Revision

Review of Financial Management I

Time Value of Money

Bond Valuation
Stock Valuation

5-1
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 Time Lines

0 1 2 3
I%

CF0 CF1 CF2 CF3

• Show the timing of cash flows.

• Tick marks occur at the end of periods, so Time 0 is
today; Time 1 is the end of the first period (year,
month, etc.) or the beginning of the second period.

5-2
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 Drawing Time Lines

$100 lump sum due in 2 years

0 1 2
I%

100

3-year $100 ordinary annuity

0 1 2 3
I%

100 100 100

5-3
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 Drawing Time Lines

Uneven cash flow stream

0 1 2 3
I%

-50 100 75 50

5-4
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 What is the future value (FV) of an initial $100
after 3 years, if I/YR = 10%?

• Finding the FV of a cash flow or series of cash flows

is called compounding.

0 1 2 3
10%

100 FV = ?

• FVN = PV(1 + I)N

• FV3 = PV(1 + I)3 = $100(1.10)3 = $133.10

5-5
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 What is the present value (PV) of $100 due in
3 years, if I/YR = 10%?

• Finding the PV of a cash flow or series of cash flows

is called discounting (the reverse of compounding).
• The PV shows the value of cash flows in terms of
today’s purchasing power.

0 1 2 3
10%

PV = ? 100

5-6
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 Solving for PV:

• Solve the general FV equation for PV:

PV = FVN /(1 + I)N
PV = FVN (1 + I)-N

PV = FV3 (1 + I)-3
= $100(1.10) -3
= $75.13

5-7
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 Other Applications of TVM

• Solving for I: What annual interest rate would

cause $100 to grow to $125.97 in 3 years?
• Solving for N: If sales grow at 20% per year, how
long before sales double?

3-8
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 What is the difference between an ordinary
annuity and an annuity due?

Ordinary Annuity
0 1 2 3
I%

PMT PMT PMT

Annuity Due
0 1 2 3
I%

PMT PMT PMT

5-9
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 Solving for FV:
3-Year Ordinary Annuity of $100 at 10%

0 1 2 3
10%

100 100 100

FV = ?

• FV = $100(1.10)2 + $100(1.10)1 +$100 = $331

5-10
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 Solving for PV:
3-year Ordinary Annuity of $100 at 10%

0 1 2 3
10%

PV = ? 100 100 100

• PV = $100(1.10)-1 + $100(1.10)-2 + $100(1.10)-3

= $248.69

5-11
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 Solving for FV:
3-Year Annuity Due of $100 at 10%
• Now, $100 payments occur at the beginning of each period.

0 1 2 3
10%

• FV $100
= $100(1.10) + $100(1.10) +$100
3
$100(1.10)
2 1
= $364.10 $100 FV = ?
• Alternatively, FVAdue= FVAord(1 + I) = $331(1.10) = $364.10

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 1.
5-12
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 Solving for PV:
3-Year Annuity Due of $100 at 10%

• Again, $100 payments occur at the beginning of each period.

0 1 2 3
10%

$100 $100 $100

PV = ?

• PV = $100 + $100(1.10)-1 + $100(1.10)-2 = $273.55

• Alternatively, PVAdue = PVAord(1 + I) = $248.69(1.10) = $273.55
5-13
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 Annuities

• Assume that you plan to buy a condo 5 years from now,

and you estimate that you can save $2,500 per year. You
plan to deposit the money in a bank that pays 4%
interest, and you will make the first deposit at the end
of the year. How much will you have after 5 years?
• Assume that you are offered an annuity that pays $100
at the end of each year for 10 years. You could earn 8%
on your money in other investments with equal risk.
What is the most you should pay for the annuity? If the
payments began immediately, how much would the
annuity be worth?

3-14
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 Annuities

• You have a choice of receiving $4,500 now or $400

every year for 10 years as well as $2,000 at the end
of year 10. Assuming money earns 5%, what would
your choice be?

• An investment costs $465 and is expected to

produce cash flows of $100 at the end of Year 1,
$200 at the end of Year 2, and $300 at the end of
Year 3. What is the expected rate of return on this
investment?

3-15
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 Perpetuity

• An annuity expected to continue forever.

• What is the PV of a annuity of $100 forever with an
interest rate of 10%?

PV = PMT/I
= $100/0.1 = $1,000.

5-16
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 What is the PV of this uneven cash flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV

5-17
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 Bonds and Their Valuation

3-18
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 The Value of Financial Assets

0 1 2 N
r% ...
Value CF1 CF2 CFN

CF1 CF2 CFN

Value    
1  r  1  r 
1 2
1  r N

The value or price of any asset in the economy is equal to

the present value of all future cash flows associated with it.
7-19
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 What is the opportunity cost of debt capital?

• The discount rate (ri) is the opportunity cost of

capital, and is the rate that could be earned on
alternative investments of equal risk.

ri = r* + IP + MRP + DRP + LP

7-20
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 What is the value of a 10-year, 10% annual coupon
bond, if rd = 10%?

0 1 2 N
10% ...
VB = ? 100 100 100 + 1,000

$100 $100 $1,000

VB     
1.101 1.1010 1.1010
VB $90.91    $38.55  $385.54
VB $1,000

7-21
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 What’s the value of its 10-year bonds outstanding with
the same risk but a 13% annual coupon rate?

• The annual coupon payment is $130. Since the risk is the same it has the
same yield to maturity as the previous bond (10%).

0 1 2 N
10% ...
VB = PV = ? 130 130 130 + 1,000

$130 $130 $1,000

VB     $1,184.34
1.10  1.10  1.10 
1 10 10

• This bond sells at a premium because the coupon rate > the yield to
maturity.
7-22
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 What’s the value of its 10-year bonds outstanding with
the same risk but a 7% annual coupon rate?

• The annual coupon payment is $70. Since the risk is the same it has the same
yield to maturity as the previous bonds (10%).

0 1 2 N
10% ...
VB = PV = ? 70 70 70 + 1,000

$70 $70 $1,000

VB     $815.66
1.10  1.10  1.10 
1 10 10

• This bond sells at a discount because the coupon rate < the yield to maturity.
7-23
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 Yield to Maturity (YTM)

• The rate of return earned on a bond held until

maturity (also called the “promised yield”).
• It is the expected rate of return on the bond if it
does not default and it cannot be called.
• A bond’s calculated YTM changes whenever interest
rates change.
• An investor who buys and holds a bond till maturity
will receive the YTM that existed on the purchase
date, but the bond’s calculated YTM will change
frequently between purchase date and maturity
date.
7-24
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 What is the YTM on a 10-year, 9% annual coupon,
$1,000 par value bond, selling for $887?

• Must find the rd that solves this model.

INT INT M
VB    
1  rd 1
1  rd  1  rd N
N

90 90 1,000
$887     
1  rd 1 1  rd 10 1  rd 10

• Solving for I/YR, the YTM of this bond is 10.91%. This

bond sells at a discount, because YTM > coupon rate. 7-25
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 Find YTM If the Bond Price is $1,134.20

• Solving for I/YR, the YTM of this bond is 7.08%. This

bond sells at a premium, because YTM < coupon
rate.

INT INT M
VB    
1  rd  1  rd  1  rd 
1 N N

90 90 1, 000
$1,134.20    
1  rd  1  rd  1  rd 
1 10 10

7-26
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 Yield to Call (YTC)

• Callable: its remaining life is the years to maturity if it is

not called, or the years to the call if it is called.
• If a callable bond is called, you do not have the option
of holding it to maturity. Therefore, the YTM would not
be earned.
• YTC is the rate of return earned on a bond when it is
called before its maturity date.
• If current interest rates are well below an outstanding
bond’s coupon rate, a callable bond is likely to be
called; and investors will estimate its most likely rate of
return as the YTC rather than the YTM.
7-27
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 Yield to Call (YTC)

• A 15-year bonds issue with a coupon rate of 10% was

callable 10 years after it’s issue date at a price of
$1,100. Suppose 1 year after issuance, the going
interest rate had declined, causing it’s price to rise to
$1,494.93. What is the bond’s YTC? What is the YTM?

7-28
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 Stocks and Their Valuation

3-29
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 Discounted Dividend Model

• Value of a stock is the present value of the future

dividends expected to be generated by the stock.

D1 D2 D3 D
P̂0  1
 2
 3
 ... 
(1  rs ) (1  rs ) (1  rs ) (1  rs )

9-30
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 Constant Growth Stock

• A stock whose dividends are expected to grow

forever at a constant rate, g.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
• If g is constant, the discounted dividend formula
converges to:
D0 (1  g) D1
P̂0  
rs  g rs  g

9-31
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 Use the SML to Calculate the Required
Rate of Return (rs)

• If rRF = 7%, rM = 12%, and b = 1.2, what is the

required rate of return on the firm’s stock?
rs = rRF + (rM – rRF)b
= 7% + (12% – 7%)1.2
= 13%

9-32
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 Find the Expected Dividend Stream for the Next
3 Years and Their PVs

D0 = $2 and g is a constant 6%.

0 g = 6%
1 2 3

2.12 2.247 2.382

1.8761
rs = 13%
1.7599
1.6509

9-33
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 What is the stock’s intrinsic value?

Using the constant growth model:

D1 $2.12
P̂0  
rs  g 0.13  0.06
$2.12

0.07
$30.29

9-34
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 What is the stock’s expected value, one year
from now?

• D1 will have been paid out already. So, expected P 1

is the present value (as of Year 1) of D 2, D3, D4, etc.
D2 $2.247
P̂1  
rs  g 0.13 0.06
$32.10

• Could also find expected P1 as:

P̂1 P0 (1.06)$32.10

9-35
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 Find Expected Dividend Yield, Capital Gains Yield, and
Total Expected Return During First Year

9-36
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 Growth rate ‘g’

Growth rate = (1 - Payout ratio)*ROE

•Growth in dividends depends primarily on the firm’s

payout ratio and its ROE.
• A firm can provide a relatively high dividend yield or
a higher growth rate but not both.
•Choice depends on what shareholders want.

9-37
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 Example

• A company recently paid a dividend of $3 and is

expected to grow at a constant rate of 8%. The
beta of its stock is 1.5. Currently, the risk-free
rate is 6% and return on the market is 10%.
– What is the stock’s intrinsic value?
– What is the stock’s expected value, one year from
now?
– Find expected dividend yield, capital gains yield, and
total return during first year.

3-38
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 Preferred Stock

• Hybrid security.
• Like bonds, preferred stockholders receive a fixed
dividend that must be paid before dividends are
paid to common stockholders.
• However, companies can omit preferred dividend
payments without fear of pushing the firm into
bankruptcy.

9-39
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 If preferred stock with an annual dividend of $5 sells for
$50, what is the preferred stock’s expected return?

D
Vp 
rp
$5
$50 
rp

$5
r̂p 
$50
0.10 10%

9-40
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