VALUE OF MONEY

Time Value Adjustment

 Two most common methods of adjusting cash flows for time value of money:   Compoundingthe process of calculating future values of cash flows and Discountingthe process of calculating present values of cash flows.

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TIME VALUE OF MONEY

Future Value
 Compounding is the process of finding the future values of cash flows by applying the concept of compound interest.  Compound interest is the interest that is received on the original amount (principal) as well as on any interest earned but not withdrawn during earlier periods.  Simple interest is the interest that is calculated only on the original amount (principal), and thus, no compounding of interest takes place.  The general form of equation for calculating the future value of a lump sum after n periods may, therefore, be written as follows: Fn= P(1+i)n  The term (1 + i)n is the compound value factor (CVF) of a lump sum of Re 1, and it always has a value greater than 1 for positive i, indicating that CVF increases as i and n increase. Fn = P*CVFn,i
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TIME VALUE OF MONEY

Discounting or present value concept

 The concept of present value is the exact opposite of that of a sum of money or series of payments, while in case of present value concept, we estimate the present worth or a future payment/installment or series of payment adjusted for the time value or money.  The basis of present value approach is that opportunity cost exist for money lying idle. That is to say, that interest can be earned on the money. This return is termed as discounting rate  Given a positive rate of interest, the present value of future Rupee will always be lower. The technique for finding the present value is termed as discounting.  Present value after n Years :  Formula : A PV = ----------(1 + i)n  Where : PV = principal amount the investor is willing to forego at present I = Interest rate A = amount at the end of the period n. N = Number of years Copyright 2006, Dr Sudhindra Bhat
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TIME VALUE OF MONEY

Example :
If Mr. X, depositor, expects to get Rs. 100 after one year at the rate of 10%, the amount he will have to forego at present can be calculated as follows : A PV = ----------(1 + i)n 100 PV = ----------- = Rs. 90.90 (1 + .10)

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TIME VALUE OF MONEY

Present Value of a Series of Cash flows :

 In a business situation, it is very natural that returns received by a firm are spread over a number of years. An investment made now may fetch returns for a period after some time. Every businessman will like to know whether it is worthwhile to invests or forego a certain sum now, in anticipating of returns he expects to earn over a number of years. The estimate the present value of future series of returns, the present value of each expected inflow will be calculated. The present value of series of cash flows can be represented by the following C1 PV = (1 + i)1 n Ct C2 (1 + i)2 C3 (1 + i)3 Cn (1 + i)n ----------- + ----------- + ----------- + -----------

 

PV = 7 ----------T=1 (1 + i)n  Where, I = Discounting rate

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PV = sum of individual present values of each cash flow : C1, C2, C3.......... Cn = Cash flows after period 1,2,3.n ,
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Illustration
Given the time value of money as 10% (i.e. the discounting factor) You are required to find out the present value of future cash inflows that will be received over next four years. Year 1 2 3 4 Cash flows (Rs.) 1,000 2,000 3,000 4,000

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TIME VALUE OF MONEY

Solution:
1 Year 1 2 3 4 2 PVF@10% 0.909 0.826 0.751 0.683 PV series 3 Cash flow 1000 2000 3000 4000 of cash flow 4(2*3) PV 909 1,652 2.253 2,732 7546

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TIME VALUE OF MONEY

Valuation of Bonds or Debentures :

  A bond or debenture is an instrument of long-term debt issued by a borrower. Technique of Valuation of Bonds or Debentures : The value of bonds or debentures is, generally, determined through the technique known as the Capitalization technique.  The process of determination of the present value of a bond or debenture can be considered under two heads viz.,   When a bond or debenture is redeemable (i.e. definite maturity period) When a bond or debenture is irredeemable (i.e. as no specified definite maturity period)

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When a bond or debengure is redeemable, its present value can be determined by estimating its guture cash flows, and then, discounting the estimated future cash flows at an appropriate capatializatin rate or discount rate.

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TIME VALUE OF MONEY

Present Value of a redeemable Bond or Debenture

 The following formula may be used to find out the present value of the bond or debenture (assuming that the bond has a maturity period of 4 years): I1 V = Where V = the present value of the bond or debenture I Kd M = annual interest payment. = the capitalization rate or the discount rate = The maturity value of the bond or debenture I2 I3 (1 + Kd)3 14+M (1 + Kd)4 ----------- + ----------- + ----------- + ----------(1 + Kd)1 (1 + Kd)2

Alternatively, the present value of the bond or debenture can be ascertained through the table called the discount rate tables or present value tables.
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TIME VALUE OF MONEY

Illustration
A Debenture of Rs. 1,000, issued by a company, matures in 5 years. The rate of interest payable by the company on the debenture is 7% p.a. the appropriate capitalization rate is 5% Calculate the present value of the debenture. Solution : Through the formula I1 I2 I3 I4 15+M  V = ----------- + ----------- + ----------- + ----------- + ---------(1 + Kd)1 (1 + Kd)2 (1 + Kd)3 (1 + Kd)4 (1 + Kd)5 70 70 70 70 100 V = ----------- + ----------- + ----------- + ----------- + ---------(1 + 05)1 (1 + 05)2 (1 + 05)3 (1 + 05)4 (1 + 05)5 The present value of interest of Rs. 70 for 5 years (70 x 4.330) = 303.1 The present value of the principal at the end of the 5th year (1000x0.784) = Present value of the debenture = 1097.1



784.0

Note : 1 As the interest of Rs. 70 is an annual payment for 5 years, it is an annuity for 5 years. The present value of an annuity of Re. 1 for 5 years, as per the present value tables is Rs. 4.330 (As per Table 2) Note : 2 The Principal repayment is a lump sum repayment at the end of the 5th year, so the present value of the principal amount (as per table 1) is 0.784 x 1000. Copyright 2006, Dr Sudhindra Bhat

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Present Value of a perpetual or Irredeemable Bond or Debenture

When a bond or debenture is irredeemable, its present value can be determined by simply discounting the stream of interest payments for the infinite period by a appropriate capitalization rate or discount rate. The following formula may be used to determine the rpesent value of the bone or debenture.

V = 1/Kd Where, V - means the present value of the bond or debenture I means annual interest payment Kd means the capitalization rate or the discount rate.
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TIME VALUE OF MONEY

Illustration
A perpetual debenture of the face value of Rs. 1,000 is issued by a company. The rate of interest payable by the Company is 6% p.a. The appropriate capitalization rate is 5%. Calculate the present value of the debenture.     Solution V = 1/Kd Here, I = Annual Interest i.e. 1000 x 6/100 = 60 Kd = 5% or 0.05 Therefore 60/0.05 = Rs. 1,200

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TIME VALUE OF MONEY

Valuation of reference shares

Meaning: preference shares are a type of shares issued by a joint stock company for raising share capital from the public. It may be redeemable preference shares or irredeemable preference shares.

The value of preference shares also is, generally, determined through the capitalization technique.

The process of determination of the present value of preference share is the same as that of bonds or debentures. The process or determination of the present value of a preference share can be considered under two heads viz.

 

When preference share is redeemable When preference share is irredeemable.

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TIME VALUE OF MONEY

When preference share is redeemable preference share:

 Present value of a redeemable preference share can be determined by estimating its future cash flows, and then discounting the estimated future cash flows at an appropriate capitalization rate or discount rate. The estimated future cash flows from the preference share consists of the stream of future dividend payment plus the par value of the preference share. The following formula may be used to determine the present value of the preference share (assuming that the bond has a maturity period of 3 years) D1 V= ----------(D + Kp)1 D2 + ----------(D + Kp)2 D+M + ----------(D + Kp)3

 

Where V = present value of the preference shares D = Annual dividend payment Kp = Capitalization rate or discount rate M = Maturity value i,e., the value of the preference share. Alternatively, the present value of the preference share can be determined though the table called the Copyright 2006, Dr Sudhindra Bhat present value Tables.
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Illustration 14
X Ltd. Has issued 7% preference shares of Rs. 100 each. The preference shares are redeemable after 5 years. The appropriate capitalization rate is 5%. Calculate the present value of a preference share D1 D2 D3 D4 D5+M V = ------------ + ------------ + ----------- + ----------- + ---------(D + Kp)1 (D + Kp)2 (D + Kp) (D + Kp)4 (D + Kp)5 7 7 7 V = ----------- + ----------- + ----------- + (1 + 05)1 (1 + 05)2 (1 + 05)3 That is, 7 x 4.330 = 30.31 100 x 0.684 = 78.40 Present value 108.71
Note (i) Present value of an annuity of Re 1 at the capitalization rate of 5% at the end of the 5th year is 4.330 (ii) Present value of rupee at the capitalization rate of 5% at the end of the 5th year is 0.784 Copyright 2006, Dr Sudhindra Bhat
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7 100 ----------- + ---------(1 + 05)4 (1 + 05)5

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Present value of perpetual or an irredeemable preference share:

The present value of irredeemable preference share can be determined by simply discounting the streams of dividend payment for the infinite period by an appropriate capitalizations rate of discount rate. Formula : D V = ---Kp Where V = Present value of the preference share. D = annual dividend payment on the preference share Kp = Capitalization rate.
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Valuation of Equity shares

 The valuation of equity shares is difficult as compared to the valuation of debenture or preference shares. This is because of two reasons.  Equity Shears do not carry a fixed dividend or interest rate as is the case with preference shares or debentures Equity shareholders may or may not get dividends.  Earnings or dividends on equity shares are expected to grow unlike interest on debentures and preference dividend.  Methods of Valuation : Valuation basically based on two approaches : (1) Dividend Capitalization Approach (2) Earning Capitalization Approach

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Assignment for Student

 Exercise one: Practice all the problems in the text Book. Exercise Two : Comparing Auto Loan Alternatives  You are considering the purchase of new car. You have negotiated with the salesperson at the dealership and you can purchase the vehicle for Rs. 30,000. You have Rs. 8,000 that you can use as a down payment.  Prior to going into the dealership, you have set an absolute limit of Rs. 375 for the amount of monthly payments that you can make on the car. You are willing to finance over five years but you cannot exceed the payment of Rs. 375 per month. The dealer is willing to offer you financing at an annual rate of 6.5% for a 5-year loan. The dealer is willing to offer 5.5% financing on a 4-year loan. Can you meet your payment restriction and finance the amount required for the car? What is the maximum amount that you can borrow to meet your payment restriction if the loan is to be paid off in 5 years? Suppose that you are limited to paying Rs. 375 per month but you want to pay the loan off in 4 years and not 5 years. What is the maximum amount that you can borrow?
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