Fin Man - Module 2

MODULE 2
TIME VALUE OF MONEY, AND USING IT TO VALUE BONDS

AND STOCKS
Time value of Money
Time value of money is the concept that the worth of a certain sum of money today is more
than the same sum of money tomorrow. One peso received today is more valuable than one
peso received after one year.
This concept might be best illustrated by a story told by Someone many of us consider the
Greatest Teacher and Greatest Storyteller. Jesus Christ made his representation of this concept
in the Parable of the Talents as depicted in Matthew 25:14-30 (21st Century King James
Version):
14 “For the Kingdom of Heaven is as a man traveling into a far country, who called his own servants and
delivered unto them his goods.
15 And unto one he gave five talents, to another two, and to another one, to every man according to his several
ability, and straightway took his journey.
16 Then he that had received the five talents went and traded with the same, and made them another five talents.
17 And likewise he that had received two, he also gained another two.
18 But he that had received one went and dug in the earth and hid his lord’s money.
19 After a long time the lord of those servants came and reckoned with them.
20 And so he that had received five talents came and brought the other five talents, saying, ‘Lord, thou deliveredst
unto me five talents. Behold, I have gained beside them five talents more.’
21 His lord said unto him, ‘Well done, thou good and faithful servant. Thou hast been faithful over a few things; I
will make thee ruler over many things. Enter thou into the joy of thy lord.’
22 “He also that had received two talents came and said, ‘Lord, thou deliveredst unto me two talents; behold, I
have gained two other talents beside them.’
23 His lord said unto him, ‘Well done, good and faithful servant. Thou hast been faithful over a few things; I will
make thee ruler over many things. Enter thou into the joy of thy lord.’
24 “Then he that had received the one talent came and said, ‘Lord, I knew thee, that thou art a hard man, reaping
where thou hast not sown, and gathering where thou hast not strewed.
25 And I was afraid, and went and hid thy talent in the earth. Lo, there thou hast what is thine.’
26 His lord answered and said unto him, ‘Thou wicked and slothful servant, thou knewest that I reap where I
sowed not, and gather where I have not strewed.
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27 Thou ought therefore to have placed my money with the exchangers, and then at my coming I should have
received mine own with interest.
28 Take therefore the talent from him, and give it unto him that hath ten talents.
29 For unto every one that hath shall be given, and he shall have abundance; but from him that hath not, shall be
taken away even that which he hath.
30 And cast ye the unprofitable servant into outer darkness: there shall be weeping and gnashing of teeth.’
Jesus is obviously talking more than just economic issues and material values but this
should not deter anybody from interpreting verses 15 to 27 literally and dismiss the idea that
when a person is entrusted with wealth, he or she should take some risk and in his or her own
creative way multiply this wealth. It is simply foolish enough to just safeguard (Jesus called the
third servant wicked/slothful or unfaithful in other translations) it because the least proper thing
to do is put it in a bank and earn interest no matter how small that interest is while taking the
risk of the bank going bankrupt.
As the parable shows, the reason why money received today is worth more than money
received tomorrow is because if one receives money today, the money can be invested and
earn a return over time.
Application of Time value of money
There are two perspectives in applying this concept. It could either be the “present value” or
the “future value” perspectives.
Present value analysis is known in mathematics parlance as discounting. It is a process of

removing the interest factor in an amount to be received in the future and reduce or convert it
to its value in the present.
Future value analysis is known in mathematics parlance as compounding. It is a process of

adding the interest factor in an amount received at present and increase or to convert it to its
value in the future.
To accomplish these analyses, the suggested approach is to use present value and future value
factors. Try to consider the following cases of single payments:
I. Ace has P100,000 on January 1, 2018. Ace wants to know how much would be its value
on December 31, 2020 if it is invested at a return of 15% annually. To accomplish this, one has
to perform this computation:
Present value P 100,000
Multiply by future value factor of P1 @ 15% for 3 yrs 1.52088
Future value P 152,088
II. Aiza is expected to receive P100,000 on December 31, 2020. She wants to know how
much would be its value on January 1, 2018 if it will be earning a return of 15% annually. To
accomplish this, one has to perform this computation:
Multiply by present value factor of P1 @ 15% for 3 yrs 0.65752
You may ask, where we got the future value factor and the present value factor. Well, they can
be obtained in a two-fold manner. One is to get it from table of values, usually found in
annexes of mathematics or MAS books. A sample is found at the end of this book. The other is
to compute for it using appropriate formulas. In consideration of CPA licensure examination
purposes, it is highly recommended that a candidate should not rely on the tables and acquire
the ability to compute for the proper factor needed. As such, factors are computed using
formulas in succeeding exercises. Also, present and future values used in the illustrations in this
chapter are rounded off to five digits.
Time Value Factor Formulas
A. Formula to compute Future Value Factors
Lump-sum amount:
1. To compute for the future value factor of 1 compounded annually:
FVF = (1+i)n
Where: n = no. of years

i = interest rate
2. To compute for the future value factor of 1 compounded more than once a year:
i nm
FVF = 1 + -----
m
where: m = no. of intervals per year (Ex: 4 for quarterly, 2 for semiannually)
Annuity (a series of consecutive payments of equal amount)

3. To compute for the future value factor of an ordinary annuity of 1 (the amount is
received at the end of the period):
[(1+i)n ]- 1
FVF = -------------
i
4. To compute for the future value factor of an annuity due of 1 (the amount is received
at the beginning of the period):
[( 1+ i )n ]- 1
FVF = ---------------- x (1+i)
I
B. Formula to compute Present Value Factors
Lump-sum amount:
1. To compute for the present value factor of 1 compounded annually:
PVF = (1+i)-n
2. To compute for the present value factor of 1 compounded more than once a year:
i -nm
PVF = 1 + -----
m
Annuity
3. To compute for the present value factor of an ordinary annuity of 1 (the amount is
received at the end of the period):
1-(1+i)-n
PVF = -----------
i
4. To compute for the present value factor of an annuity due of P1 (the amount is
received at the beginning of the period):
1-(1+i)-n
PVF = ------------ x (1+i)
i
In management advisory services problems, present value formulas are more commonly used
than future value formulas.
Further illustrations:
III. Arcie has exactly P100,000 in his bank savings account on January 1, 2018. If her bank
gives a 6% interest compounded quarterly on savings deposits, how much would be the
balance of the account on December 31, 2019 assuming no withdrawals or deposits will be
made and tax effects are ignored?
Solution:
Determine the right formula to be used. In this case, we will use the formula on A-2. Compute
the factor for 2 years, and multiply it with the amount of the deposit.
Multiply by future value factor of P1 @ 6%,
compounded quarterly for 2 yrs 1.12649
Computation of the future value factor:

.06 (2x4)
FVF = 1 + -----
4
= 1.12649
IV. Venus has a son who has just started college studies. On January 1, 2018, Venus
opened a savings account by initially depositing 25,000 as a gift to her son on his graduation.
She intends to deposit the same amount every start of the year for the next years when her
son should be graduating. Her bank grants a 7% interest. How much would be the balance of
the account on December 31, 2021 assuming no withdrawals will be made and tax effects are
ignored?
Solution: Determine the right formula to be used, formula A-4 in this case. Compute the factor
for 4 years, and multiply it with the amount of the deposit.
Amount of the annuity P 25,000.00
Multiply by future value factor of an
annuity due @ 7% for 4 years 4.75074
Future value P118,768.50
Computation of the future value factor:

[( 1+.07 )4 ]- 1
FVF = ----------------- x (1+.07)
.07
= 4.75074
V. Richard Company is depositing P50,000 every December 31st for the next eight years for
possible plant expansion. How much would be the value of the deposit today if the interest rate
is 15%, ignoring tax effects?
Solution: Determine the right formula to be used, formula B-4 in this case. Compute the factor
for 4 years, and multiply it with the amount of the deposit.
Amount of the annuity P 50,000.00
Multiply by present value factor of an
Present value P 258,021.00
Computation of the present value factor:

1-( 1+.15 )8
PVF = --------------- x (1+.15)
.15
= 5.16042
VI. On January 1, 2018, Susie Company agreed to set aside part of their net income and put
it in a fund that is expected to earn 12%. The savings is to be used to purchase a second
machine to improve output efficiency. The arrangement will start on December 31, 2018 and is
expected to end on December 31, 2023. The expected cash price of the machine is P1,500,000.
How much should be set aside each year to be able to purchase the machine?
Solution: One may also perform the unconventional accounting process to find a resolution to
this problem using the principles of converting the amounts.
This formula is also equivalent to this one

Amount of Income ? P Future value P 1,500,000
x Future value factor ? ÷ Future value factor ?
------------ --------------
Future value P1,500,000 Amount of income P ?
======= ========
Therefore: All one has to do is find the correct future value factor. We are doing the
solution in reverse so the deposit, originally an annuity due, is now treated as an ordinary
annuity.
Future value P 1,500,000
Divided by present value factor of an
Present value P 184,838.56
Computation of the present value factor:

[(1+.12 )6 ] - 1
FVF = ------------------
.12
= 8.11519
Proof:
Annual Interest earned
Date Total
Deposit 2018 2019 2020 2021 2022 2023
12/31/2018 184,838.56 22,180.63 24,842.30 27,823.38 31,162.18 34,901.65 325,748.70
12/31/2019 184,838.56 22,180.63 24,842.30 27,823.38 31,162.18 290,847.05
12/31/2020 184,838.56 22,180.63 24,842.30 27,823.38 259,684.87
12/31/2021 184,838.56 22,180.63 24,842.30 231,861.49
12/31/2022 184,838.56 22,180.63 207,019.19
12/31/2023 184,838.56 184,838.56
Final amount 1,499,999.86
USING TIME VALUE OF MONEY TO VALUE BONDS AND STOCKS
Overview on Bond and Stock Valuation
Investors and investees have many different ways of measuring values of investments and also
have various reasons for buying and selling a bond or a share of stock. Some terms associated
to valuation are the cost, the carrying or book value, the fair or market value, and the intrinsic
value.
Intrinsic Value versus Market Value; Intrinsic Value versus Book Value
The market value is the value an investor is willing to pay for a security. It can be easily
observed for publicly traded companies in the stock exchange.
The book value is an accountant’s view of the value of the security. It is the value of an
investment following application of accounting principles.
The intrinsic value represents the “true” or “real” value of a security, the amount which the
security should be selling. It is what the security is really worth, it cannot be directly observed
and must instead be estimated or calculated. The intrinsic value is normally referred to as the
“price”.
It is common that these three values will vary with one another. The accounting methodology
applied in deriving the book value makes it rare for the book value to be a good indication of the
true value or market value because intangible values are not considered.
While the market value is a good indicator of the intrinsic value of a security, the market value
may also not be equal to the true value because there are different considerations of intangible
values by investors that will make market prices sway frequently. The best example is the case
of a “listed shell company”. A shell company is generally one that has immaterial or negative
net worth but is a publicly traded company. Its real value is low because it really has no or little
net assets and no or little operational earnings, thus, practically giving no dividends to
investors. Its market value, however, might be seen higher to investors because it has an
intangible value that being a potential vehicle for an unlisted company to become publicly
traded via “backdoor listing”.
The Purpose of Intrinsic Value
The purpose of estimating intrinsic value is for one to have a basis to take advantage of
mispriced stocks or bonds. If the market value of a stock or bond is above the intrinsic value
then the investor might choose to sell it. If the market value of a stock or bond is below its
intrinsic value then the investor might choose to consider purchasing it.
Difficulty in computing the intrinsic value of a stock than computing the price of a
bond
The price of a bond is easier to calculate than its corresponding equity share. The reason is that
a bond has fixed interest and principal payments and set duration. Therefore, cash flow and
growth are usually fixed. The only variable is the amount the analyst chooses to discount the
risks of the bond coupon (interest) not being paid and the cost of capital.
A stock has many more variables, both tangible and intangible, that can affect future cash flow,
growth, and the discount for risk.
USING TIME VALUE OF MONEY TO VALUE BONDS
The price of an investment in bonds is the present value of the cash flows the bonds is
expected to produce. The process of determining a bond’s price involves finding the present
value of an asset's expected future cash flows using the investor's required rate of return. As
such, one should know what these cash flows are. They consist of:
 Interest payments during the bond’s life.

 And the amount borrowed (the face value) when the bond matures.
Note that serial bonds have multiple principal maturities and interest payments are uneven.
Formula:
Present value of interest payments xx
Add: Present value of principal payments at maturity xx
Current price xx
This means that one should use formula for present value of a lump sum payment or a
combination of lump sum payment and annuity. If the coupon rate is the required rate of
return, the price would be equal to the face value.
ILLUSTRATIONS:
I. ACE Company invested in term bonds of Jack Company. The following information pertains
to the investment:
Face value of the bonds P1,000,000
Date of investment January 1, 2018
Interest payment date Every December. 31
Date of Maturity December 31, 2020
Coupon rate 12%
Rate of return 12%
Required: Find the value of the bonds on January 1, 2018.
Solution:
PV of Principal due 12/31/18 (1,000,000 x PVF)
(1.12) -3 ; .71178 P 711,780 PV
of Interest due 12/31/18 (120,000 x PVF)
(1.12)-1; .89286 107,143
PV of Interest due 12/31/19 (120,000 x PVF)
(1.12)-2; .79719 95,663
PV of Interest due 12/31/20 (120,000 x PVF)
(1.12)-3; .71178 85,414
Present value/Price P 1,000,000
-OR-

(1.12) -3 ; .71178 P 711,780
PV of Total interest due (120,000 x PVF)
{[1-(1.12) -3]÷.12}; 2.40183 288,220
Present value/Price P 1,000,000
***The present value/price is equal to the face value because the rate of return is equal to the
coupon rate.
II. ACE Company invested in term bonds of Jack Company. The following information pertains
to the investment:
Date of investment Jan. 1, 2018
Interest payment date Dec. 31
Date of Maturity Dec. 31, 2020
Coupon rate 10%
Required rate of return 12%
Required: Find the value of the investment on January 1, 2018.
Solution:
(1.12)-3; .71178 P 711,780
PV of Total interest due (100,000 x PVF)
{[1-(1.12)-3] ÷.12}; 2.40183 240,183
Present value/Intrinsic value P 951,963
***The principal is a lump-sum payment being received only once while the interest is an
annuity as it’s received yearly at equal amounts.
III. ACE Company invested in serial bonds of Jack Company. The following information pertains
to the investment:
Date of investment Jan. 1, 2018
Bond maturity every December 31 P3,000,000
Interest payment date Dec. 31
Date of Maturity Dec. 31, 2020
Coupon rate 12%
Required rate of return 10%
Required: Find the value of the investment on January 1, 2018
Solution:
PV of Annual Principal due every year
3,000,000 x 1-(1.10)-3÷.10; (2.48690) P 7,460,700
PV of interest due on 12/31/18
1,080,000 x (1.10)-1; (.90909) 981,817
720,000 x (1.10)-2; (.82645) 595,044
360,000 x (1.10)-3; (.75131) 270,472
Present value/Intrinsic value P 9,308,033
***It is the reverse in serial bonds. The principal is an annuity as it’s received yearly at equal
amounts while the interest is treated as a lump-sum payment annually because the amounts
received each year are different notwithstanding the fact that it is indeed received annually.
Observations:
If the coupon rate is the equal to the investor’s required rate of return, intrinsic value is
equal to the principal amount or the par value of bonds. If the coupon rate is lower than the
investor’s rate of return, intrinsic value is lower than the face amount, thus, the bonds are said
to be issued at a discount if the price is equal to its intrinsic value. If the coupon rate is higher
than the investor’s rate of return, intrinsic value is higher than the principal amount, in this
case, the bonds are said to be issued at a premium.
Bond Yields
Yield refers to income return on an investment. In the United States, if one examines a bond
market table of Wall Street Journal or a price sheet put out by a bond dealer, one will see
information regarding each bond’s maturity date, price, and coupon interest rate. One will also
see a reported yield. Unlike the coupon interest rate which is fixed, the bond’s yield varies from
day to day depending on current market conditions.
To be most useful, the bond’s yield should give us an estimate of the rate of return we would
earn if we bought the bond today and held it over its remaining life. If the bond is not callable,
its remaining life is its years to maturity. If it is callable, its remaining life is the years to
maturity if it is not called or the years to the call if it is called.
Current Yield
Current yield is described as “the yield rate that is based on market value”. This measure looks
at the current price of a bond instead of its face value and represents the return an investor
would expect if he or she purchased the bond and held it for a year. This measure is not an
accurate reflection of the actual return that an investor will receive in all cases because bond
prices are constantly changing due to market factors which means it does not account for the
capital gain or loss that will be realized if the bond is held until it is called or matures.
Annual Interest
Formula: -------------------
Market price
Illustration:
ABC Co. bought 10 units of P1,000 par, 12%, 3 year bonds of CDE Co. for P9,600.
Required:
1. How much would ABC receive as interest?
2. What will be the current yield?
Solution:
1. ABC will actually receive P1,200, computed by multiplying the total face amount of P10,000
by the coupon rate of 12%.
2. Based on the market value of P9,600, the equivalent percentage would be 12.5% computed
by dividing the interest received with the market value (P1,200/P9,600). This is known as
the current yield rate.
Yield to maturity
Yield to maturity (YTM) can be described simply as the “The percentage of profit the investor
earns from the time of investment until maturity stated in percentage per year.” The rate of
return anticipated on a bond if it is held until the maturity date. YTM is considered a long-term
bond yield expressed as an annual rate. The calculation of YTM takes into account the current
market price, par value, coupon interest rate and time to maturity. It is also assumed that all
coupons are reinvested at the same rate. Sometimes this is simply referred to as "yield" for
short. Computing for the can be done by interpolation or maybe approximated by using a
formula. In case the problem is silent, the interpolation method should be preferably used.
Approximating by formula:
The yield can be approximated using the following formula for term bonds:
Principal payment-Market price
Annual interest payment + ---------------------------------------
Number of years to maturity
-----------------------------------------------------------------------------
(50% x Market price) + (50% x principal payment)
ILLUSTRATION:
A five-year bond pays 6% interest on a P10,000 face value annually. If it currently sells for
P8,833, what will be its yield to maturity?
Solution: The approximate yield is computed as follows:
10,000 – 8,833
P600 + --------------------
5 833.40
--------------------------------------- = ---------- = 8.85%
(50% x 8,833) + (50% x 10,000) 9,416.50
Computing by interpolation:
The underlying concept of the YTM can be expressed in the following formula:
0 = (Present value of cash inflows) - (Present value of cash outflows).
In other words, the present value of the cash inflows must be equal to the present value of the
cash outflows when subjected to the yield to maturity
With this in mind, the following provides an initial guide to computing the yield to maturity:
Bought at Yield rate Coupon Rate
a. discount xx > Xx
b. xx < Xx
premiu
We can see that the price is less
m
than the face of the bond thus it
was bought at a discount. Based on the guide, we can conclude that the YTM is more than the
coupon rate.
Interpolation provides a shorter way of obtaining the rate with a more systematic approach.
Interpolation is a technique that should be extracting a percentage closest to the actual yield if
done at shorter ranges. The shorter the gap between the two selected rates, the closer the rate
obtained to the actual rate. Ideally, increments of 1% can be used. The following steps are to
be undertaken:
The first step is to establish a range where the rate is to be located. Using the illustration
above, what to do basically is to choose a percent higher than 6% and compute the present
value of the cash inflows. Stop at the point when it results to a present value of cash inflows
equal or lower than present value of the cash outflow of P8,833. One can compute the
following:
@7%
Periods Cash inflow x PVF@7% = PV of inflows
(1-5) P 600.00 x 4.10020 = P 2,460.12
( 5) P10,000.00 x 0.71299 = 7,129.90
Total = P 9,590.02
@8%
(1-5) P 600.00 x 3.99271 = P 2,395.63
( 5) P10,000.00 x 0.68058 = 6,805.80
Total = P 9,201.43
@9%
(1-5) P 600.00 x 3.88965 = P 2,333.79
( 5) P10,000.00 x 0.64993 = 6,499.30
Total = P 8,833.09
Stop the computations as one can observe that at 9% return, the present value of cash inflows equal
the present value of the cash outflows, thus making this rate equal to the YTM.
In case the present value of the inflows is not exactly the same as the outflows, the following
additional steps will be undertaken: (1) Get the difference between the present values of the
lower rate of the range and the YTM.(2) Get the difference between the present values of the
lower rate of the range and the higher rate of the range. (3) Divide the result of “1” with “2”.
(4) Multiply the result of “3” with the interval of the range and add it to the lower rate of the
range for the YTM.
Obtaining the rate by trial and error:
While interpolation process does give a very, very accurate rate, it may not coincide to the
exact one. If one like the exact rate up to the last decimal, he or she may have to extract it via
trial and error:
Substitute the values in the formula, with “i" the only remaining unknown and guess the rate.
The guessing should be easier because the rate should be located within the range used under
interpolation.
Using the same Illustration, what will be its yield to maturity using trial and error?
Step 1: Substitute the figures in the formula with “i” remaining to be the only unknown item:
0 = [(10,000 x 1.i-5) + (600 x 1.i-1) + (600 x 1.i-2) + (600 x 1.i-3) + (600 x 1.i-4) +
(600 x 1.i )] - (8,833)
-5
The cash inflows refer to interest payments to maturity and principal repayment at maturity.
Cash outflow refer to amount invested, which is the market price of the bond when the
investment was made.
NOTE: The answer on the right side of the equation should be exactly zero (0) to obtain the
exact yield. In the event it is improbable to extract exactly zero, it should be the smallest
positive number closest to zero (0). This will represent the highest attainable yield.
Step 2: Guess/Compute the value of “i”, the interest rate, bearing in mind that the rate should
be above 6%. Keep on guesing “I” until both sides would equal to zero. This process is
completed through a trial and error approach which is normally tedious and time consuming if
your guess is far from the rate. The use of spreadsheet applications like Excel would be ideal in
this scenario and should make it happen in a few minutes. By applying 9%, as obtained during
interpolation, as the value of “i", the result will be as follows:
0.10 = (6,499.31 + 550.46 + 505.00 + 463.31 + 425.06 + 389.96) - (8,833)
Step 3: One can therefore conclude that 9% is the yield to maturity.
ILLUSTRATION 2:
A five-year bond pays 6% interest on a P10,000 face value annually. If it currently sells for
P9,000, what will be its yield to maturity?
As seen in the previous problem, the rate lies between 8% and 9%. To interpolate, do the
following:
Interest rates Present value of cash inflows Difference

(Step 1)
8% P 9,201.43
P 201.43 (Step 2)
YTM P 9,000.00 P 368.34
9% P 8,833.09
Step 3: (201.43 ÷ 368.34) = .546859
Step 4: To compute for the yield, the following should be made:

YTM = 8% + [1% x .546859]
= 8.5469%
The solution can be validated by substituting it in the trial and error formula.
0 = [(10,000 x 1.085469-5) + (600 x 1.085469-5) + (600 x 1.085469-4) + (600 x
1.085469 ) + (600 x 1.08547-2) + (600 x 1.08547-1)] - (9,000)
-3
0 = (7034.26 + 432.2 + 469.14 +509.23 + 552.76) – (9,000)

0 = 2.41***
***The difference is due to the rounding off of the present value factors to five digits. This
shows how good and accurate use of interpolation method.
The yield to maturity can also be viewed as the bond’s promised rate of return, which is the
return that investors will receive if all of the promised payments are made. However, the yield
to maturity is equal to the expected rate of return only when:
(1) the probability of default is zero and;
(2) the bond cannot be called
If there is some default risk or the bond may be called, there is some chance that the promised
payments to maturity will not be received, in which case the calculated yield to maturity will
exceed the expected return. Note also that a bond’s calculated yield to maturity changes
whenever interest rates in the economy change, which is almost daily. An investor who
purchases a bond and holds it until it matures will receive the YTM that existed on the purchase
date, but the bond’s calculated YTM will change frequently between the purchase date and the
maturity date.
Additional illustrations of the interpolation process:
1. (Bonds bought at a Premium with income tax ) XYZ Company bought 1,000 pieces of 5
year P1,000 face value bonds at 105. The bonds pay annual interest of 12%. The bonds
mature in 2 years after the purchase date. Calculate the yield if XYZ Company is subject to
30% income tax.
Solution:
The buying price of the bonds is P1,050 (P1,000 x 105%). Since it was bought at a premium,
the yield must be lower than coupon rate of 12%.
at 10%
PV Principal (P1,000 x .82645) P 826.45
PV of interest payments (P120 x 1.73554) 208.26
Total P1,034.71
PV Factor computations:
Principal PV of 1 at 10% for 2 years = (1.10)-2 = 0.82645
Interest PV annuity of 1 at 10% for 2 years = 1 – (1.10)-2 = 1.73554
.10
at 9%
PV Principal (P1,000 x .84168) P 841.68
PV of interest payments (P120 x 1.75911) 211.09
Total P1,052.67
Principal PV of 1 at 9% for 2 years = (1.09)-2 = 0.84168
Interest PV annuity of 1 at 9% for 2 years = 1 – (1.09)-2 = 1.75911
.09
Therefore, the yield must be between 9% and 10%.

Rate PV of Cash Flows
9% P1,052.67
P2.67
1% Yield P1,050 P17.96
P15.29
10% P1,034.71
Using the Interpolation method, the yield to maturity is 9.15%.

YTM = 9% + 1% x (P2.67/P17.96) = 9.15%
Therefore, the YTM after tax is = 9.15% x (1 -30%) = 6.41%
2. (Bonds bought at Discount with income tax) XYZ Company bought 1,000 pieces of
P1,000 face value bonds at P800. The bonds pay interest every 6 months at 12% per
annum. The bonds mature in 7 years. Calculate the yield to maturity if XYZ Company is
subject to 30% income tax.
Solution:
Since the bonds are bought at a discount, the yield rate of interest must be higher than coupon
rate of 12%. Also, since the interests are paid semiannually, the PV cash flows must be
computed using the equivalent semi-annual rate.
at 16%/yr = at 8% semiannually:
P340.4
PV Principal (P1,000 x .34046) 6
PV of interest payments (P120/2) x 8.24424) 494.65
P835.1
Total 1
Principal: PV of 1 at 8% for 14 periods = (1.08)-14 = 0.34046
Interest: PV annuity of 1 at 8% for 14 periods = 1 – (1.08)-14 = 8.24424
.08
at 18%/yr = at 9% semiannually:
P299.2
PV Principal (P1,000 x .29925) 5
PV of interest payments (P120/2) x 7.78615) 467.17
P766.4
Total 2
Principal: PV of 1 at 9% for 14 periods = (1.09)-14 = 0.29925
Interest: PV annuity of 1 at 9% for 14 periods = 1 – (1.09)-14 = 7.78615
.09
Therefore, the semi-annual yield rate must be between 8% and 9%.
Rate PV of Cash Flows

8% P835.11
P35.11
1% Yield P800 P68.69
P33.58
9% P766.42
Using the Interpolation method, the yield rate is 8.51%.
YTM = 8% + 1% x (P35.11/P68.69) = 8.51%

YTM = 9% - 1% x (P33.58/P68.69) = 8.51%
Therefore, yield to maturity rate is (8.51% x 2) = 17.02%

The YTM after tax is 17.02% x (1-30%) = 11.91%.
Yield To Call
When one purchases a bond that is callable and the company called it, he or she does not have
the option of holding it to maturity. As such, the yield to maturity would not be earned. If
current interest rates go below an outstanding bond’s coupon rate, the issuing company would
likely call the bond. In this case, investors will estimate the bond’s most likely rate of return as
the yield to call (YTC) rather than the yield to maturity (YTM). The yield of a bond applies as if
one were to buy and hold the security until the call date. This yield is valid only if the security is
called prior to maturity. The calculation of yield to call is based on the coupon rate, the length
of time to the call date and the market price.
Formula: Same as Yield to Maturity, except Cash inflows refer to interest payments up to call
date and the call price. Cash outflow still refer to amount invested.
ILLUSTRATION:
A five-year bond pays 6% interest on a P10,000 face value annually that can be called in at a
price equal to face value at the end of the third year. If it currently sells for P9,005, what will
be its yield to call?
Solution:
1. The following formula should be prepared:
0 = [(10,000 x 1.i-3) + (600 x 1.i-1) + (600 x 1.i-2) + (600i-3)] - (9,005)
2. By interpolation process, the value of i, by the end of the process, 10% will result to the
closest positive number to 0 as follows:
0.26 = (7,513.15 + 545.45 + 495.87 + 450.79) - (9,005)
3. One can therefore conclude that 10% is the yield to call.
USING TIME VALUE OF MONEY TO VALUE STOCKS
Overview of Stock Valuation
Stock represents shareholders’ ownership in the company. It carries voting rights and these
shareholders are legally entitled to receive dividend payments. However, ordinary share returns
are not contractual—they depend on the firm’s earnings, which in turn depend on many random
factors, making their valuation more difficult. Stock valuation can be calculated using a number
of different methods.
Use of the Discounted Method
One of the two of the fairly straightforward models used to estimate stocks’ intrinsic value is
the discounted dividend model. As a guiding rule when investing, a stock should, of course, be
bought if its price is less than its estimated intrinsic value and sold if its price exceeds its
intrinsic value.
Stock valuation is interesting in its own right; but you also need to understand valuation when
you estimate the cost of capital for use in capital budgeting, which is probably a firm’s most
important task. Capital Budgeting was discussed in detail in the first volume of this book.
Ordinary Stock Investments
The value of a share of common stock depends on the cash flows it is expected to provide, and
those flows consist of two elements: (1) the dividends the investor receives each year while he
or she holds the stock and (2) the price received when the stock is sold. The final price includes
the original price paid plus an expected capital gain. Keep in mind that there are many different
investors in the market and thus many different sets of expectations. Therefore, different
investors will have different opinions about a stock’s true intrinsic value and thus proper price.
As stated earlier, the discounted dividend model will be used in valuing shares. Under
this method, the valuation would be interpreted by the shareholder as the present value of an
expected stream of future dividends. The ultimate value of any holding lies with the distribution
of earnings in the form of dividend payments (The earnings must be translated into cash flow
for the stockholder)
A. No growth in dividends – This is similar to valuation preference shares where the annual
dividend remains constant.
Therefore, the formula would be
D1
V = --
r
Where:
V = Intrinsic value of the share
D1 = The dividend for the year it is being valued
r = The required rate of return (yield)
ILLUSTRATION:
On January 1, 2018, Diamond Company invested in one of Ace’s ordinary share that has a par
value of P1,000 and a market value of P1,250. The 2017 dividend paid to each shareholder
amounted to P225. The dividend rate is not expected to grow. What is its value if the required
rate of return is 16%?
D1 P225
V = -- = ------ = P1,406.25
r 16% =======
B. Constant growth dividends – This is a situation where the annual dividends are expected
to increase every year at a certain rate. The formula to compute its value would be:
D1
V = ------
r-g
Where:
g = The growth rate
D0 = The dividend of the previous year
This formula is known as the Constant Growth Model, or Gordon Model, named after Myron J.
Gordon, who did much to develop and popularized it.
ILLUSTRATION:
On January 1, 2018, Diamond Company invested in one of Ace’s ordinary share that has a par
value of P1,000 and is selling at P1,100. The 2017 dividend paid to each shareholder amounted
to P75. The dividend is expected to grow annually at a rate of 10%. What is its value if the
required rate of return is 16%?
D1 ( P75 x 110%)*
V = ---- = ------------------ = P1,375
r-g 16% - 10%
* D1 = (D0 x g)
C. Supernormal or non-constant growth dividends – This is a situation where the annual

dividends are expected to increase suddenly for the first few years upon investment then
grow steadily at a certain rate or remains constant every year thereafter. Firms typically go
through life cycles, during part of which their growth is faster than that of the economy and
then falls sharply.
C.1 Supernormal growth then constant growth
The value of stock during such supernormal growth can be found by taking the following steps:
1. Compute the dividends during the period of supernormal growth and find their
present value
2. Find the price of the stock at the end of the supernormal growth period (or the year
when the constant or no growth era begins) by applying the formula for constant
growth shares and compute its present value; and
3. Add these two PV figures to find the value of the common stock.
ILLUSTRATION:
Diamond Company was incorporated on January 1, 2017 with their ordinary shares having a
par value of P100 each. Diamond became immediately profitable that it actually paid a P2
dividend per share to its shareholders from 2017 accumulated profits.
On January 1, 2018, Ace Company is considering to invest in the ordinary shares of diamond.
Diamond’s dividends are expected to grow at a 25 percent rate in 2018, 45% in 2019, and then
grow 5 percent annually thereafter. Ace desires a 12 percent return on the investment.
Required: What should be the price of one share?
To find the value of this stock, take the following steps:

1. Compute the dividends during the supernormal growth period and find their present
value. Thus:
D1 = (2 x 125%) P2.50 x (0.89286) P2.23
D2*= (2.50 x 145%) 3.625 x (0.79719) 2.89
Total PV of dividends P5.12
* D0 = dividend of year before investing; D1 = dividend of 1st year of investment; D2 =

dividend of 2nd year; and so on.
2. Find the price of the stock at the end of the supernormal growth period by first
establishing the dividend of the third year:
D3 = P3.625 x 1+Growth (1.05) = P3.80625
3. Once obtained, the dividend at first year of the constant growth era is subjected to
the formula for valuing shares with growth. Therefore:
3.80625
------------- = 54.375
0.12 - 0.05
4. Then bring the computed amount to its present value:

PV = 54.375(PVF@12% for 3 years) = 54.375(0.71178) = P38.70
5. Add the two PV figures obtained in steps 1and 4 to find the value of the stock.
V = 5.12 + 38.70 = P43.82
C.2 Supernormal growth then no growth
The sequence to compute its value would be the same as in C.1. except for the second step
where the computation of the price is different, thus:
The value of stock during such supernormal growth can be found by taking the following steps:
1. Compute the dividends during the period of supernormal growth and find their
present value;
2. Find the price of the stock at the end of the supernormal growth period (or the year
when the constant or no growth era begins) by applying the formula for no growth
shares and compute its present value; and
3. Add these two PV figures to find the value of the common stock.
ILLUSTRATION:
Diamond Company was incorporated on January 1, 2017 with their ordinary shares having a
par value of P100 each. Diamond became immediately profitable that it actually paid a P2
dividend per share to its shareholders.
On January 1, 2018, Ace Company is considering to invest in the ordinary shares of Diamond.
Diamond’s dividends are expected to grow at a 25 percent rate in 2018, 45% in 2019, and then
remains at this level annually thereafter. Ace desires a 12 percent return on investment.
Required: What should be the price of one share?
To find the value of this stock, take the following steps:

1. Compute the dividends during the supernormal growth period and find their present
value. It should result in the same output as in C.1., thus:
D1 = (2 x 125%) P2.50 x (0.89286) P2.23
D2*= (2.50 x 145%) 3.625 x (0.79719) 2.89
Total PV of dividends P5.12
2. Find the price of the stock at the end of the supernormal growth period.
D3 = P3.625 x 1+Growth (1.05) = P3.80625
The price of the stock at the end of the supernormal growth is therefore:
3.80625
--------- = 31.71875
0.12
3. Then bring this to its present value:

PV = 31.71875 x (PVF@12% for 2 years) = 31.71875 x 0.71178 = P22.58
4. Add the two PV figures obtained in steps 1 and 3 to find the value of the stock.
V = 5.12 + 22.58 = P27.70
Why is the value based on the stream of dividends alone while the price of the share
is ignored?
To get the idea, visualize the formula for bonds. In order to get the intrinsic value, one needs
the maturity value and the annual interest payments. To compare, the counterpart of the
maturity value for stocks is the selling price received when the stock is finally sold. As for the
annual interest payments, it would be the annual dividends to be received. How would you
obtain these values? Remember that in bonds, they are exact and can be obtained easily.
Try to think of yourself as an investor who buys the stock of a company that is expected to go
on indefinitely (for example you are buying shares of a corporation which has just starting and
you intend to hold shares forever being an original incorporator like passing it to your children
so it stays in your family). Or you are an investor who buys the stock of a company for capital
appreciation and sell it in the proper future time. In both cases, how can you value the shares
as of a certain future date when you finally decide to sell the shares and how much can you get
as yearly dividend?
As already seen, the annual dividends can be predicted due to the growth assumption. But what
about the future selling price? The future sale price of the share becomes hard to determine
because it depends on the dividends some future investor expects, and that investor’s expected
sale price is also dependent on some future dividends. The basis of the future selling price is
dependent on the amount of future dividends to be received. Therefore, any expected selling
price coming from the stock will be much based on the dividends to be received. Being so,
unless a firm is liquidated or sold, the cash flows it provides to its stockholders will consist only
of a stream of dividends. Therefore, the value of a share of stock must be established as the
present value of the stock’s expected dividend stream and the value of the stock today can be
calculated as the present value of an infinite stream of dividends.
Preference Stock Investments
Preference shares represent perpetuity, having no maturity date. It has a fixed dividend
payment. It has no binding contractual obligation of interest on debt. Being a hybrid security, it
does not have:
 The full ownership privilege like that of a common stock; and
 The legal provisions that could be enforced on debt.
Valuation formula:
D
V = --
r
Where:
V = Intrinsic value of the share
D = The annual dividend
r = The required rate of return
ILLUSTRATION:
A preference share has a par value of P100 and a rate of 10%, and the stockholder requires an
8% rate of return, the price of the preferred stock would be:
D (P100 x .1)
V = -- = ------------- = P125
r .08
Determining the Rate of Return (Yield) from the Market Price
Valuation formula:
D
r = --
V
ILLUSTRATION:
A preference share has a par value of P100 and a rate of 10%. It is currently selling in the
market at P110. The rate of return (yield) would be:
D (P100 x .1)
r = -- = ------------- = 9.09%
V 110
DISCUSSION QUESTIONS:
1. What is time value of money? Explain or illustrate its concept.

2. Give the two perspectives in applying time value of money. Explain each perspective.
3. What is a present value factor? How is it being derived?
4. What is a future value factor? How is it being derived?
5. What is intrinsic value? Compare it with market value and book value.
6. How do you get the intrinsic value of an investment in bond? Illustrate cases of term and
serial bonds.
7. What is a bond yield?
8. What is the current yield? Give the formula to compute it.
9. What is the yield to maturity? Give the formula to compute it
10. What is the yield to call? Give the formula to compute it differentiate it from yield to
maturity.
11. Name the two models of estimating the true value of investment in stocks?
12. How is the discounted dividend model used in determining a stock value?
13. Illustrate the discounted dividend model in no growth and with growth situations involving
investment in ordinary shares.
14. Illustrate the discounted dividend model in situations involving preference shares.
15. How is the situation of investment in preference shares different form that of investment in
bonds?
Problems and Exercises

Test I: Choose the best possible answer.
1. Which statement is incorrect?

A. The time value of money concept is fundamental to the analysis of cash inflow and outflow
decisions covering periods of over one year.
B. When the inflation rate is zero, the present value of P1 is identical to the future value of P1.
C. Higher interest rates reduce the present value of amounts to be received in the future.
D. Starting to invest early for retirement increases the benefits of compound interest
E. If the discount (or interest) rate is positive, the future value of an expected series of payments
will always exceed the present value of the same series.
2. Which statement is false? The greater the number of compounding periods within a year,
A. the greater the future value of a lump sum investment made today
B. the smaller the present value of a given lump sum to be received at some future date.
C. the greater the annuity payment required to earn a desired amount to be received in the
future.
D. None of the above
E. All of the above
3. A peso today is worth more than a peso to be received in the future because
A. of risk of nonpayment in the future.
B. the peso can be invested today and earn interest.
C. inflation will reduce purchasing power of a future peso.
D. all of the above
E. None of the above
4. Which statement is most correct?

A. The present value (PV) of annuity due will exceed the PV of ordinary annuity (assuming all
else equal).
B. The future value (FV) of annuity due will exceed the FV of ordinary annuity (assuming all else
equal).
C. The nominal interest rate will always be greater than or equal to the effective annual interest
rate.
D. A and B are correct
5. S1: The higher the rate used in determining the future value of an annuity, the greater the future
value at the end of a period. S2: As the interest rate increases, the present value of an amount
to be received at the end of a fixed period increases.
A. both are true C. S1 is true
B. both are false D. S2 is true
C.
6. An annuity may be defined as
A. A payment at a fixed interest rate
B. A series of payments of unequal amounts
C. A series of yearly payments
D. A series of consecutive payments of equal amounts
7. Increasing the number of periods will increase all of the following except the
A. present value (PV) of P1 C. PV of an annuity
B. future value (FV) of P1 D. FV of an annuity.
8. PERRY has P750,000 in bank account as of Dec. 31, 2016. If he deposited P40,000 in the
account at the end of each next three years and the account earns 8% per annum, the amount
he will have in the account by the end of 2019 will be closest to
A. P920,000 C. P1,070,000
B. P960,000 D. P1,120,000
9. If P100,000 is placed in an account that earns a nominal 4%, compounded quarterly, what will it
be worth in 5 years?
A. P105,100 C. P120,900 E. P135,410
B. P117,480 D. P122,020
10. Bill plans to deposit P200 into a bank account at the end of every month. The bank account
has a nominal interest rate of 8% and interest is compounded monthly. How much will Bill have
in the account at the end of 2½ years? (Brigham 49)
A. P502.50 C. P6,594.88 E. P22,656.74
B. P 5,232.43 D. P6,617.77
11. What is the present value of a 5-year ordinary annuity with annual payments of P200,
evaluated at a 15% interest? (Brigham 20)
A. P670.43 C. P1,169.56 E. P1,522.64
B. P 842.91 D. P1,348.48
12. You are considering buying a new car. The sticker price is P15,000 and you have P2,000 to
put toward a down payment. If you can negotiate a nominal annual interest rate of 10% and you
wish to pay for the car over a 5-year period, what are your monthly car payments? (Brigham 40)
A. P216.67 C. P276.21 e. P318.71
B. P252.34 D. P285.78

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MODULE 2

TIME VALUE OF MONEY, AND USING IT TO VALUE BONDS

Time value of Money

Application of Time value of money

Present value analysis is known in mathematics parlance as discounting. It is a process of

Future value analysis is known in mathematics parlance as compounding. It is a process of

Time Value Factor Formulas

A. Formula to compute Future Value Factors

Where: n = no. of years

Annuity (a series of consecutive payments of equal amount)

B. Formula to compute Present Value Factors

Computation of the future value factor:

Computation of the future value factor:

Computation of the present value factor:

This formula is also equivalent to this one

Computation of the present value factor:

USING TIME VALUE OF MONEY TO VALUE BONDS AND STOCKS

Overview on Bond and Stock Valuation

The Purpose of Intrinsic Value

USING TIME VALUE OF MONEY TO VALUE BONDS

 Interest payments during the bond’s life.

PV of Principal due 12/31/20 (1,000,000 x PVF)

Obtaining the rate by trial and error:

Step 3: One can therefore conclude that 9% is the yield to maturity.

Interest rates Present value of cash inflows Difference

Step 4: To compute for the yield, the following should be made:

0 = (7034.26 + 432.2 + 469.14 +509.23 + 552.76) – (9,000)

Additional illustrations of the interpolation process:

Therefore, the yield must be between 9% and 10%.

Using the Interpolation method, the yield to maturity is 9.15%.

Therefore, the YTM after tax is = 9.15% x (1 -30%) = 6.41%

Therefore, the semi-annual yield rate must be between 8% and 9%.

Rate PV of Cash Flows

Using the Interpolation method, the yield rate is 8.51%.

YTM = 8% + 1% x (P35.11/P68.69) = 8.51%

Therefore, yield to maturity rate is (8.51% x 2) = 17.02%

3. One can therefore conclude that 10% is the yield to call.

Overview of Stock Valuation

Use of the Discounted Method

Ordinary Stock Investments

C. Supernormal or non-constant growth dividends – This is a situation where the annual

C.1 Supernormal growth then constant growth

Required: What should be the price of one share?

To find the value of this stock, take the following steps:

* D0 = dividend of year before investing; D1 = dividend of 1st year of investment; D2 =

4. Then bring the computed amount to its present value:

C.2 Supernormal growth then no growth

Required: What should be the price of one share?

To find the value of this stock, take the following steps:

3. Then bring this to its present value:

Preference Stock Investments

Determining the Rate of Return (Yield) from the Market Price

1. What is time value of money? Explain or illustrate its concept.

Problems and Exercises

1. Which statement is incorrect?

4. Which statement is most correct?

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