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Valuation Principles

# Valuation Principles

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04/18/2015

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PRINCIPLES OF VALUATION Because rational people prefer to receive benefits sooner than later and make sacrifices later thansooner, money, which provides the option to buy benefits, is likewise preferred sooner to later.If an individual prefers money sooner than later, then he/she values a dollar today more than adollar tomorrow or a dollar in one year from now. A dollar today is worth a dollar today:therefore, a dollar next year must be worth less than a dollar today since it is less preferable/valuable. In other words, the same amount of money will be more or less valuable depending upon when itis received. What would you prefer, \$100 today or \$100 in

one year from today? Most people prefer \$100 today since

it gives them the option to spend it today or save it and spend it in oneyear. Receiving \$100 in one year doesn't allow for \$100 in consumption today.For equal amounts of money, the decision when to take money --today or in the future-- is aneasy one: sooner is always better than later. But what about situations where the amounts differ?What decision rule should be used in those situations?For example, what is preferable? \$100 today or \$133.1 in three years? Simply picking the largestnumber may not provide the best value. (Another way of viewing this situation is to ask: wouldyou pay \$100 today to receive \$133.1 in three years?) The answer depends upon what could beearned with the \$100 in alternative investments. Suppose that it's possible to earn 5% on the\$100. Then after three years it would accrue to \$115.76. In that case, it would be better to waitand take the \$133.1. If 15% could be earned, the \$100 today would grow to \$152.08 and the\$100 today would be more attractive.
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In this example, we compared future values of the alternatives (at the same point in time).Alternatively, we could have looked at present values by asking "what are you willing to paytoday for a promise of \$133.31 in three years?"As you might infer, when choosing an investment among various alternatives it's necessary tovalue each option at the same point in time (at present or in the future). That means to determinewhich investment to select, compare future values in year three with futures value in year threeor compare the present values, but don't compare the present value of a cash flow with the futurevalue of another cash flow.A simple example illustrates this point: If John is 24 today and Mary will be 28 in five years,who is older?" Obviously, comparing the 24 with the 28 will lead to the erroneous conclusionthat Mary is older. This is illogical since these ages occur in different time periods. To correctlysee that John is one year older than Mary, it is necessary to add five years to his current age or subtract five from her future age. Whatever is method is chosen, looking at either both their future ages or both their present ages will lead to the correct answer.The previous financial example introduced three concepts, related to the time value of money: 1)future value (\$133.1) - the amount of cash to be delivered at a subsequent date; 2) present value(\$100) - the amount of cash available to invest today or the price, today, of future cash flows(\$114.98 or \$87.75), and 3) opportunity cost (5% or 15%) - the rate of return forsaken, with theselection of a particular investment. The opportunity cost is the rate of return that could have been earned on similar investments elsewhere.
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This guide covers each of these topics in depth; however, to develop an intuitive understandingremember:1.Receiving cash sooner is better than later.2.Receiving more is better than less.3.The higher the opportunity cost --the more that is forsaken-- the lower the relativevalue of a particular future cash flow.Time value of money calculations provide the algorithms to find today's price of future cashflows. By the end of this guide, you will be able to price financial instruments such as leases and bonds and understand the basics of stock valuation. This knowledge is necessary to develop asound understanding of capital markets phenomena and corporation finance issues.
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