BFW1001 Foundations of Finance

Lecture 1
Valuation Fundamentals
Prof. Keshab Shrestha
keshab.shrestha@monash.edu

March 11, 2020 (Wednesday)

Contents
1 Financial Markets 2
1.1 Primary and Secondary Markets . . . . . . . . . . . . . . . . . . . . . 2
1.2 Money and Capital Markets . . . . . . . . . . . . . . . . . . . . . . . 3

2 Interest Rate 3
2.1 Borrowing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.1.1 Important Comments . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 Investing or Lending . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

3 Valuation Principle 7
3.1 Valuation of a Single Payment . . . . . . . . . . . . . . . . . . . . . . 7
3.2 Valuation of Multiple Payments . . . . . . . . . . . . . . . . . . . . . 10
3.3 Cash Flows Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . 11

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 BFW1001 Foundations of Finance Lec. 1

Important Notes
1. Visit Moodle often - I will post important announcements and course materials
on Moodle.

2. Calculator:

– You can use any calculator approved by Course Management Office.

– You need to show the formula and values of the variables used in obtaining
the answer. Simply reporting the answer using financial functions in the
financial calculator is NOT acceptable.

3. Please attend all the lectures.

Assumption 1: Through out this Lecture, we assume that there are no uncertain-
ties.

1. Financial Markets
Financial markets are markets where financial securities like bonds, common stocks,
preferred stocks, foreign currencies and derivative securities etc. trade. Financial
markets can be a physical place or computer network where the actual computers
or electronic devices can be located in different parts of a country or in different
countries.

1.1. Primary and Secondary Markets

(i) Primary market : The market where the securities are traded for the first
time, e.g. IPOs (initial public offerings), developer selling new condominiums
to the buyer for the first time.

(ii) Secondary market. The market where the original buyers in the primary
market sell to other buyers. This is also known as resale market, e.g., the stock
market.

For example, the Facebook Inc. sold its shares at $38 per share at its IPO (May 18,
2012). The IPO market is considered primary market. Those who bought Facebook
shares during IPO can sell to other investors through NASDAQ (secondary market).
The closing price on August 20, 2012 was $18.06. Its closing price on February 21,
(Friday), 2020 was $210.10 per share. One of the important features of financial
markets, as opposed to other markets like commodity markets is that, in the financial
markets, the price can significantly increase over time as opposed to commodity mar-
kets. You can think of the original price of a new computer and the price of a used
computer. The used commodity prices are usually lower than the original prices.

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1.2. Money and Capital Markets

The following categorization is based on maturity. The maturity of a security is equal
to the length of time after which the security cease to exit.

i. Money market: This is the market where the debt securities with maturity
equal to or less than one year trade. Examples: Certificate of Deposits (CDs)
and Treasury bills - these securities have maturities less than or equal to one
year.

ii. Capital market: This is the market where securities with maturities more
than one year are traded. Examples: Stock and Bond markets. Usually bonds
(also known as Debt Instruments) have maturities after which the securities
cease to exist. For example, a 5-year bond will cease to exist after 5 years.

2. Interest Rate
Interest rates play a very important role in the valuation of financial securities as well
as financial decision making. During the discussion of the interest rate, the length
of time will be expressed in number of periods where one period could be one year,
half a year or one month etc. We also assume that the compounding period is one
period. Finally, the effective one period interest rate r.1 That means we can borrow
or lend (invest) at this rate depending on the situation. However, the borrowing and
lending rates can be different - in such cases we use subscript to r to distinguish
between these two rates.

2.1. Borrowing
Assume that the effective 1-period borrowing rate is rb . If we borrow X0 dollars today
(at time T = 0) for one period, we need to pay back the principal (X0 ) plus interest
on the principal (rb X0 ) in one period (at time T = 1). The total amount we need to
payback in one period (denoted by X1 ) is equal to X1 = X0 (1 + rb ) (See Figure 1.)

X1 = X0 + rb X0 = X0 (1 + rb ) (1)
|{z} |{z}
principal interest

In Figure 1, the time 0 cash flow (X0 ) is a cash inflow (since we are borrowing,
we receive this amount, represented by blue font). However, the time 1 cash flow
(X0 (1 + rb )) is a cash outflow (we pay this amount, represented by red font)).
1
We will discuss more about the compounding period and effective rates during Lecture 2 - stay
tuned.

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X0 X1 = X0 (1 + rb )

Time = 0 1

Figure 1: Borrowing X0 for one period.

Equation (1) implies that if we borrow for one period, the amount of
payment due at the end of the period is equal to the amount borrowed
at the beginning of the period times 1 plus the effective 1-period interest
rate.
How about borrowing for more than one period? We can implement a sequence
of one period borrowing to effectively borrow for more than one period.
Suppose that we want to borrow X0 for two periods. This involves receiving X0
today and payback the loan in two periods - there is no cash flow in one period. We
implement this as follows:

i. Borrow X0 for one period at the effective 1-period borrowing rate rb .

ii. In one period (time t = 1), we need to pay back the load which requires a
payment of X0 (1 + rb ).

– To make this payment, at time t = 1, we borrow X0 (1 + rb ) for one period.

– Now, we need to make the payment at time t = 2
– The payment will be equal to (1 + rb ) times the borrowed amount.
– So, we need to pay X0 (1 + rb )(1 + rb ) = X0 (1 + rb )2 at time t = 2

iii. In two periods (at time t = 2), payback X0 (1 + rb )2

Therefore, if we borrow X0 dollars today for two periods, the amount due in two
periods (denoted by X2 ) will be equal to X0 (1 + rb )(1 + rb ) = X0 (1 + rb )2 (see Figure
2).
In Figure 2, the time 0 cash flow (X0 ) is cash inflow (we receive this amount,
represented by blue font). However, the time 2 cash flow (X0 (1 + rb )2 ) is the cash
outflow (we pay this amount, represented by red font)). The time 1 amount (X0 (1 +
rb )) indicated is used for computation only and it does not represent any cash outflow
or inflow.

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 BFW1001 Foundations of Finance Lec. 1

X2 = X1 (1 + rb )
X0 X1 = X0 (1 + rb ) = X0 (1 + rb )2

0 1 2

Figure 2: Borrowing X0 today for two periods.

Note the following general formula for computing the amount of payment due in
n periods (denoted by Xn ) where the original principal borrowed is equal to X0 :

Xn = X0 (1 + rb )n (2)

X0 X0 (1 + rb ) X0 (1 + rb )2 X0 (1 + rb )3 ... X0 (1 + rb )n

0 1 2 3 ... n

Figure 3: Borrowing X0 for n periods.

2.1.1. Important Comments

Note that equation (2) not only tells you how to compute the amount of payment
due in the future, but it is a relationship between four variables (Xn , X0 , rb and n).
If you know the values of any three of them, you should be able to compute the value
of the fourth one.
Example 1: [Finding n] Suppose that you borrowed today $10,000 at the effective
interest rate of 10 percent per period. How many periods does it take you so that
you owe $1 million.
Soluton: Note that X0 = 10, 000, rb = 0.1 and Xn = 1, 000, 000. From equation
(2), we have

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1, 000, 000 = 10, 000(1 + 0.1)n

Or,
1, 000, 000
= 1.1n ⇔ 100 = 1.1n
10, 000
Take log of both sides.
ln(100)
ln(100) = nln(1.1) ⇔ n = = 48.3177
ln(1.1)
So the answer is approximately 48.32 periods.2 How about if the borrowing rate
is 20 percent. The answer is given by
ln(100)
n= = 25.2585
ln(1.2)
It will take approximately 25.26 periods.

2.2. Investing or Lending

Similar argument can be used to calculate how much our investment today would
be worth in n periods (denoted by Xn ). If we invest or lend X0 dollars today for n
periods at the effective one period rate of ri . The formula is given by equation (2)
with the borrowing rate (rb ) replaced by investment rate (ri )3

Xn = X0 (1 + ri )n (3)

Example 2: [Finding ri ] You have $10,000 today and want to be a millionaire in 10

periods. What effective one-period interest rate do you need to earn? Instead of 10
period, if you want to be millionaire in 20 periods, what effective one-period interest
rate do you need to earn?
Solution:
X0 = 10, 000, Xn = 1, 000, 000, n = 10 & ri =?

Xn = X0 (1 + ri )n
1, 000, 000
1, 000, 000 = 10, 000(1 + ri )10 ⇒ = (1 + ri )10 ⇒ 100 = (1 + ri )10
10, 000
2
You can verify this answer. 10, 000(1.1)48.3177 = 999, 998.49 which is close to one million.
3
Actually, lending is the flip side of the borrowing. In borrowing X0 for n periods, we needed
to pay back X0 (1 + rb )n . But, the party we borrowed from is the lending party. So, the party is
lending X0 for n periods and will receive X0 (1 + rb )n in n periods, where our borrowing rate is that
lender’s lending rate.

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 BFW1001 Foundations of Finance Lec. 1

1
(1 + ri ) = 100 10 = 1.584893 ⇒ ri = 0.584893 = 58.49%
For n = 20,
1
(1 + ri ) = 100 20 = 1.25893 ⇒ ri = 0.25893 = 25.89%
Therefore, you need to earn 58.49% and 25.89% to be millionaire in 10 and 20 periods
respectively.

3. Valuation Principle
So far we have discussed how much a certain amount invested today would be in
certain periods in the future; or how much we need to pay in certain periods in the
future, if we borrowed a given amount today. Now, we want to find the fair value
today of an amount due in the future. This payment could be associated with a
financial instrument.
Suppose that a financial instrument issued by a Company promises to pay the
holder or the owner of the instrument Vn dollars in n periods. What is the fair value
today (denoted by P0 ) of this instrument? Or, how much should you pay to own this
instrument?
Example, what is value of a debt instrument issued by Maybank that promises to
pay RM100,000 in 3 years?
The valuation principle (‘valuation by replication’) can be stated as follows:
If you need V0 today to exactly duplicate the cash flows associated with a
financial security, then the fair value of the security today is V0 .

3.1. Valuation of a Single Payment

Let us start with the valuation of a financial instrument with a single payment in the
future, e.g., payment of Vn due in n periods.
For example, consider an IOU (“I owe you”) issued by Citibank which says that
the Citibank will pay the holder or bearer of the IOU $1 million in five years. This
is a financial security or instrument with a single future payment.

• The question is how much is this security worth today?

• At what price should the security be trading today?

• Note that here we are talking about the valuation of security that involves a
single payment in the future.4
4
The valuation of securities with multiple payments will be discussed later.

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Assumption 2: For valuation, we need to assume that the borrowing rate (rb ) is
the same as the investment rate (ri ) denoted by r without the need of a subscript.

• Note that we are trying to value or find the fair value of the security with a
single payment of Vn due in n periods.
Vn
• If we have (1+r)n today, we can exactly duplicate the cash flow associated with

the security

– How?
Vn
– Invest (1+r)n
at the rate r for n periods.
– In n periods, our investment will lead to the cash flow equal to
Vn
(1 + r)n = Vn
(1 + r)n

• Then, the fair value today (V0 ) of the financial instrument is given by the
following formula:5

Vn
V0 = (4)
(1 + r)n

• Note that we assumed that there are no uncertainties.

According to the above valuation equation (equation (4)), the fair value today
of Xn due in n periods is equal to the amount due (Vn ) divided by (1 + r)n . This
Vn
process of dividing by (1 + r)n is called discounting ( n period discounting) and (1+r)n

is called present value (PV) of Vn .

Where does the valuation equation come from? This is based on principle of
valuation by replication. According to this principle, if an amount X today can
replicate the cash flow Vn in n periods, then the value today of the future cash flow
should be equal to X.
Let us see what happens if the market price of the financial instrument is dif-
ferent from the fair value given by the valuation equation (equation (4)).
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Note that I used the term fair value instead of the term price. In equilibrium the price
will be equal to the fair value. However, if the market is not in equilibrium, the fair value will be
different from the price. Suppose that the fair value of a stock is $10.25 per share, but it is trading
at $9.50 per share (price is $9.50). Then, the stock is under-valued, i.e., it is worth more than
its market price. If the fair value is below the price, then the financial instrument is said to be
over-valued, i.e., it is worth less than is market price. Sometimes, ‘true’ value or ‘fundamental’
value are used to mean the fair value.

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Vn
Case 1. Supppose P0 > V0 = (1+r) n , i.e., the market price P0 is greater than the fair
Vn
value, (1+r)n . If this is the case, the current holder of the security is better off
by following the strategy described below:

– Sell the financial instrument for P0 and invest the fund for n periods.
– In n periods, she/he will receive P0 (1 + r)n which is greater than Vn .
Vn
Since P0 > (1+r)n
, we have P0 (1 + r)n > Vn .
– If she/he did not sell, she/he would receive Vn
– Therefore, those who own the financial security would be better off by
selling the security at the current market price (P0 ). They will be better
off by P0 (1 + r)n − Vn - this is like free-money

Note that when market price is greater than the fair value, it is beneficial for
the current holders to sell the security or instrument.

By assumption, there are no uncertainties or risk here. So the free-money is

guaranteed.

When more and more holder sell the security, the market price will fall and,
eventually, the market price will be equal to the fair value.
Vn
Case 2. Supppose P0 < V0 = (1+r) n , i.e., the market price P0 is lower than the fair
Vn
(1+r)n
value. If this is the case, anyone can better off by following the strategy
described below:

– Borrow P0 today for n periods and buy one unit of the financial security.
– In n periods, she/he will receive Vn due to holding one unit of the financial
security.
– In n periods, she/he needs to pay back the loan amount, which is equal to
P0 (1 + r)n .
– In summary, she/he will receive Vn and needs to pay P0 (1 + r)n .
Vn
Since P0 < (1+r)n
, we have P0 (1 + r)n < Vn .
– So, she/he would receive more than she/he would have to pay.
– This extra cashflow is equal to Vn − P0 (1 + r)n and it is free-money

Note that when market price lower than the fair value, it is beneficial for anyone
to buy the security or instrument with borrowed money.

This allows anyone to make free-money without any uncertainties – risk-free or

guaranteed.

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When more individuals buy the security, the market price will increase and,
eventually, the market price will be equal to the fair value.

Therefore, the fair value of the financial security or instrument is give by equation
(4).
Example 3: Consider an IOU (this is an financial instrument or security) issued by
Citibank which says that the Citibank will pay the holder or bearer of the IOU $1
million in 10 periods. What is the fair price of this IOU today if the effective one
period interest rate is 5%? What is the fair value of the IOU, if the effective one
period interest rate is 2.5%.
Solution:
Vn 1, 000, 000
V0 = n
= = 613, 913.25
(1 + r) (1 + 0.05)10
At 2.5%,
Vn 1, 000, 000
V0 = n
= = 781, 198.40
(1 + r) (1 + 0.025)10
The value of IOU is $613,913.25 at the effective one period interest rate of 5%.
The value of IOU is $781,198.40 at the effective one period interest rate of 2.5%.
The IOU is an example of debt instrument whose fair value will increases when the
interest rate falls and vice-versa.

3.2. Valuation of Multiple Payments

Now the question is how to value a security that is associated with multiple payments
like bonds and stocks. The valuation is easy. We can consider a security with mul-
tiple payments as a portfolio of securities with single payments. Then the price of
the security is equal to the sum of the prices of the single payment securities that
constitutes the portfolio.
For example, consider a security that pays C1 in the one period and C3 in third
periods and there are no cash flows in other periods. This security can be considered
as a portfolio of two single-payment securities where the first one pays C1 in one
period and the second one pays C3 in three periods. Then the fair value of this
security is given by the fair value of the first security plus the fair value of the
second security.
C1 C3
V0 = +
(1 + r) (1 + r)3
Therefore, the general formula for valuating a security that pays Ct in t period,
t = 1, 2, . . . , n is given by

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n
C1 C2 Cn X Ct
V0 = + + · · · + n = (5)
(1 + r) (1 + r)2 (1 + r) t=1
(1 + r)t

Some comments about the pricing or valuation equation (equation (5)):

• Note that V0 is the fair price of the security.

• The market price is amount the buyer would pay the seller per unit in an
actual transaction.

• If nothing is mentioned, it is assumed that the fair value is equal to the market
price, i.e., the market is in equilibrium.

• Ct is the cash flow received by the holder of the security in t periods if Ct > 0.
But, if Ct is negative, then the holder of the security must pay to the seller -
this usually happens with a short position. Finally, in the most general case,
Ct could be positive, negative or zero.

3.3. Cash Flows Uncertainty

In the valuation principle, we assumed that there is no uncertainty about the future
cash flows. However, we may not know the amount due in the future with certainty.
For example, consider a bond (debt instrument) issued by a firm that promises to pay
$100,000 to the holder of the bond in one year. However, if the firm goes bankrupt,
it may not be able to pay that amount. Instead, after the liquidation of the firm, the
holder of the bond my end up receiving only $60,000.
In the future lectures, we will discuss about how to handle such uncertainties
associated with cash flows.

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