Time Value of Money is a fact that the dollar one is holding today is worth

more than the dollar promised at some time in the future. This is because, one could
earn interest on the dollar during the waiting duration therefore, the dollar today
would grow into more than a dollar later. The rate of return from the investment is
one of the factor that will determine the trade-off between money today and money
later.

Formulas FV = PV (1 + r)t
PV = FV/ (1 + r)t
r = (FV/PV)1/t – 1
t = ln (FV/ PV)/ ln (1 + r)

Compound period: m
FV = PV (1 + r/m)m x t

Continuous
FV = PV x e r x t

Rule of 72
Years to double your money = 72/ r%

Relationship
t = PV given r

r = PV given t

compounding frequency = FV
 r = 4.25/12 Lump sum = r + [PV/ 1+r t]
t = 6 x 12 = 72 months

Annuity
Finite series of equal payments made at regular interval.

Ordinary Due
PVA = C [1 – 1 / (1 + r)t ] / r PVA due = C [1 – 1 / (1 + r)t ] / r × (1 + r)
FVA = C [(1 + r)t – 1] / r FVA due = C [(1 + r)t – 1] / r × (1 + r)

Growing payments PV = [C / (r - g)] x [ 1 – [(1 + g)/(1 + r)] t ]

Perpetuities
Infinite series of equal payments.

Preference shares Ordinary shares

Growing payments

PV = C / r PVA = C1 / [r - g]

Annual Percentage Rate Effective Annual Rate

(APR) (EAR)
APR = period rate % x num of period/ yr Capital gain = [(FV – PV)/PV] x 100%

APR = m [(1 + EAR) 1/m – 1] EAR = [1 + (APR/m)] m – 1

EAR cont. = e APR – 1

M = EAR
 Debt
A type of financing whereby
the company sells debt
instruments to creditors.
 Bonds - bondholders
How does it work?
Bonds are repaid along
with interest according to a
fixed schedule of payments.
Documents and rights
To potential buyers:
prospectus
To bond buyers: indenture
agreement
Legal right to be repaid
Voice in Management
Bondholders are not owners
hence they only rely on the
company’s contractual
obligation.
Equity
A type of financing whereby the company sells part
of its ownership right to investors.
 Common stocks – common stockholders
 Preferred stocks – preferred stockholders
Common stocks receive dividend when the
company declares it, depending on the financial
performance.
Preferred stocks are promised a fixed periodic
dividend payment thus, it is known as quasi-debt.
Common stockholders have pre-emptive rights
 Maintain their ownership proportion
 Protects them from dilution of ownership
 Maintain pre-issuance voting control
 Protects them against dilution of earnings
 Limited liability – will not lose any more than
invested.
Stockholders have the expectation to be repaid.
Common stockholders are the true owners of the
firm as they have the right to vote on electing the
board of directors or other issues.
Preferred stockholders represent an ownership in
the corporation but have no rights to vote.
Claims on income and assets
Senior to common and
preferred stockholder.
Bondholders’ claim on
income and asset must be
satisfied first.
Common stockholders are the last to receive any
distribution hence are called residual owners.
Preferred stockholders claim must be satisfied
first before common stockholders’

They can legally claim the

Unlike debt financing, equity stockholders do not
company’s asset because
have the legal right to be repaid because they are
an unpaid debt is the
owners therefore, the possibility of company’s
company’s liability.
financial failure in equity financing.
Therefore, there is a
possibility of company’s
financial failure.
Tax treatment and risk
Interest payment are tax Dividend payments are not tax deductible
deductible and reduces the
company’s tax liability since Common stockholders are residual owner hence,
it is the cost of doing they expect to be compensated higher due to the
business. Therefore, the higher risk that they took.
actual cost of debt is lower.
Therefore, the cost of equity is high.
Benefit
Tax benefit of debt Bankruptcy benefit of equity
Maturity
Bonds have maturity date. Common stocks are true perpetuity as it is a
When the bonds mature, the permanent form of financing.
principal payment must be  No maturity
repaid.
Preferred stocks most are not true perpetuity, it
may be called or retired.
Discuss the key differences between debt and equity.

 Debt financing is a type of financing whereby the company sells debt

instruments to creditors. Conversely, equity financing is a type of financing
whereby the company sells part of its ownership right to investors and it
consists of common and preferred stocks.
 In terms of the voice in management, creditors does not have voting rights
and only rely on the company’s contractual obligations but common
stockholders have voting rights to elect the board of directors or vote on other
issues.
 In terms of the claim on the company’s income and asset, creditors have
seniority over stockholders. creditors’ claim on income and asset must be
satisfied first before the residual are distributed to stockholders.
 In terms of financial failure risk, there is possibility of company’s financial
failure under debt financing because unpaid debt to creditors is the company’s
liability. However, equity financing does not induce this risk.
 In terms of tax treatment, interest payment to creditors are tax deductible but
dividend to stockholders are not. Therefore, the cost of debt is lower than the
cost of equity.
 In terms of maturity, bonds have maturity dates in which principal payment
must be repaid. However, stocks are perpetuities with no maturity date.

Discuss the key differences between common stocks and preferred stocks.

 The primary distinction is that common stockholders only receive dividend

when the company declares it and it depends on the financial performance
but preferred stocks are promised a fixed periodic dividend payment thus, it is
known as quasi-debt.
 In terms of voice in management, common stockholders are the true owners
of the firm as they have the right to vote on electing the board of directors or
other issues but preferred stockholders have no rights to vote as they merely
represent an ownership in the corporation.
 For this reason, unlike preferred stockholders, common stockholders have
pre-emptive rights to maintain their ownership proportion, protects them from
dilution of ownership, maintain their pre-issuance voting control and protects
them against dilution of earnings.
 In terms of claim on income and asset, preferred stockholders fixed dividend
claim must be satisfied first before common stockholders’ claim thus, common
stockholders are called residual owners.
 Common stocks are true perpetuity as it is a permanent form of financing but
preferred stocks most are not true perpetuity, it may be called or retired.
Discuss the key differences between debt and preferred stocks.

 Bonds are promised a fixed schedule of periodic interest payments. Similarly,

preferred stocks are promised a fixed periodic dividend payment thus, it is
known as quasi-debt.
 When the bonds mature, the principal payment must be repaid, but preferred
stocks do not have maturity date and will not be repaid.
 Bondholders are not owners of the corporation but, preferred stockholders do
represent an ownership in the corporation.
 Bondholders’ claim on the corporation’s income and asset must be satisfied
first before preferred stockholders.
 Interest payments to bondholders are tax deductible and reduces the
company’s tax liability however, the dividend pay to the preferred stockholders
are not tax deductible.

Why is debt financing cheaper than equity financing?

 The cost of debt financing, which is the interest paid to bondholders are tax
deductible thus, reduces the company’s tax liability since it is the cost of doing
busiess. Conversely, the cost of equity financing, which is the dividend paid to
stockholders are not tax deductible.
 Furthermore, the issuing and transaction cost to raise and service debts are
cheaper than those for common stocks.
 Moreover, since common stockholders are residual owners with higher risk
than bondholders, they expect a higher rate of return to compensate them.
 Therefore, the cost of debt financing is cheaper than equity financing.

How do venture capitalists reduce the risk of their investment?

 Venture capitalists provide funding in stages to allow themselves to reassess

and reevaluate the project, the company’s financial performance, the
management team periodically and to take necessary corrective measures
throughout the project period.
 Venture capitalists require the entrepreneur to make significant personal
investment into the company to ensure that they are highly committed and
motivated to achieve success.
 Bond
Par Value Principle amount

Coupon Stated interest payment

Coupon rate Percentage of coupon payment from principle amount

= Annual coupon/ Par value

YTM Rate of return required in market

= Current yield + capital gain yield

 capital gain yield = B1 – B0 / B0

Bond Yield = Actual rate per period x number of periods

Current Yield = Annual coupon/ Bond price

Bond Price = C [1 – 1/(1 + YTM) t ]/ YTM + FV/ (1 + YTM) t

= PV annuity + PV lump sum

 semi-annual
 C=
 YTM =
 FV =
 T=
Bond price = C [1 – 1/(1 + YTM) t ]/ YTM + FV/ (1 + YTM) t
Bond types Par = YTM = Coupon rate = Par value = Bond price

Discount = YTM > Coupon rate = Par value > Bond

price

Premium = YTM < Coupon rate = Par value < Bond

price

Company is offering a higher return (coupon rate) than the market (YTM)
Relationship YTM = PV of remaining cash flow = Bond Price

r = PV = Bond Price
Sensitivity interest rate risk: bond price change more

 Long term bonds

 Low coupon rate bonds

Stock
Why valuing common stock is difficult than bond or preferred?
 The uncertainty of the size and timing of the dividends as compared to bond
coupon payments because dividends would usually depend on the company’s
earnings and when they declare it.
 The inability to directly observe the rate of return of common stock from the
market.
 The absence of maturity date because common stocks are true perpetuities.

Zero growth rate Constant dividend every payment

Preference shares  Regular interval forever

Perpetuity formula:
E.g. paid 20 years from now
P0 = D/R P19
P0 = Pt / (1 + R) t P0
P0 = D1 + P1 / (1 + R) P0

Constant growth Increased dividend by constant percent

rate
Growing perpetuity model:
Ordinary shares
P0 = D0 (1 + g)/ (R – g)
P0 = D1/ (R – g)
Pt = Dt+1/ (R – g)
Pt = P0 ( 1 + g)t Price grows at the same rate with dividend

Dt = D0 (1 + g)t
Dt = D1 (1 + g)t – 1
 Pt = Dt + 1 / (R – gconstant)

Implied return: Price grows at the same rate with

dividend
Pt = P0 ( 1 + implied return)t

Mixed growth rate Supernormal growth or non-constant growth

Ordinary shares  Initially not constant, eventually constant

Multistage model:
1. Compute dividends until growth levels off
Dt = Dt – 1 (1 + g)

2. Find expected future price

Pt - 1 = Dt / (R – g)

3. Find PV0 of expected future cash flows

P0 = D1/ (1 + R1) + D2/ (1 + R1)2 + Dt/ (1 + R1)t + Pt/ (1 + R1)t

R, rate of return DGM:

R = [ D0 (1 + g)/ P0 ] + g
R = [ D 1 / P0 ] + g
R = dividend yield + capital gains yield

Dividend yield: percentage return investor expect to earn

from the stock’s dividend
[ D1 / P0 ]

Capital gains yield: (growth rate) rate at which the

investment value grows
g = (P1 + P0)/ P0
Relationships Growth rate > discount rate = dividend PV and Price
Dividend growth rate = Share price growth rate
Required return = Stock price
The required return and stock price have an inverse
relationship. The higher the required return, the lower
the stock price and vice versa. This is the time value
of money function whereby, a higher discount rate will
lower reduce the present value of the cash flows.

Mixed required return rate

 D0 = 2.65
 g = 3.8
 R = 15 (3yrs), 13 (3yrs), 11

Step 1

D1 = 2.65 (1.038) = 2.7507

D2 = 2.7507 (1.038) = 2.8552
D3 = 2.8552 (1.038) = 2.9637

D4 = 2.9637 (1.038) = 3.0763

D5 = 3.0763 (1.038) = 3.1932
D6 = 3.1932 (1.038) = 3.3146

D7 = 3.3146 (1.038) = 3.4405

Step 2

P6 = 3.4405/ (0.11 – 0.038)

P6 = $47.79

P3 = 3.0763/ (1.13) + 3.1932/ (1.13)2 + 3.3146/ (1.13)3 + $47.79/ (1.13)3

P3 = $40.64

P0 = 2.7507/ (1.15) + 2.8552/ (1.15)2 + 2.9637/ (1.15)3 + $40.64/ (1.15)3

P0 = $33.22

No dividend growth given

 D0 = 2.75
 R = 11%

D1 = 2.75 + 4.50 = 7.25

D2 = 7.25 + 4.50 = 11.75
 D3 = 11.75 + 4.50 = 16.25
D4 = 16.25 + 4.50 = 20.75
D5 = 20.75 + 4.50 = 25.25

P0 = 7.25/1.11 + 11.75/ 1.112 + 16.25/ 1.113 + 20.75/ 1.114 + 25.25/ 1.115

P0 = $56.60

Dividend vs Investment growth

The trade-off between retained earnings
 Reduce the dividend payout and invest more (only if firm’s investments are NPV
positive projects)
 Reduce investment and increase the dividend payout

EPS = (Earnings/ Shares outstanding)

EPSt = EPS0 (1 + g)

Dt = (EPSt) x Dividend payout rate

P0 = Dt / (R – g)

Shares repurchase
The trade-off between retained earnings
 Repurchase shares to increase EPS and dividend payout
 Pay dividend

PV (Future total dividends and repurchase) = dividend payout/ (R – g)

P0 = PV (Future total dividends and repurchase)/ Shares outstanding