FINA2303 Topic 02 Time Value of Money and Valuation

Topic 2: Time Value of Money and
Valuation
Learning Outcomes
cost-benefit
analysis
valuation principle
time value of money
future value and compounding
present value and discounting
cash flow streams
annuities and perpetuities
compounding frequency
interest rate quotes
Topic 2 Time Value of Money and Valuation
M K Lai
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Learning Outcomes
application:
discount rates and loans

determinants of interest rates
opportunity cost of capital
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Cost-Benefit Analysis
a
financial manager needs to identify the costs

and benefits of a financial decision in terms of
cash flows
costs as cash outflows
benefits as cash inflows
he needs the help of the other departments (such
as marketing, production, etc.) to quantify the
costs and benefits
cost-benefit analysis helps him make the best
financial decision among a number of
alternatives
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Cost-Benefit Analysis
when
benefits exceed costs, it adds value to a

company and hence increases its shareholders
wealth
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Role of Competitive Market Price

a
competitive market is a market in which a good

can be bought and sold at the same market
price
in
a competitive market, the market price

determines the value of a good (value in
exchange) which has nothing to do with the
personal preferences of a consumer (value in use)
or his assessment of its fair value
what do you do if the market price of an item
is $10 and its assessed fair value is $12?
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Role of Competitive Market Price
fair value of stock

stock price
source: ABCI Securities

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Role of Market Price

in
finance, we are more concerned with market

value of an item than its book value in the
financial statements
e.g. a concert ticket with a face value of $100
can be sold at $250 in the market
the book value is $100
the market value is $250
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Valuation Principle
The
value of a commodity or an asset to the firm

or its investors is determined by the competitive
market price. The benefits and costs of a decision
should be evaluated using those market prices.
When the value of the benefits exceeds the value
of the costs, the decision will increase the market
value of the firm.
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Example: Valuation Principle

You
are the operations manager of a firm. Due to

a pre-existing contract, you have the discretion to
decide whether to acquire 200 barrels of oil for
$16,000. The current market price of oil is $90
per barrel. You believe that the value of oil would
plummet to $70 over the next month. Should you
or should you not buy the oil at the contract price
of $16,000?
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Example: Valuation Principle

market
value of 200 barrels of oil (benefit) =
$18,000
cost
$16,000
buy 200 barrels
decision:
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Law of One Price and Arbitrage

law
of one price (no-arbitrage condition): in

competitive markets, securities with the same
cash flows (and risk) should have the same price
arbitrage: the practice of simultaneous buying
and selling equivalent goods in two markets to
take advantage of a price discrepancy (buy low,
sell high) may take time
arbitrage opportunity: any situation in which it is
possible to make a profit without taking any risk
or making any investment
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Given
that there are no transaction costs, an item

is sold at $1,000 in one market and $1,200 in
another market, what do you do?
1.
buy it at $1,000
2.
resell it at $1,200
3.
make a profit of $200
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does not hold

if
a lot of people rush to buy in the undervalued

market, the market price will rise
if
a lot of people rush to sell in the overvalued

market, the market price will fall
sooner
or later, the market prices will converge to

the same level and the law of one price holds
again
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source: The Economist

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Time Value of Money

cash flows appear to have different values to us if

they occur in different time periods
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Time Value of Money

which
of the following options do you choose?
receive $10,000 right away

will receive $10,000 in a years time
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Why Time Value of Money?

a
dollar received today is worth more than a

dollar received later
better to receive money earlier and pay later
why?
1. inflation
2. deferred consumption
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Effect of Inflation
inflation
refers to a rise in general price level

it leads to a decline in the purchasing power of
money, i.e. the same amount of cash flows under
inflation cannot buy the same quantity of goods
as the case without inflation
for example, you have $1,000
if the price of an item is $100 each, you can
buy 10 units
if the price of an item increases to $200
each due to inflation, you can buy only 5
units
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Effect of Inflation
inflation
rate: the change in the average price

level of a basket of goods over a period, usually
measured through the consumer price index (CPI)
consumer
price index (CPI) is a measure of the

average price of a basket of consumer goods and
services purchased by households
inflation
rate at time t = (CPI at time t CPI at

time t-1)/CPI at time t-1
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Example: Inflation Rate
source: Census and

Statistics Department
inflation rate = (120.2115.1)/115.1 = 4.43%

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Nominal and Real Interest Rates

nominal
interest rate: interest rate observed in

the financial market that indicates the rate which
money will grow if invested for a certain period of
time
real
interest rate: the rate of growth of purchasing

power, after adjusting for inflation
from
perspective of an investor, which is more

important?
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Nominal and Real Interest Rates

Fisher
equation
(1 + nominal rate) = (1 + real rate)*(1 +
inflation rate)
nominal rate real rate + inflation rate
Irving
Fisher
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Example: Nominal and Real Interest

Rates
If
the nominal interest rate on a financial

instrument is 5% and the expected inflation rate
is 3%, what is the real interest rate?
real
interest rate = (1+5%)/(1+3%) 1 = 1.94%
real
interest rate 5% - 3% = 2%
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Inflation
inflation rate
= 10%
source: hongkong.coach.com
now
in a years time
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Deferred Consumption
given
that inflation rate = 0%

if we receive cash flows now, we can consume
right away (current consumption)
if we will receive cash flows in a years time,
we can only consume in the future (future
consumption)
other
things being equal, people prefer to

consume now to later (time preference)
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that
is why we demand for a rate of return or an

interest rate on an investment because we have
to postpone the current consumption to a later
period
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inflation rate
= 0%
for a whole
year!
receive $4,400
now
will receive $4,400 in a

years time
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How to Compare Cash Flows in Different

Time Periods?
which
of the following options do you choose?
receive $10,000 right away

will receive $10,300 in a years time
what
additional information is required to make a

direct comparison?
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Time Periods?
the
trick is to convert all cash flows into a

common benchmark through interest
rate/discount rate
present
value: the value of a cash flow

computed in terms of cash today
future
value at a specified future date N: the

value of a cash flow that is moved forward in
time to date N
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Time Periods?
interest
rate or discount rate is the rate at which

money can be borrowed or lent over a given
period
the process of converting a future value into a
present value is known as discounting
the process of converting a present value into a
future value is known as compounding
discounting
present
value
compounding
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future
value
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Time Periods?
rule
1: it is only possible to compare or combine

values at the same point in time
rule
2: compound a cash flow to calculate its

future value
rule
3: discount a cash flow to calculate its

present value
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Timeline of Cash Flows

end of beginning
period 2 of period 3
now
period
N-2
N-1
$5
$5
$105
cash
-$100
flow
$5
cash
outflow
$5
cash
inflows
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Present Value and Future Value

FVN
FVN = PV * (1 + r ) or PV =
(1 + r )N
N
where
PV = present value; FVN = future value at

time N; r = interest rate or discount rate and N =
number of years
(1+r)N is called the interest rate factor for N years
1/(1+r)N is called the discount factor for N years
mathematically, as long as we know three out of
these four variables (PV, r, N and FVN), we can
determine the fourth one
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Future Value in a Single Period

suppose
that the annual interest rate is 2%

receive $10,000 now = will receive
$10,000*(1+2%) = $10,200 in a years
time = future value in a years time
will receive $10,300 in a years time =
future value in a years time
decision: choose over
1
year
0
cash flow $10,000
$10,200
cash flow
$10,300
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Present Value in a Single Period

suppose
that the annual interest rate is 2%

receive $10,000 now = present value
will receive $10,300 in a years time =
receive $10,300/(1+2%) = $10,098.04 now
= present value
decision: choose over
1
year
0
cash flow $10,000
$10,300
cash flow $10,098

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Simple Interest Rate

simple
interest rate: earn interest on original

principal, e.g. principal = $10,000, simple
interest rate = 3%
interest
in year 1 = $10,000*3% = $300

principal + total interest = $10,000*(1+3%) =
$10,300
interest in year 2 = $10,000*3% = $300
principal + total interest in year 2 =
$10,000*(1+3%*2) = $10,600
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Simple Interest Rate

interest
in year 3 = $10,000*3% = $300

principal + total interest in year 3 =
$10,000*(1+3%*3) = $10,900
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Compound Interest Rate

compound
interest rate: earn interest on the

original principal and interest on interest, e.g.
principal = $10,000, compound interest rate =
3%
interest in year 1 = $10,000*3% = $300
principal + total interest over 1 year =
$10,000*(1+3%) = $10,300
interest in year 2 = $10,000*3% + $300*3%
= $309 ($300*3% = $9 is the interest on
interest effect)
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principal
+ total interest over two years =

$10,000*(1+3%)2 = $10,609
interest in year 3 = $10,000*3% + $300*3%
+ $309*3% = $318.27 ($300*3% + $309*3%
= $18.27 is the interest on interest effect)
principal + total interest over three years =
$10,000*(1+3%)3 = $10,927.27
the interest on interest effect is also called the
compounding effect
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rule
of 72: the years to double your money is

approximately equal to 72 divided by the interest
rate in percent
example:
if the interest rate is 6%, the years to

double = 72/6 = 12 years
$1*(1+6%)12 = $2.01
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Example: The Power of Compounding

Effect
accumulated wealth ($)
$120,000
$100,000
$80,000
$60,000
initial investment =
$10,000; annual
interest rate = 5%;
annual compounding
$114,674
$70,400
$43,219
$40,000
$26,533
$20,000 $16,289
$0
0
10
20
30
40
investment horizon (years)
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50
Page 42
Present Value and Future Value in More

Than One Year
for
long term investment, the investment horizon

is usually longer than 1 year and we still use the
same basic formula where N > 1
FVN
FVN = PV * (1 + r ) or PV =
N
(1 + r )
N
where

time N; i = interest rate and N = number of years
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Example: Present Value

You
want to accumulate a wealth of $500,000 in

10 years time so that you can afford to make the
down payment for a mortgage. If the interest
rate is 5% and it is compounded on an annual
basis, how much do you need to put aside now?
$500,000
PV =
= $306,956.63
10
(1 + 5%)
year
10
$500,000
$306,957
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Example: Future Value

You
put $100,000 in a time deposit account for

three years with an interest rate of 3% per
annum. If it is compounded on an annual basis,
what will be the principal plus interest in three
years time?
3
FV3 = $100,000 * (1 + 3%) = $109,272.70

year
$109,273
$100,000
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Determining the Interest Rate

if
we know about the present value, the future

value and the investment horizon, we can
determine the interest rate or the rate of return
on the investment
example:
If the present value and future value in

year 3 are $100,000 and $135,000 respectively,
what is the interest rate?
$135 ,000 = $100 ,000 * (1 + r ) 3

r = 10 .52 %
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Determining the Investment Horizon

if
we know about the present value, the future

value and the interest rate, we can determine the
investment horizon
example:
You have a lump sum of $50,000. The

interest rate is 6% and it is compounded on an
annual basis. Your financial objective is to save
$200,000 for your wedding. How many years
does it take for your wedding to take place?
N
$200,000 = $50,000 * (1 + 6%)
N = 23.79 years
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Multiple Cash Flows Over Time:

Additivity Principle
cash
flows in the same time period t can be

added up or subtracted one from the other and
this is known as the additivity principle
the
present value of the cash flow stream is

the sum of the present values of the individual
cash flows over time
N
Ct
PV =
t
t =1 (1 + r )
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Multiple Cash Flows Over Time:

Additivity Principle
the
future value of the cash flow stream at

time N is the sum of the future values of the
individual cash flows over time at time t
N
FVN = C t * (1 + r )
N t
t =1
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The
winner of Americas Got Talent will get

$1,000,000 in 40 annual installments, i.e.
$25,000 annually in each of the coming 40 years.
If the annual interest rate is 6%, what is the
present value of this cash flow stream?
40
$25,000
PV =
= $376,157.42
t
t =1 (1 + 6%)
year
38
40
39
$25,000
$25,000 $25,000 $25,000 $25,000
$376,157
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source: www.realityblurred.com
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Example: Future Value

You
have just bought a financial instrument

which expects to generate $1,000, $1,000 and
$11,000 in years 1, 2 and 3 respectively, e.g. a 3year bond. If the interest rate is 4% and it is
compounded on an annual basis, what is the
future value of this cash flow stream in year 3?
FV3 = $1,000 * (1 + 4%) 2 + $1,000 * (1 + 4%) + $11 ,000
= $13,121.6
year
$1,000
$1,000
$11,000
$13,122
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Special Cash Flow Patterns

annuity:
a level stream of cash flows starting in

year 1 for a fixed period of time
perpetuity:
an annuity in which the cash flows

continue indefinitely
non-growing
perpetuity: a constant stream of

cash flows that lasts forever
growing
perpetuity: a growing stream of cash

flows at a constant rate that lasts forever
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Annuity
5-year
annuity with a constant cash flow of $100
year
$100
$100
$100
$100
$100
1
1
PV = C * * 1
r
(1 + r )N
1
FVN = C * * [(1 + r )N 1]
r
where FVN = future value at N; PV = present value;
r = interest rate; N = number of years; C =
constant cash flow in each year
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Retirement Annuity Plan
source: HSBC
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Example: Present Value and Future

Value of Annuity
Suppose
that you are saving $100 at 5% in each

of the coming 5 years as an annuity. What is the
present value of the annuity? What is the future
value of the annuity in year 5?
1
1
PV = $100 *
* 1
= $432.95
5
5%
(1 + 5%)
1
5
FV5 = $100 *
* [(1 + 5%) 1] = $552.56
5%
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Example: Annuity Amount

If
you borrow a loan of $100,000 at an annual

interest rate of 12% and have to repay it in five
equal annual payments, what is the annuity
amount of your payment? This is called an
amortized loan.
1
1
$100,000 = C *
* 1
5
12%
(1 + 12%)
C = $27,740.97
C
in an annuity is usually denoted by PMT in a

financial calculator or spreadsheet
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Page 57
Example: The Number of Payments

You
have a credit balance of $10,000 on your

credit card. You can only afford to pay the
minimum payment of $200 per month. The
interest rate on the credit card is 1.5% per month.
How long will you need to pay off the credit?
1
1
$10,000 = $200 *
* 1
1.5%
(1 + 1.5%)N
N = 93.11 months or 7.76 years
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Page 58
Example: The Interest Rate

An
insurance company offers to pay you $10,000

per year for 10 years if you will pay $70,000
upfront. What rate is implicit in this 10-year
annuity policy?
1
1
$70,000 = $10,000 * * 1
10
r
(1 + r )
r = 7.07%
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Page 59
Growing Annuity
5-year
annuity with a first year cash flow of $100

growing at 3%
year
1
$100
$103 $106.69 $109.27 $112.55
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Growing Annuity
N
1
1+g
PV = C1 *
* 1

r-g
1 +r
1
FVN = C1 *
* [(1 + r )N (1 + g )N ]
r-g
where
FVN = future value at N; PV = present value;

r = interest rate; N = number of years; C1 = cash
flow in year 1
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Page 61
Example: Present Value and Future

Value of Growing Annuity
Suppose
that you will start to save money in each

of the coming 5 years at an interest rate of 5%.
In the first year, the saving is $100 which is
expected to grow at 3% in each year. What is the
present value of the growing annuity? What is the
future value of the growing annuity in year 5?
1 + 3%
1
PV = $100 *
* 1
= $458.39
5% - 3% 1 + 5%
1
FV5 = $100 *
* [(1 + 5%) 5 (1 + 3*) 5 ] = $585.04
5% - 3%
5
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Page 62
Perpetuity
non-growing
perpetuity with a constant cash flow
of $100
year
$100
$100
$100
$100
growing
perpetuity with a first year cash flow of

$100 at a growth rate of 3% (discount rate >
growth rate)
0
1
2
3
4
year
$100
$103 $106.69 $109.27

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Page 63
Perpetuity
C1
non - growing perpetuity : PV =
r
C1
growing perpetuity : PV =
r-g
where
PV = present value; C1 = cash flow in year

1; r = interest rate; g = constant growth rate
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Page 64
Perpetual Bond
source: Cbonds
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Example: Non-Growing Perpetuity

Suppose
that you are receiving $100 each year

indefinitely. What is the present value of this
cash flow stream if the interest rate is 5%?
PV
= $100/5% = $2,000
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Page 66
Example: Growing Perpetuity

Suppose
that you are receiving $100 next year

which will grow at an annual rate of 3%
indefinitely. What is the present value of this
cash flow stream if the interest rate is 5%?
PV
= $100/(5%-3%) = $5,000
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Interest Rates in Financial Market

different
terminologies, e.g. interest rate,

discount rate, yield, cost of capital, required rate
of return, etc.
cost of using funds to a company
rate of return to an investor
cost of capital
interest income
of investing funds
usually
annualized in percentage with a

tenor/(term to) maturity
interest rate will be affected by the term to maturity
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Page 68

there
are many interest rates in the financial

markets, e.g. saving rate, 3-month time deposit
rate, prime rate, Hong Kong Interbank Offered
Rate (HIBOR), base rate, etc.
total return: interim income:
interest
rate reflects time value of money and

risk of an investment
interest rate
with risk
interest rate usually
over time
increase
increases
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Page 69

change
continuously depending on demand and

supply of funds in financial markets
increase
demand
for funds increases, interest rate
decrease
supply
of funds increases, interest rate
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Page 70
Demand And Supply Analysis of Interest

Rate
consider
the good as availability of funds, F and

the price as (market) interest rate, r
r
r*
D
F*
F
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Page 71

Rate
discuss
the effect of the following factors on the

interest rate and the availability of funds in the
financial market
the
central bank injects funds into the financial

market
business
organizations want to borrow more

loans as they expect better economic outlook
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Page 72

Rate
i
S0
S1
i1
i0
i1
D
F0 F1
D1
i0
D0
F0 F1
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Page 73
Annual Percentage Rate (APR)

in
the US
compound monthly basis --> 12 months
APR:
the amount of interest earned in one year

without the compounding effect (simple
interest earned)
also
called flat or quoted interest rate
monthly
quoted rate = 1%; APR = 1%*12 =
12%
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Page 74

in
Hong Kong
close to the actual interest rate you are paying
APR:
the amount of interest earned in a year,

which is calculated based on Code of Banking
Practice (consider compounding effect)
similar
to effective annual rate to make

present value of all relevant cash flows equal
to zero
(including bank fees and
charges)
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Page 75
APR in US = 0.31%*12 = 3.72%

APR in HK
source: DBS
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Page 76
Compounding Frequency
the
compounding frequency will affect the cash

flows generated
rules
for non-annual cash flows
the
(divide US APR/12-->monthly interest rate)
interest rate is specified as a periodic rate,

e.g. monthly interest rate if it is compounded
on a monthly basis
the investment horizon is expressed in terms
of the number of periods, e.g. 36 months if it is
compounded on a monthly basis for 3 years
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Page 77
Compounding Frequency
APR
FVN = PV * 1 +
FVN
PV =
mN
(1 + APR / m)
mN
where

time N; APR = annual percentage rate (in US); m
= number of periods in a year and N = number of
years
half year-->2
quarterly-->4
monthly-->12
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Page 78
Effective Annual Rate (EAR)

(1+APR/m)m
- 1 is known as the effective annual

rate (EAR) or annual percentage yield (APY)

show
the actual interest rate you are paying in

a year where APR/m is the periodic quoted
rate, e.g. on a month basis, m = 12 and the
monthly quoted rate = APR/12
in hk--> bank fees and charges are considered in EAR but not
APR
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Page 79
Example: Compounding Frequency

suppose
that the principal is $10,000, the quoted

annual interest rate is 6% and the investment
horizon is 1 year
annual compounding
600-->interest
FV1 = $10,000*(1+6%) = $10,600
annual flat rate = 6%
in US, EAR and APR are
the same if compund in
EAR = (1+6%) 1 = 6%
annual basis
semi-annual compounding
FV1 = $10,000*(1+6%/2)2*1 = $10,609
semi-annual flat rate = 6%/2 = 3% 9-->interest on interest
effect
2
EAR = (1+6%/2) 1 = 6.09%
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Page 80

quarterly
compounding
FV1 = $10,000*(1+6%/4)4*1 = $10,613.64
quarterly flat rate = 6%/4 = 1.25%
EAR = (1+6%/4)4 1 = 6.14%
monthly compounding
FV1 = $10,000*(1+6%/12)12*1 = $10,616.78
monthly flat rate = 6%/12 = 0.5%
EAR = (1+6%/12)12 - 1 = 6.17%
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Page 81

borrow loan****
daily
compounding
FV1 = $10,000*(1+6%/365)365*1 =
$10,618.31
daily flat rate = 6%/365 = 0.02%
EAR = (1+6%/365)365 1 = 6.18%
continuous
compounding
FV1 = $10,000*e6%*1 = $10,618.36
EAR = e6%*1 - 1 = 6.18% (highest)
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Page 82
Equivalent n-Period Discount Rate

n=3
n-period discount rate = (1+r)n 1

where n can be larger than 1 or less than 1 and r
= effective annual rate
equivalent
e.g. investment horizon: 3years,, total interest rate you earn?
when
computing present value or future value,

we should adjust the discount rate to match
the time period of the cash flows
M K Lai
Page 83
Example: Equivalent n-Period Discount

Rate
the
effective annual rate = 5%
equivalent
2-year discount rate = (1+5%)2 1 =
10.25%
compounding effect
equivalent
semi-annual discount rate =

(1+5%)0.5 1 = 2.47%
M K Lai
Page 84
Application: Amortizing Loan

(popular in HK) tax loan
a
bank loan is a major source of finance to a

company and whenever a bank grants a loan to a
borrower, some provision will be made for the
payment of interest and repayment of the
principal
the borrower has to pay regular interest
calculated based on the beginning balance of the
loan and repay parts of the principal amount over
time, usually quoted in APR e.g. tax loan,
mortgage loan, and it is called an amortized loan
decline
interest payments
over time (why?)
increase
principal repayments
over time (why?)
M K Lai
Page 85
Application: Amortizing Loan

the
cash flow stream is an annuity of even cash

payment of C in each period lasting for N periods
0
loan
balance
-C
-C
-C
year
N-1
-C
-C
usually,
the credit officer of a bank prepares a

loan amortization schedule to show a client the
repayment schedule
M K Lai
Page 86
Tax Loan
source: DBS
M K Lai
Page 87
Example: Loan Amortization Schedule

Consider
an amortized $50,000, two-year loan at

an interest rate of 12%. Suppose that interest
payments are made on a monthly basis.
the
first step is to determine the 24-month

annuity (monthly interest rate = 12%/12 = 1%)
1
1
$50,000 = C *
* 1
24
1%
(1 + 1%)
C = $2,353.67
every month
M K Lai
Page 88

the
second step is to prepare the loan

amortization schedule i=1%
month
beginning
loan balance
monthly
payment
1
2
3
4
5
6
7
8
9
10
11
12
$50,000.00
$48,146.33
$46,274.12
$44,383.18
$42,473.34
$40,544.40
$38,596.17
$36,628.46
$34,641.07
$32,633.81
$30,606.47
$28,558.86
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
interest payment =
beginning loan balance *
monthly interest rate
$500.00
$481.46
$462.74
$443.83
$424.73
$405.44
$385.96
$366.28
$346.41
$326.34
$306.06
$285.59
decreasing over time
principal repayment =
monthly payment interest payment
$1,853.67
$1,872.21
$1,890.93
$1,909.84
$1,928.94
$1,948.23
$1,967.71
$1,987.39
$2,007.26
$2,027.34
$2,047.61
$2,068.08
ending loan balance =

beginning loan balance principal repayment
$48,146.33
$46,274.12
$44,383.18
$42,473.34
$40,544.40
$38,596.17
$36,628.46
$34,641.07
$32,633.81
$30,606.47
$28,558.86
$26,490.78
increasing over time

M K Lai
Page 89

month
beginning
loan balance
monthly
payment
13
14
15
16
17
18
19
20
21
22
23
24
$26,490.78
$24,402.01
$22,292.36
$20,161.61
$18,009.55
$15,835.97
$13,640.66
$11,423.39
$9,183.95
$6,922.12
$4,637.67
$2,330.37
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
interest payment =
beginning loan balance *
monthly interest rate
$264.91
$244.02
$222.92
$201.62
$180.10
$158.36
$136.41
$114.23
$91.84
$69.22
$46.38
$23.30
decreasing over time
principal repayment =
monthly payment interest payment
$2,088.77
$2,109.65
$2,130.75
$2,152.06
$2,173.58
$2,195.31
$2,217.27
$2,239.44
$2,261.83
$2,284.45
$2,307.30
$2,330.37
ending loan balance =

beginning loan balance principal repayment
$24,402.01
$22,292.36
$20,161.61
$18,009.55
$15,835.97
$13,640.66
$11,423.39
$9,183.95
$6,922.12
$4,637.67
$2,330.37
$0.00
increasing over time
M K Lai
Page 90

ending loan balance
$50,000
$45,000
$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
$0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
months
M K Lai
Page 91

interest payment
$2,500
principal repayment
$2,000
$1,500
$1,000
$500
$0
1
2 3 4
5 6 7
8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
months
M K Lai
Page 92
Opportunity Cost of Capital

(opportunity)
cost of capital: the best available

expected return offered in the market on an
investment of comparable risk and term to the
cash flow being discounted
it can also refer to the return an investor
foregoes on an alternative investment of
equivalent risk and term when the investor
takes on a new investment
it is the relevant interest rate used for an
investment under consideration
M K Lai
Page 93
Example: Opportunity Cost of Capital

Suppose
that you are considering making an

investment of $100 in a financial instrument
which generates a return of $110 in a years time.
An alternative investment available in the market
offers a rate of return of 12% with the same risk
level. What do you do?
M K Lai
Page 94

rate
of return on financial instrument = ($110$100)/$100 = 10%

10%
< the expected return of 12% on the

alternative investment (opportunity cost of
capital)
better
not to invest in the financial instrument

and invest in the alternative investment
M K Lai
Page 95

alternatively,
use the opportunity cost of capital

as discount rate and present value of financial
instrument = $110/(1+12%) = $98.21
no
good to invest $100 in a financial

instrument with a present value of $98.21
better
not to invest in the financial instrument,

but to invest in the alternative investment
M K Lai
Page 96
Notice
so
far, we assume that the interest rate or

discount rate is constant over time
in
reality, it can vary with the investment horizon;

usually it increases with the investment horizon
M K Lai
Page 97
Challenging Questions
1. In financial principle, how important are our
personal preferences in valuing an investment
decision?
2. Given that the exchange rate is CNY 10 for HKD
11.50. If the stock of Company XYZ sells at CNY
10 in the A share market in Mainland China and
sells at HKD 11.86 in Hong Kong. What do you
do to take advantage of the arbitrage
opportunity?
sell
for HKD11.86,
buy CNY10
HKD11.5
0.36
M K Lai
Page 98
4. Give two reasons why arbitrage may not work in
real life.
A. govt restriction, the Exchange
B. transaction cost
5. The value of a dollar today relative to the value
of a dollar in a years time tends to increase if
people put a heavier weight on current
consumption relative to future consumption and
the inflation rate is positive
.
6. If the observed interest rate of a security is 5%
and the expected inflation rate is 3%, what is
the nominal interest rate of the security? Explain.
M K Lai
Page 99
increase
6. Nominal interest rate tends to

with the
expected inflation rate. Who will benefit from a
higher inflation rate, the borrower or lender of a
loan?
7. When the interest rate rises, the interest rate
factor is
, the discount factor is
and the
present value is
.
higher
lower
lower
M K Lai
Page 100
8. If a depositor puts $10,000 in a three-year time
deposit account and the annual compound
interest rate is 3%, what are the conditions
under which the depositor can really earn the
3% annual compound interest rate?
A. keep all cash flows in the bank account
B. until the end of your investment horizon
9. The present value of a future cash flow is higher
if the interest rate is
and the investment
horizon is shorter .
lower
M K Lai
Page 101
True, because of compounding effectsgrowth on growth.
10.If a companys earnings per share grew from $1

to $2 over a 10-year period, the total growth
would be 100%, but the annual growth rate
would be less than 10%. True or false? Explain.
11.Other things being equal, a borrower would like
to pay a lower interest rate on a loan while an
lender would like to receive a higher interest rate
from an investment. A borrower wants the
compounding frequency to be smallerand a lender
wants the compounding frequency to be larger.
M K Lai
Page 102
12.Which of the following financial instrument
should offer the highest interest rate?
A. the maturity is 10 years and the risk is low
B. the maturity is 5 years and the risk is low
C. the maturity is 10 years and the risk is
high
D. the maturity is 5 years and the risk is high
13.Other things being equal, which is higher, APR
or EAR? Explain why. Which is more relevant for
compounding effect
financial decisions?
M K Lai
Page 103
14.In view of a recessionary economy, a central
bank may use an expansionary monetary policy
increase
to stimulate it. It usually
the money supply
so as to lower the general interest rate level. In
such an interest rate environment, consumption
and investment tend to increase.
M K Lai
Page 104
15.An investment is expected to generate a rate of
return of 16%. There are three alternative
investments with the same risk and the subject
investment with an expected rate of return of
14%, 12% and 10% respectively in the market.
What is the opportunity cost of capital of the
subject investment?
14%--> highest valued option forgone
M K Lai
Page 105

FINA2303 Topic 02 Time Value of Money and Valuation

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FINA2303 Topic 02 Time Value of Money and Valuation

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Topic 2: Time Value of Money and

discount rates and loans

Topic 2 Time Value of Money and Valuation

financial manager needs to identify the costs

benefits exceed costs, it adds value to a

Topic 2 Time Value of Money and Valuation

Role of Competitive Market Price

competitive market is a market in which a good

a competitive market, the market price

Topic 2 Time Value of Money and Valuation

Role of Competitive Market Price

fair value of stock

source: ABCI Securities

Role of Market Price

finance, we are more concerned with market

Topic 2 Time Value of Money and Valuation

value of a commodity or an asset to the firm

Topic 2 Time Value of Money and Valuation

Example: Valuation Principle

are the operations manager of a firm. Due to

Topic 2 Time Value of Money and Valuation

Example: Valuation Principle

value of 200 barrels of oil (benefit) =

buy 200 barrels

Topic 2 Time Value of Money and Valuation

Law of One Price and Arbitrage

of one price (no-arbitrage condition): in

Law of One Price and Arbitrage

that there are no transaction costs, an item

make a profit of $200

Topic 2 Time Value of Money and Valuation

does not hold

Law of One Price and Arbitrage

a lot of people rush to buy in the undervalued

a lot of people rush to sell in the overvalued

or later, the market prices will converge to

Topic 2 Time Value of Money and Valuation

Law of One Price and Arbitrage

source: The Economist

Time Value of Money

cash flows appear to have different values to us if

Topic 2 Time Value of Money and Valuation

Time Value of Money

of the following options do you choose?

receive $10,000 right away

will receive $10,000 in a years time

Topic 2 Time Value of Money and Valuation

Why Time Value of Money?

dollar received today is worth more than a

Topic 2 Time Value of Money and Valuation

refers to a rise in general price level

rate: the change in the average price

price index (CPI) is a measure of the

rate at time t = (CPI at time t CPI at

Topic 2 Time Value of Money and Valuation

Example: Inflation Rate

source: Census and

inflation rate = (120.2115.1)/115.1 = 4.43%

Nominal and Real Interest Rates

interest rate: interest rate observed in

interest rate: the rate of growth of purchasing

perspective of an investor, which is more

Topic 2 Time Value of Money and Valuation

Nominal and Real Interest Rates

cash flow $10,098