Global Financial Management

University of Memphis (FIR 7155)

Handout-Time Value of Money, Bond and Stock Pricing
Future Value
Assume that you have $1000 today to invest for 10 years at an annually compounded rate of
10 percent. How much will you have at the end of the 10 years?
I
0

I
1

I I I I I I I I
2 3 4 5 6 7 8 9

I FV10 ?
10

FV1 = 1000 + 1000*.1 = 1000(1+.1) = $1100

FV2 = 1100 + 1100*.1 = 1100(1+.1) =1000(1+.1)(1+.1)= 1000(1+.1)2 = $1210
10
FV2 = 1000(1+.1) = 1000 (2.59374) =$2,593.74
In General: FV = PV(1+r)N

Present Value
Assume that you will have $1000 in 10 years. What is the value today assuming an annually
compounded discount rate of 10 percent. What is the Present Value today?
PV0?

I I
0 1

I
2

I
3

I
4

I
5

I
6

I
7

I
8

I I
9 10

Given: FV = PV(1+r)N
Then,
PV = FV/(1+r)N or PV = FV(1+r)-N
Thus, the present value of receiving $1,000 in 10 years is:
PV = $1,000/(1+.1)10 = $1,000/2.59374 = $1,000(0.3855433) = $385.54

Future Value of an Annuity-FVA

Assume that you will receive $1000 per year for 10 years. What is the value of this annuity in 10
years assuming an annually compounded interest rate of 10 percent?
I
0

I
I
I
I
I
I
I
I
I
I FVAN
1
2
3
4
5
6
7
8
9
10
$1000 $1000 $1000 $1000 $1000 $1000 $1000 $1000 $1000 $1000

Or
(1)
Multiply equation (1) by (1+.1)
(2)
Subtract equation (1) from equation (2)

Thus,
= 1000[15.9374] = $15,937.40
In General,

PVA Value of an Annuity-PVA

Assume that you will receive $1000 per year for 10 years. What is the present value of this
annuity assuming an annually compounded discount rate of 10 percent?
PVA I
0

I I
I
I
I
I
I
I
I
I
1 2
3
4
5
6
7
8
9
10
$1000 $1000 $1000 $1000 $1000 $1000 $1000 $1000 $1000 $1000

Or
(1)
Multiply equation (1) by (1+.1)

(2)
Subtract equation (1) from equation (2)

or

Thus,
= 1000 (6.14457) = $6,144.57
In General;

A time value of money problem that FIR 3410 students should be able to solve
You want to retire in 30 years (360 months), and have a retirement income equal to 3,000 per
month in current . Thus, assuming an inflation rate of 2.0% per year compounded annually for
the next 30 years, you need to determine what your monthly retirement income will need to be to
have the same purchasing power as 3,000 today. Your actuarial life expectancy is anticipated
to be 24 years at the time of your retirement, thus you can buy an annuity from an insurance
company at the time you retire that time that assumes you will receive 288 (24*12) monthly
payments. You have 20,000 in your retirement savings account today. Given a rate of return of
6.5% for the foreseeable future, how much do you need to save each month for the next 30 years
(first payment to be made in one month) if your are to afford to purchase an annuity contract that
will pay your retirement annuity for 288 months? (Assume that you make the last monthly
payment in 359 months one before you retire and receive your first retirement payment.)
Needed per month retirement income.
FV30 years = 3,000 (1.020)30 = 3,000 (1.8114) = 5,434 per month.
Total amount Needed in retirement account one month before retirement.

PVAmonth 359 =

= 5,434 (145.6574)= 791,502

Value of Current Savings in 359 months.

FV359 months = 20,000 (1.0054)359 = 20,000 (6.9541)= 139,083
New Total Saving by month 359 =

652,419

Saving Each month for 359 Months.

=

Then,
A = 652,319/1,099.224 = 593.44 per month
Bond Pricing
A bond is a promissory note issued by a business or a governmental unit. Treasury bonds,
sometimes referred to as government bonds, are issued by the Federal government and are not
exposed to default risk. Corporate bonds are issued by corporations and are exposed to default
risk. Different corporate bonds have different levels of default risk, depending on the issuing
company's characteristics and on the terms of the specific bond. Municipal bonds are issued by
state and local governments. The interest earned on most municipal bonds is exempt from
federal taxes, and also from state taxes if the holder is a resident of the issuing state. Foreign
bonds are issued by foreign governments or foreign corporations. These bonds are not only
exposed to default risk, but are also exposed to an additional risk if the bonds are denominated in
a currency other than that of the investor's home currency.

Example Bond Pricing

Your firm has a $1,000 par value bond with 10 years to maturity, annual coupon rate of 9%
semiannual coupon payment, and the market yield to maturity on similar bonds is 8 percent.
What should be your asked price for the bond?
VB =
VB = PMT((1- 1/(1+rd)N )/rd) + FV(1/(1+rd)N).
M = $1,000. SemiAnnual INT = [0.09($1,000)]/2 = $45, r = .08/2 =.04.
VB = $45((1- 1/(1+.04)20)/.04) + $1,000(1/(1+.04)20) = $45(13.5903) + 1000(0.4564)
=611.56+456.39 = $1,067.95

If on the other hand, we know that the price was $1,067.95, we could determine the YTM by
trial-and-error. We know that if the YTM were 9%, the bond would sell at par. Since the bond
sells at a premium, the YTM is lower than 9%. Let's try 7 percent.
At 7%, VB = $639.56 + $502.57
= $1,142.07
Since$1,142.07 > $1,067.95; therefore, the bond's YTM is greater than 7 percent.
We know that 8% is the correct YTM
Calculator solution:
1.

Input N = 20, PV = -1,067.95, PMT = 45, FV = 1000,

I = ? = 4% semiannual or I = 2*4% = 8.00%.

Stock Pricing
Common Stockholders are the owners of the firm thus they are entitled to all residual earnings of
the firm. However, there is no contract that states the amount of stock payout, thus we usually
make assumptions about the firm to enable us to price its common stock. Assuming that a stock
will be owned for perpetuity by a stockholder, we assume that the payout to stockholders will
come from the flow of dividends for perpetuity. For the most common stock pricing model,
Gordons constant growth model, we normally assume a constant future growth rate in EPS.
Assuming that the firm will have a constant future rate of return on invested capital, rb, and a
constant payout ration, we can write:
(1)
Where,
g = rb (1-p)
rb = constant return on invested capital,
p = constant payout ratio.
Equation (1) is a geometric perpetuity. To simplify (1), we can multiply by (1+k)/(1+g).
(2)
Subtracting (1) from (2) gives:

However,
may take the value if g > k; 1 if g = k or 0 if g < k, Zero is the only value
that does not make the equation indeterminate. Thus, assuming that g < k and

is zero,

the Gordon constant growth model (also called the discounted cash flow model) becomes:

Example:
A company currently pays a dividend of $2 per share, D0 = $2. It is estimated that the stock will
grow at a 20% rate for the next two years and then grow at 7% thereafter. The companys stock has
a beta of 1.2, the risk free rate is 3% and the markets long-term risk premium has been 5.5%. What
is your estimate for the stocks price?
0
I

1
I
D0 = 2.00

2
I

3
I
P2=?

Step 1: Calculate the required rate of return on the stock:

ks = rRF + (kM - rRF)b = 5.0% + (5.5%)1.2 = 11.6%.
Step 2: Calculate the expected dividends
D0 = $2.00
D1 = $2.00(1.20) = $2.40
D2 = $2.00(1.20)2 = $2.88
D3 = $2.88(1.07) = $3.08
Step 3: Calculate the PV of the expected dividends:
PVDiv = $2.40/(1.116) + $2.88/(1.116)2 = $2.15 + $2.31 = $4.46.

Step 4: Calculate P2:

P2 = D3/(rs - g) = $3.08/(0.116 - 0.07) = $66.96.
Step 5: Calculate the PV of

PV = $66.96/(1.116)2 = $53.76.
Step 6: Sum the PVs to obtain the stocks price:
= $4.46 + $53.76 = $58.22.

Next is the intuitive derivation of the Capital Asset Pricing Model

An example of diversification:
You have been given twp different investments: Stock X and Stock Y. The Economist for your
firm has given you the following expected returns given three different states of the economy for
the next year.
State of
the Economy

Prob.

Recession
0.3
Average
0.4
Boom
0.3
Mean
Variance
Standard Deviation
Covariance
Correlation

Stock X

Stock Y

-10%
-5%
12
25.0
35
10.0
_______
11.50%__
_______
155.26___
________
_12.46%_
_98.55__
_0.45___

.22 X and .78 Y

-6.10%
22.14
15.50
__11.68%
142.98__
_11.96%

a)
What are the means, variances and standard deviations of returns for each of the two
stocks and a portfolio of 22% stock X and 78% stock Y? Also, calculate the covariance and
correlation between stocks X and Y.
E(RX ) = .3 (-10) + .4 (12) + .3 (35) = 12.30%
Var (RX ) =(10-12.3)2.3 + (12-12.3)2.4 + (35-12.3)2.3 =303.82
Std. Dev(RX ) = 17.43%
Cov(RX, RY) = (-10-12.3)(-5-11.5).3 + (12-12.3)(25-11.5).4 + (35-12.3)(10-11.5).3

= 98.55
XY = Cov (RX,RY)/X Y = 98.55/(17.43)(12.46) = 0.45
Portfolio (P) expected return, variance and standard deviation:
E(P) = .22E(RX ) + .78E(RY ) = .22(12.3% ) + .78(11.50% ) = 11.68%
Var(P) = (.22)2Var (RX ) + (.78)2Var (RY ) +2(.22)(.78)Cov(RX,RY)
= (.22)2303.82 + (.78)2155.26 +2(.22)(.78)98.55 = 142.98
And
Stn Dev(P) = 11.96%
Thus, we can observe the effect of diversification since the portfolio of two stocks has a
higher expected return and a lower standard deviation that stock Y.

Now Assume that we have a portfolio that consists of all of the N stocks in
the market. What is the mean and variance of the market?
Portfolio Mean:
E(P) = w1 E(R1 ) + w2 E(R2 ) + w3 E(R1 ) +---------+ wN E(RN )
Portfolio Variance:
Var(P) = (w1)2Var (R1 ) + (w2 )2Var (R2 ) + (w3)2Var (R3 ) +--------+ (wN )2Var (RN )
+2(w1)(w2)Cov(R1,R2) +2(w1)(w3)Cov(R1,R3) +-----------+2(w1)(wN)Cov(R1,RN)
+2(w2)(w3)Cov(R2,R3) +2(w2)(w4)Cov(R2,R4) +-----------+2(wN-1)(wN)Cov(RN-1,RN)
Where, wi is the proportion or weight of each stock in the market portfolio.
If for example, there were only 100 stocks in your portfolio, there would be 3950 Cov
terms. Thus, this is a huge equation if we include all of the N stocks in the market. How
did Sharpe solve this problem?

If you can solve this problem, you will receive an A in the class.