Chapter 3

Present values, and bond

and share valuation
 Learning Objectives
• The time-value of money.
• The financial arithmetic underlying compound interest and
discounting.
• Present value formulae for single amounts, annuities and
perpetuities.
• The valuation of bonds and shares.
 Time Value of Money
Value of money depends on when the cash flow occurs – Rs 100 now is worth more
than Rs 100 at some future time.

Reasons for this:

Personal consumption preference. Most of us have a strong preference for

immediate rather than delayed consumption.

Inflation. Under inflationary conditions, the value of money, in terms of its

purchasing power over goods and services, declines.

Risk. One hundred rupees now is certain, whereas Rs 100 receivable next year is
less certain.
FINANCIAL ARITHMETIC FOR CAPITAL GROWTH

• Simple and compound interest

• More frequent compounding and annual percentage rates
Future Value
Present Value
 Present Value
Present value of a single future sum

Year 10% 15% 20%

0 £1.00 £1.00 £1.00
5 0.60 0.50 0.40
10 0.40 0.25 0.16
15 0.24 0.12 0.06
20 0.15 0.06 0.03
25 0.09 0.03 0.01
 Valuing Perpetuity
An perpetuity is an investment paying a fixed sum each year for an indefinite period of
time (infinite series)
 Questions

Dear Students

I am 42 years old and hope to retire in 18 years. After retirement I will receive Rs
15,000 per month as monthly pension. Unfortunately my monthly living
expenses would need Rs 50,000. I have Rs 20 lacs invested in a high-quality bond
mutual fund. The after-tax return on the fund is around 5% per year. I intend to
make annual withdrawals from the fund to cover the difference between the
pension and my living expenses. How long will the money last?

Yours truly
 Questions
You own an office building. You expect the annual rental income for the building to
be Rs.10,00,000 for the next year and to increase at 5% per year indefinitely. An IT
company offers to rent the building at a fixed annual rent for 5 years. After year 5,
you may re-negotiate or rent the building to another entity. What is the minimum
fixed rental payments for this five-year agreement? Assume discount rate of 12%.
Valuing Bonds
Valuing Shares
End of chapter