tvm, valuation, risk and return

8/20/2019 TVM, Valuation, Risk and Return

1/23

Financial management

Time value of money, Risk

and return, Valuation


2/23

Objectives of Financial

management• Profit maximisation/EP – !mbiguity, "uality of benefits/risk, timing of benefits

• #ealt$ maximisation

– Value, ie%, &ort$ to t$e o&ners

– 'a(italisation/discount rate t$at reflects risk and time (references

– Economic value added )EV!*

•

!fter tax o(erational (rofits of a firm less t$e cost of funds used tofinance investments

– Focus on stake$olders

• Em(loyees, customers, su((liers, creditors, o&ners and ot$ers

&$o $ave direct link &it$ t$e firm•


3/23

Time value of money

+ &ill gladly (ay you Tuesday for a $amburger

can eat today- . Wimpie, from the Popeye cartoon


4/23

earning Objectives

0 Ex(lain t$e meaning of t$e time value of money and t$eim(ortance of t$e timing of cas$ flo&s in making financial

decisions

0 'alculate t$e future value and (resent value of cas$ flo&s for

one (eriod and multi(le (eriods

0 olve for t$e interest rate im(lied by a given set of (resent

value and future value cas$ flo&s

0 !((ly time value of money tec$ni"ues to solve basic (roblems

facing financial managers

0 1se a calculator/excel s$eet to solve time value of money

(roblems


5/23

'entral conce(ts in finance

0 Risk-return tradeoff . nvestors &ill take on additional

risk only if t$ey antici(ate $ig$er return%

0 Time value of money 2 value of a unit of money is

different in different time (eriods

! ru(ee available today is &ort$ more t$an a ru(ee

available at a future date%

T$is is because a ru(ee today can be invested to earn a

return%


6/23

Tec$ni"ues•

Future value or 'om(ounding – 'om(ound interest is t$e interest earned on a

given de(osit/(rinci(al t$at $as become a (art of

t$e (rinci(al at t$e end of a s(ecified (eriod

– Princi(al refers to t$e amount of money on &$ic$

interest is received

•

Present value or 3iscounting – Present value is t$e current value of a future

amount

–

3iscounting is determining t$e (resent value of afuture amount


7/23

R4 and RET1R5


8/23

Risk and return of a single asset

• Return 2 actual income received (lus any

c$ange in t$e market (rice of an asset /

investment

• 'alculation of ex(ected return 2 single (eriod

• Risk 2 variability of actual return from t$e

ex(ected return associated &it$ a given asset


9/23

6easurement of risk

• 7e$avioural (oint of vie&

– ensitivity analysis

–

Probability distribution• 8uantitative/statistical (oint of vie&

– tandard deviation

– 'o.efficient of variation


10/23

Risk and return of a (ortfolio

• Portfolio 2 combination of t&o or more

securities/assets

•

Portfolio ex(ected return• Portfolio risk

• 'orrelation/covariance

• 3iversification

• Risk return trade off


11/23

Risk return trade off

•

ystematic risk – 'aused by factors t$at affect t$e overall market/all

securities

–

5on diversifiable/unavoidable• 1nsystematic risk

– 1ni"ue to (articular com(any/industry/security

– 3iversifiable/ avoidable

• '!P6

–

Provides a frame&ork for basic risk return trade


12/23

'a(ital !sset Pricing model• 6odel t$at describes t$e relations$i(/tradeoff

bet&een risk and ex(ected/re"uired rate of return

• Ex(lains t$e be$aviour of security (rices and

(rovides a mec$anism to assess t$e im(act of

(ro(osed security investment on investors9 overall(ortfolio risk and return

• Provides a frame&ork for basic risk return trade off in

(ortfolio management

• Enables dra&ing certain im(lications about t$e risk

and si:e of risk (remium necessary to com(ensate

for bearing risk


13/23

!ssum(tions• Efficiency of market

–

nvestors &ell informed

– Transaction costs are lo&

– 5egligible restrictions on investments

–

5o investor is large enoug$ to influence – nvestors in general agreement about likely (erformance

– Ex(ectations are based on one year $olding (eriod

•

nvestor (references – Prefer to invest in securities &it$ t$e $ig$est return for a given

level of risk or lo&est risk for a given level of return

– Return a risk measured in terms of ex(ected value and standard

deviation res(ectively


14/23

6easure of risk• 7eta coefficient is an index of t$e degree of

res(onsiveness/comovement of security return &it$market return

• Risk free return

• Ex(ected return less risk free return ; excess return

• 7eta coefficient re(resents t$e c$ange in excess

return on t$e individual security over c$anges in

excess return on market (ortfolio• 7eta of market (ortfolio is e"ual to <

• ndex of systematic risk of individual security relative

to t$at of market (ortfolio


15/23

7eta of a security and '!P6

formula

T$e '!P6 formula is= ra ; rrf > 7a )rm.rrf*Required Return = Risk free rate + (Market return – Risk free rate) *

Beta

Portfoio Beta = (the sum of) !"ei#ht of security $ Beta of security%


16/23

Valuation of long term securities


17/23

Valuation of bonds/debentures

• 7ond 2 long term debt instrument used by

government, government agencies and

business enter(rises to raise a large sum of

money

• Par value 2 value on t$e face of t$e bond

•

'ou(on rate 2 s(ecified interest rate availableon security

• 6aturity (eriod 2 number of years after &$ic$

t$e (ar/s(ecified value is (ayable to t$e


18/23

llustration

• ! firm $as issued a


19/23

7asic bond valuation

•

Present value of contractual (ayments its issuer )cor(orate* isobliged to make from t$e beginning till maturity

• !((ro(riate discount rate &ould be t$e re"uired return

commensurate risk and (revailing interest rate

• #$en t$e re"uired return is e"ual to t$e cou(on rate, t$e

bond value e"uals t$e (ar value


20/23

m(act of re"uired return on bond

values• '$ange in t$e basic cost of long term funds• '$ange in t$e basic risk of t$e firm

•

f RRC'R t$en bond value D (ar value= 3iscount )6.7*

• f RRD'R t$en bond value C (ar value= Premium)7.6*


21/23

m(act of maturity on bond value• Time to maturity

• RR

• 7ond value

–

'onstant RR – '$anging RR

• 'onstant re"uired returns

•

'$anging re"uired returns

• T$e s$orter t$e time to maturity, t$e smaller t$e

im(act on bond value caused by a given c$ange in

t$e re"uired return


22/23

ield to maturity

• Rate of return investors earn if t$ey buy a

bond at a s(ecific (rice and $old it till maturity

•

llustration


23/23

Valuation of (reference s$ares

• Ex(ected return is t$e return t$at is ex(ected

to be earned on a given security over an

infinite time $ori:on

• ero gro&t$ model

• 'onstant gro&t$/Gordon model

•

Variable gro&t$ model

tvm, valuation, risk and return

Documents