Equity - Valuation - Topics On Finance

Equity Valuation
Equity Valuation
What is Equity?
What is Equity?
Equity represent ownership on business
Give right to earnings after tax and residual
interest to assets after all liabilities has been
met.
Give right to participate in the growth and
profitability of the business.
Equity Valuation
What are Equity Securities?
Represent ownership on the entity
Include common and preferred shares
Have no specified maturity date, and since the
entity has a life separate and apart from its
owners, equities are treated as investments with
infinite life
Equities may pay dividends from after-tax earnings
at the discretion of the board of directors
Common shares give rise to the following rights:

Rights to residual earnings after-tax (after all legal obligations
to other claimants have been satisfied)

Rights to residual assets upon dissolution/liquidation

Have control over the corporation through voting rights to
elect board of directors, accept financial statements, appoint
auditors and approve major issues such as takeovers and
corporate restructuring
Preferred Shares have some preference over the common share
class.

Have a right to a fixed annual dividend (not legally enforceable by
shareholders if dividends are not declared)
Have prior claim to dividends and assets over the common shares
Non-voting rights except if dividends are seriously in arrears
Often have a cumulative feature (dividends in arrears must be paid
before common shareholders can receive dividends)
Often called a fixed income investment because the regular annual
dividend is fixed (set) at the time the shares are originally issued.

Equity Valuation
What is Valuation?
What is Valuation?
Valuation is the art/science of determining
what an assets/security is worth.

The value of a security or asset is going to
depend on the asset pricing model,
assumptions and bias.
What is Valuation?
If there is no market for buying and selling shares,
valuation is a need.

But, if there is a market price, IS VALUATION A NEED?

As markets are not perfects, assets get mispriced.

If assets are mispriced, there is a need for valuation and
an opportunity to make profits.

Valuation give a foundation for deciding whether to buy
or sell. When we compare the market price against the
value, we can say whether a security is over or
undervalue.

Equity Valuation
Misconceptions about Valuation
Misconceptions on Valuation
A VALUATION IS AN OBJECTIVE SEARCH FOR
TRUE VALUE
All valuations are biased. The only question is how
much and in which direction

The direction and magnitude of the bias in your
valuation is directly proportional to who pays you
and how much you are paid.
THE MORE QUANTITAVE A MODEL, THE
BETTER THE VALUATION
Ones understanding of valuation is inversely
proportional to the number of inputs required for
the model.

Simpler valuation models do much better than
complex ones.
A GOOD VALUATION PROVIDES A PRECISE
ESTIMATE OF VALUE
There are no precise valuations, only good or bad
estimates.

A valuation without risk analysis is a bad one.

Risk Analysis provides a range of possible values
(maximum, minimum, mean, standard deviation,
probability distributions)
Equity Valuation Models
Equity
Valuation
Market Price
Accounting
Based Models
Book Value
Asset
Replacement
Cost
Discounted
Models
FCFE
Dividends
Residual
Income
RelativeValuation
Models
Price Earning
Ratio (PER)
I. VALUATION METHODS

A .MARKET VALUE METHOD
This valuation method is appropriate for quoted firms. The market value per share is the the
price for which the share can be sold on the market. The total market value of the shares of a firm is
equal to the number of outstanding shares times the price per share.

B. BOOK VALUE METHOD
This method relies on accounting data included in the firms balance sheet. The book value per
share is equal to the total shareholderss equity, after subtracting the claims of preferred
shareholders, divided by the number of shares outstanding.

BV= Total shareholders equity- preferred shares
Number of ordinary common stock shares

A major disadvantage of this method is the lack of consideration of a firms earnings potential.

C. ASSET VALUE METHOD
The asset value method considers an actual market value that could be obtained if the firms
assets are sold and then calculates the residual value after creditors and preferred stockholders are
paid. The residual value is available for distribution to ordinary shareholders and the value of a share
is calculated by dividing the residual value by the number of outstanding common shares. This
method does not take into account the earnings potential of the firm.

MARKET VALUE METHOD

The market value per share is the the price for
which the share can be traded on the market.

The total market value (market capitalization) of
the shares of a firm is equal to the number of
outstanding shares times the price per share.

This valuation method is appropriate for listed firms
(firms registered on stock exchanges).

BOOK VALUE METHOD

This method relies on accounting data included in
the firms balance sheet.

The book value per share is equal to the total
shareholderss equity, after subtracting the claims of
preferred shareholders, divided by the number of
shares outstanding.

A major disadvantage of this method is the lack of
consideration of a firms earnings potential.

Shares Common g Outstandin of Number
Shares Preferred - Equity rs Shareholde
= BV
LIQUIDATION METHOD

This method relies on accounting data included in
the firms balance sheet.

The book value per share is equal to the total
shareholderss equity, after subtracting the claims of
preferred shareholders, divided by the number of
shares outstanding.

A major disadvantage of this method is the lack of
consideration of a firms earnings potential.

Shares Common g Outstandin of Number
Shares Preferred - Equity rs Shareholde
= BV

C. ASSET VALUE METHOD
The asset value method considers an actual market value that could be obtained if the firms
assets are sold and then calculates the residual value after creditors and preferred stockholders are
paid. The residual value is available for distribution to ordinary shareholders and the value of a share
is calculated by dividing the residual value by the number of outstanding common shares. This
method does not take into account the earnings potential of the firm.

EXAMPLE:

1.Total market value of assets( excluding goodwill)= $ 3,500,000
Total debt = $ 2,500,000
Number of outstanding shares = 2,000,000
Book value of assets = $ 4,000,000

2. Goodwill = $ 2,000,000
Life of goodwill= 4 years
Annual goodwill= $ 500,000
k = 10%

3.PV of goodwill= 500,000x PVIFA
10% ,4

= 500,000x 3.1699
= $ 1,584,950

4. Value of equity= (4,000,000+ 1,584,950)- 2,500,000
= $ 3,084,950
Book value per share = 3,084,950/ 2,000,000
= 1.54

5. Asset value per share= 3,500,000+ 1,584,950 2,500,000
2,000,000
= 1.29 pounds
D. PRICE EARNINGS METHOD
This method assumes that a firms earnings after taxes are valued in the same
way as those of the industry to which the firm belongs. If the industry P/E ratio is
obtained, the market value per share is:

Market value per share= Industry P/E ratio x Expected earnings per share (EPS
)of the firm

This method is believed to provide a better valuation approach than the book
value and asset value methods because it implicitly takes into account the firms
expected earnings. EPS reflects the current position but does not reflect the
future consequences of some expenditures like R&D.

E.DISCOUNTED CASH FLOW METHODS
The appropriate model used in valuation is the one that focuses on the
cash-flow consequences of the firms decisions for the future, not just current
period, because this is how the investors value the investments.
E.I. Dividend Valuation Method
The dividend valuation model is appropriate for firms:
1.that pay dividends
2.that have relatively slow and constant growth rate in earnings
3.that have relatively constant payout ratio
4.that maintain a relatively constant capital structure
5.that are expected to continue on to the indefinite future rather than to merge with some other
company

This method has two assumptions:
1.Time is divided into yearly intervals.All the cash flows associated with an ordinary share are paid
annually at the end of each year.
2. The risks ( business and financial) that accompany a firms shares are incorporated in the investors
required rate of return.

A. One-year DVM:
Shares are purchased at the beginning of the term and held for one year:
P
0
= D
1
+ P
1

(1+k)
1
(1+k)
1
B. T-year DVM:

n
P
0
= D
t
/ (1+k)
t
+ P
t
/ (1+k)
t
t=1

P0 is the intrinsic or theoretical value of the stock as seen today by the investors doing the analysis.It
is based on the investors estimate of the expected dividends and the riskiness of the dividend stream.
While the market price is fixed and is the same for all investors, intrinsic value can differ among
investors depending on how optimistic they are regarding the company.The intrinsic value can be
below or above the market value.We think of a group of marginal investors whose actions
determine the market price.For these marginal investors the intrinsic value should equal the market
price.

In a competitive capital market where investors are assumed to share the same accurate
information, the intrinsic value of a share is equal to its market price.In such a market, the investors
expectations about the risk and return asociated with the future cash flows from a share determine
the current price of a share.Therefore, if the market is efficient, investors can only expect to earn a
return commensurate with the risk associated with the future cash flows.

Some important points about the T-year model:
1.If a firm pays no current dividends, its share price is not zero because investors believe that either
the firm will pay dividends at some future point in time or they expect to realize something which
is as good as dividend payments( e.g. capital gains).

2.Since the T-year valuation model calculates the intrinsic value of existing shares, the expected
dividends are related to the existing shares only.If the company issues additional shares near the
end of the year which are entitled to a dividend payment, then the current intrinsic value should
not include the dividends paid to a new share.

Small privately held companies and newly public firms do not meet the specifications mentioned
above , so DVM is not appropriate for these firms.Moreover, this model can not be applied to parts
of the firm such as subsidiaries and divisions.So a cash flow model for valuing the entire corporation
or divisions is developed.
E.2. FREE CASH FLOW (FCF) VALUATION MODEL

Value of the firm= Present value(PV) of operating assets+ PV of
nonoperating assets+ PV of growth options
= PV of free cash flows+ PV of assets at balance
sheet values + option pricing model

Present Value of Operating Assets= PV of projected free cash
flows+ PV of terminal value

II. FREE CASH FLOW METHOD OF VALUATION

To judge managerial performance , we must compare managers ability to generate
operating income(EBIT) with the operating assets under their control.

Free cash flow:
Free cash flow is the cash flow actually available for distribution to investors after the
company has made all the investments in fixed assets or working capital necessary to
sustain the ongoing operations.The value of the company is determined by the stream of
cash flows that the operations will generate now and in the future.The value of the
company depends on all the expected free cash flows defined as after tax operating
income minus the amount of investment in working capital and fixed assets necessary to
sustain the business.
A.MODIFYING ACCOUNTING DATA

To judge managerial performance , one must compare managers ability to generate operating
income (EBIT) with the operating assets under their control.

Assets are decomposed into operating assets and non-operating assets. Operating assets are further
decomposed into working capital and fixed assets.

A.1 Operating assets include cash, accounts receivable, inventories and fixed assets. Since inflows and
outflows of cash do not coincide perfectly, a company must keep some cash in its account. Some cash
is needed to conduct operations. However, any short-term securities the firm holds generally result
from investment decisions made by the treasurer and are not used in the core operations. Large
holdings of marketable securities are held as a reserve for some contingency or else a temporary
parking place for funds prior to an acquisition or investment program Therefore, short-term
investments ( marketable securities) are normally excluded when calculating net operating working
capital.If the marketable securities are held as a substitute for cash and reduce the cash
requirements, they may be classified as part of operating working capital.

Some current liabilities- accounts payable and accruals- arise in the normal course of
operations.Funds raised from these sources determine the sources that the company does not have
to raise from investors to acquire current assets. Therefore, when finding the net operating working
capital, we deduct accounts payable and accruals from the operating current assets.Notes payable to
banks are treated as investor-supplied funds and are not deducted.

A.2.Non-operating assets would include cash and short-term investments above the level required for
normal operations; investments in subsidiaries, land held for future use and the like.
B. Those current assets used in operations are called operating
working capital.Operating working capital less accounts payable and
accruals is called net operating working capital.

Net operating working capital=All current assets that- All current
do not pay interest liabilities
that do not
charge
interest

Net operating working capital is the amount of working capital
acquired with investor supplied funds.

If a manager generates a given amount of profits and cash flows
with a relatively small amount of investment in operating assets,
this reduces the amount of capital to be invested and increases the
rate of return on that capital.
C. Free Cash Flow Estimation

Total Operating Capital (TOC) = Net Operating Working Capital+ Operating Fixed
Assets
Free Cash Flow= (EBIT Taxes) ( Additional net operating working capital
investment+ new investments in operating fixed assets)

Free Cash Flow=NOPAT- Total Operating Capital

The free cash flows can be used in several ways:
1.Pay interest to debtholders
2. Pay-off some debt
3.Pay dividends to shareholders
4.Repurchase stock from shareholders
5.Buy marketable securities or other nonoperating assets

Or combine these so that the net cash flow from these activities is equal to FCF.

The value of operations of a company depends on the present value of its expected future free cash flows
discounted at the companys weighted average cost of capital.

n
V= FCF
t
/ (1+k)
t
+ TV
t
/ (1+k)
t
t=1

V= value of the firm
FCF
t
= Free cash flow in period t
TV
t
= Terminal value of investment in period t
k= weighted average cost of capital of the firm
FIN 2808, Spring 10 - Tang Chapter 18: Equity Valuation
Accounting Based
Valuation Methods
Book Value

Liquidation Value

Replacement Cost

CHAPTER 7 Equity
Valuation
7 - 30
Valuation of Equity Securities
Risk-Premium Approach
Valuation of equities can follow a discounted
cash flow approach
The discount rate used reflects current level of
interest rates (based on the risk-free rate) plus
a risk premium
This relationship is expressed as:
Premium Risk RF+ = k
[ 7-1]
CHAPTER 7 Equity
Valuation
7 - 31
Valuation of Equity Securities
Risk-Premium Approach

The risk-free rate is equal to the rate from a default free asset/security

The risk premium is based on an estimate of the risk associated with the
security.
Premium Risk RF+ = k
[ 7-1]
Equity Valuation
CHAPTER 7 Equity Valuation 7 - 33
Common Share Valuation
Discount Models
All discount valuation models estimate the current economic value of any
security as the sum of the discounted (present) value of all promised future
cash flows.

The current value is therefore a function of the timing, magnitude and
riskiness of all future cash flows:

=
+
=
+
+ +
+
+
+
=
n
i
i
i
n
n
k
Flow Cash
k
Flow Cash
k
Flow Cash
k
Flow Cash
V
1
2
2
1
1
0
) 1 (

) 1 (
...
) 1 ( ) 1 (
Discount Models
In the case of common stock the cash flows of a going-concern business are
expected to go on in perpetuity (forever).

The purchaser exchanges the price she/he paid for the investment at time 0
with a possible series of future cash flows.

Risk is factored into the equation through k (investors required return)
=
+
=
+
+ +
+
+
+
=
o
o
o
1
2
2
1
1
0
) 1 (

) 1 (
...
) 1 ( ) 1 (
i
i
i
k
Flow Cash
k
Flow Cash
k
Flow Cash
k
Flow Cash
V
Discount Models

The formula can be illustrated graphically as follows:
=
+
=
+
+ +
+
+
+
=
o
o
o
1
2
2
1
1
0
) 1 (

) 1 (
...
) 1 ( ) 1 (
i
i
i
k
Flow Cash
k
Flow Cash
k
Flow Cash
k
Flow Cash
V
V
0
= Market Price Paid $
CF
1
CF
2
CF
3
CF

0
1 2 3
Discount Models

Remember, the amount and timing of future dividends (if that is the cash flow
you are using) is highly uncertain for most businesses because dividends are
not fixed obligation of the firm, but rather are declared at the discretion of the
board of directors, when, and if the firm is profitable, and doesnt have other
uses for the cash.
=
+
=
+
+ +
+
+
+
=
o
o
o
1
2
2
1
1
0
) 1 (
) 1 (
...
) 1 ( ) 1 (
i
i
i
k
Flow Cash
k
Flow Cash
k
Flow Cash
k
Flow Cash
V
CHAPTER 7 Equity
Valuation
7 - 37
Common Share Valuation using DDM
The Basic Dividend Discount Model Intrinsic Value Estimate

The DDM says the intrinsic value or inherent
economic worth of the stock is equal to the sum
of the present value of all future dividends to be
received.
n
c
n
c c
k
D
k
D
k
D
P
) 1 (
...
) 1 ( ) 1 (
2
2
1
1
0
+
+ +
+
+
+
=
[ 7-4]
CHAPTER 7 Equity
Valuation
7 - 38
Equity Valuation using DDM
Fundamental Analysts and the Basic Dividend Discount Model
Security analysts that use the DDM model are called FUNDAMENTAL
ANALYSTS because they base the estimate of inherent worth on the
economic fundamentals of the stock.

Once they have estimated the inherent worth, they compare their
estimate with the actual stock price in the market to determine
whether the stock is UNDER, OVER, or FAIRLY valued.
=
+
=
+
+ +
+
+
+
=
o
o
o
1
2
2
1
1
0
) 1 ( ) 1 (
...
) 1 ( ) 1 (
t
t
c
t
c c c
k
D
k
D
k
D
k
D
P
CHAPTER 7 Equity
Valuation
7 - 39
Equity Valuation using DDM
The Constant Growth DDM
When the firms dividends are growing at a slow, constant rate, and
reasonably can be expected to do so for the foreseeable future, we
use the constant growth dividend discount model.

Which can be simplified by multiplying D
0
by a factor of (1+g)/(1+k
c
)
every period to get:
o
o
) 1 (
) 1 (
...
) 1 (
) 1 (
) 1 (
) 1 (
0
2
2
0
1
1
0
0
c c c
k
g D
k
g D
k
g D
P
+
+
+ +
+
+
+
+
+
=
[ 7-6]
g k
D
g k
g D
P
c c

=
+
=
1 0
0
) 1 (
[ 7-7]
Estimating the Required Rate of Return
The Constant Growth DDM can be reorganized to solve for the investors
required return

This formula can be decomposed into two components, demonstrating that
equity investors receive two forms of prospective income from their
investment, dividends and capital gains.
g
P
D
k
c
+ =
0
1
[ 7-8]
| | | | | | Yield Gain Capital Yield Dividend Current

0
1
+ = +
(
= g
P
D
k
c
CHAPTER 7 Equity
Valuation
7 - 41
Estimating the Value of Growth Opportunities
Assuming the firm has no profitable growth opportunities g should be equal
to 0, and D
1
=EPS
1

The Constant Growth DDM reduces to:

Therefore, the share price of any constant growth common stock is made up
of two components:
The no-growth components and
The present value of growth opportunities

This can be expressed as:

(See the following slide)
c
k
EPS
P
1
0
=
[ 7-9]
CHAPTER 7 Equity
Valuation
7 - 42
Constant Growth DDM Two
Components
Estimating the Value of Growth Opportunities

Decomposing the constant-growth DDM into its two
components gives us an analytical tool to examine the
two sources of current value of the firm.
| | | | ies opportunit growth of value present component growth no
PVGO
k
EPS
P
c
+ =
+ =
1
0
[ 7-10]
Examining the Importance of the Growth Assumption

The formula assumes that the growth rate will remain the same in period 1
through infinity.
This is a very long period of time
It assumes a compound growth rate
...
3 2 1 o
g g g g = = = =
g k
D
P
c

=
1
0
[ 7-7]
Time
Earnings
5% growth rate

CHAPTER 7 Equity
Valuation
7 - 44
Examining the Importance of the Growth Assumption

The formula assumes that the growth rate will remain the same in
period 1 through infinity.
This is a very long period of time
Because of compounding over time, small changes in g will have dramatic
effects on the estimated stock value today.
If g is assumed to be greater than k
c
a non-sense answer would result. In
practice this could never happen because no company can continue to
grow at compound rates of return to infinity at a rate that exceeds the
long-term rate of growth in the economy.
g k
D
P
c

=
1
0
[ 7-7]
CHAPTER 7 Equity
Valuation
7 - 45
Examining the Inputs of the Constant Growth DDM

The formula predicts stock price increases if:
D
1
is increased
g is increased
k
c
is decreased
Conversely, the formula predicts stock price increases if:
D
1
is decreased
g is decreased
k
c
is increased

g k
D
P
c

=
1
0
[ 7-7]
CHAPTER 7 Equity
Valuation
7 - 46
Estimating DDM Inputs Sustainable Growth
Sustainable growth can be estimated using the
following equation:

Where: b = the firms earnings retention ratio
= (1 firms dividend payout ratio)
and

ROE = firms return on common equity
= net profit/common equity

ROE b g =
[ 7-11]
Clearly, the value of the firm will rise if the firm retains and
reinvests its profits at a rate of return (ROE) greater than k
c
Under such conditions, g increases more than k
c
CHAPTER 7 Equity
Valuation
7 - 47
Estimating DDM Inputs Sustainable Growth

Decomposing ROE using the DuPont system allows managers to see
how they can increase the value of the firm:
increase the profit margin on sales
Increase the turnover rate on sales
Leverage the firm using less equity and more debt (although use of more debt
implies higher risk and the benefits may be offset by a higher k
c
)

ROE b g =
[ 7-11]
Ratio Leverage Ratio Turnover Margin Profit Net
Equity
Assets Total
Assets Total
Sales

Sales
income Net
ROE
=
=
[ 7-12]
The Multiple Stage Growth Version of the DDM
Firms with earnings that are
growing rapidly (more rapid
than the general rate of
economic expansion) require
another approach.
Remember, no firms growth
in earnings can exceed the
general rate of economic
expansion foreverat some
point, earnings growth will
fall.
...
5 4 3 2 1 o
g g g g g g = = = = > >
Time
Earnings
g
1
= 50%
g
2
= 30%
g
3
= g
4
= g
=4%
CHAPTER 7 Equity
Valuation
7 - 49
Multiple Stage Growth Version of DDM
The Cash Flow Pattern for Multiple Stage Growth in Dividends
t
c
t t
c c
k
P D
k
D
k
D
P
) 1 (
...
) 1 ( ) 1 (
2
2
1
1
0
+
+
+ +
+
+
+
=
[ 7-13]
7-2 FIGURE

0 1 2 t t +1

D
1
D
2
D
t
D
t+1

Growth rate long-term growth rate (g) Growth rate = g from t to
g k
D
P
c
t
t
=
+1
CHAPTER 7 Equity
Valuation
7 - 50
Multiple Stage Growth Version of DDM
Using Multiple Stage Growth Version of the DDM
Predict each dividend during the high growth years
Predict the first dividend during the constant growth years
Discount the individual dividends to the present and sum together with the
price at time t when the constant growth model is used.

The following is the formula you would use for two years of high earnings
growth followed by a constant growth in years three through infinity.
2
2
2
2
1
1
2
3 2 1 0
2
2 1 0
1
1 0
0
) 1 ( ) 1 ( ) 1 (
) 1 (
) 1 )( 1 )( 1 (
) 1 (
) 1 )( 1 (
) 1 (
) 1 (
c c c
c
c
c c
k
P
k
D
k
D
k
g k
g g g D
k
g g D
k
g D
P
+
+
+
+
+
=
+
+ + +
+
+
+ +
+
+
+
=
Example of Two-stage DDM
Using a Spreadsheet Modeling Approach

Forecast Assumptions:
Investors required return = k = 10.9%
Most recent dividend per share = D
0
= $0.25
Growth rate in first year = g
1
=14.8%
Growth rate in second year= g
2
= 10%
Growth rate in years three through infinity = g
3-
= 5%
Time
Dividend / Price
Calculation
Dividend
/Price
Present
Value
Factor
Present
Value
1 $0.25 X (1+.148) = $0.29 0.901713 $0.26
2 $0.287 X (1+.1) = $0.32 0.813087 $0.26
2 P(2) = D(3)/ (.109 - .05) = $5.62 0.813087 $4.57
Intrinsic Value Estimate = $5.08
08 . 5 $
) 109 . 1 (
62 . 5 $
) 109 . 1 (
32 . 0 $
) 109 . 1 (
29 . 0 $
) 109 . 1 (
05 . 109 .
) 05 . 1 )( 1 . 1 )( 148 . 1 ( 25 . 0 $
) 109 . 1 (
) 1 . 1 )( 148 . 1 ( 25 . 0 $
) 109 . 1 (
) 148 . 1 ( 25 . 0 $
) 1 ( ) 1 ( ) 1 (
2 2
2 2 1
2
2
2 1
0
= + + =
+

+
+
+
+
=
+
+
+
+
+
=
c c c
k
P
k
D
k
D
P
CHAPTER 7 Equity
Valuation
7 - 52
Constant Growth DDM
Limitations of the DDM
The Model predictions are highly sensitive to
changes in g and k
c

Not helpful in valuing non-dividend paying firms.
g k
D
P
c

=
1
0
[ 7-7]
CHAPTER 7 Equity
Valuation
7 - 53
Constant Growth DDM
Best Application of the Constant Growth DDM
Use of the Model is best suited to:
Firms that pay dividends based on a stable dividend
payout history that are likely to maintain that practice
into the future
Are growing at a steady and sustainable rate.

This model works for large corporations in mature
industries such as banks and utility companies.
CHAPTER 7 Equity
Valuation
7 - 54
Summary and Conclusions
In this chapter you have learned:
Basic approaches to valuing preferred and
common shares including:
Dividend discount models
Relative valuation models
The importance of recognizing the
sensitivity of the valuation process to
assumptions regarding input variables such
as growth rates, discount rates and general
market conditions.
A Review on Time Value of Money
Overview*
In order to estimate the value of a firms projects and
assets, we must compare futures cash flows

This comparison is complicated by the fact that they
occur:

at different points in time

in different currencies, or

with different risks

*
Costs and Benefits
Example: Suppose you are offered the
following investment opportunity.
In exchange for $20,000 today, you will receive
200 shares of stock in the Coca-Cola Company today,
and
11,000 euros today.
Should you take this opportunity? Assume:
The current price of Coca-Cola is $40 and,
the current exchange rate is 0.80 euros per dollar.

Overview: Example (cont.)
Example (cont.). We need to convert the costs
and benefits to their cash values:

(200 shares Coca-Cola)x($40/sh)=$8,000 today

(11,000 euros) (0.80 euros/dollar) =$13,750 today

The net value of the opportunity is

$8,000 + 13,750 20,000 = $1,750 today.

Interest Rates
For most financial decisions, costs and
benefits occur at different points in time.
Typical investment projects incur costs upfront
and receive benefits in the future.
How do we account for this time difference when
valuing a project?

The Time Value of Money
Consider an investment opportunity with the
following cash flows:
Cost: $100,000 today
Benefit: $105,000 in one year
In general, money today is not the same as money in
one year.
If you have $1 today, you can invest it (for example, in a
bank account) and end up with more than $1 in one year.
We call the difference in value between money today
and money in the future the time value of money.
Interest Rates
By investing money at the bank, we can convert
money today into money in the future.
Similarly, by borrowing money from the bank, we can
exchange money in the future for money today.
The rate at which we can exchange money today for
money in the future by investing or borrowing is
determined by the current interest rate.
An interest rate is like an exchange rate across time.
Interest Rates
Lets evaluate the prior investment
opportunity, assuming the current annual
interest rate is 7%.
We can express both costs and benefits in
dollars one year from today:
Cost:
($100,000 today) x($1.07 in one year/dollar today) =
$107,000 in one year.
Benefit: $105,000 in one year.
Net: $105,000 107,000 = -$2000 in one year.

Interest Rates
Alternatively, we may express the value of this
investment in dollars today:
Cost: $100,000 today
Benefit: ($105,000 in one year) ($1.07 in one
year/dollar today) = $98,130.84 today
Net: $98,130.84 100,000 = -$1,869.16 today
Comparing our results, they are equivalent:
(-$1,869.16 today)($1.07 in one year/dollar today)
= -$2,000 in one year
Time Value of Money Rules

We refer to a series of cash flows lasting several
periods as a stream of cash flows.
Every stream of cash flows can be represented on a
timeline.
Financial decisions often require combining cash
flows or comparing values. To do so:
First: It is only possible to compare or combine
values at the same point in time.
A dollar today is worth more than a dollar in the future,
because you can invest it and earn interest.
Money at different points in time has distinctly different
values.

Second: To move a cash flow forward in time, you
must compound it.
Example: The current interest rate is 10% per year,
and you have $1000 today to invest for 2 years.
On a timeline:

During the first year you earn $100 in interest, but
during the second year you earn more.
Compound interest: earning interest on interest.

0
$1000
2
$1210
1
$1100
1.10 1.10
The value of a cash flow that is moved forward
in time is its future value (FV).
The future value (FV) of a cash flow today (C) at
an interest rate r, n periods in the future is
FV
n
=C(1+r)
n
Example: You have $500 today, and the interest rate
is 4% per year. What is the future value of this cash
flow 3 years from today?
FV
n
=C(1+r)
n
=500(1+.04)
3
=$562.43

(100)(1+.05)
190
= $1,061,614
Third: To move a cash flow back in time, we discount
it.
The interest rate we use is therefore also called the
discount rate.
Suppose you anticipate receiving $1000 two years
from today, you can work backward by dividing by
(1+r) each year.

1.10
0
$826.45
2
$1000
1
$909.09
1.10
In general, to move a cash flow C backward n
periods at an interest rate of r per period,
compute its present value (PV):
PV=

Example: A bond will pay $15,000 in ten years. If
the interest rate is 6% per year, what is the bond
worth today?
PV=

(1 )
n
C
r +
10
15, 000
$8375.92
(1 .06)
=
+
Valuing a Stream of Cash Flows
Consider a stream of cash flows: C
0
at date 0, C
1
at
date 1, and so on up to C
N
at date N.
We represent this cash flow stream on a timeline:

To compute the present value of this cash flow
stream, we
Compute the present value of each individual cash flow.
Once the cash flows are in common units (dollars today),
we can combine them.
N
C
N

0
C
0

2
C
2

1
C
1

Present Value, Net Present Value
The Present Value (PV) is

The Net Present Value (NPV) is

NPV Rule: If the NPV is positive, undertake the
project.

1 2
2
...
(1 ) (1 ) (1 )
N
N
C C C
PV
r r r
= + + +
+ + +
1 2
0
2
(1 ) (1 ) (1 )
N
N
C C C
NPV C
r r r
= + + + +
+ + +
Example
Suppose a project will produce $50,000 after 1
year, $10,000 after 2 years, and $210,000 after 4
years.
It costs $200,000 today to invest.
The interest rate is 9% per year.
The NPV of this project is

2 4
50, 000 10, 000 210, 000
200, 000 0 3, 057.65
1.09 (1.09) (1.09)
NPV = + + + + =
A Lecture on Equity Valuation based on
Disocunted Cash Flow Model
1 2
3 4
Market Prices and Arbitrage
The practice of buying and selling equivalent
goods in different markets to exploit a price
difference is called arbitrage.
If you can earn a positive profit with no net
investment and no risk, you have an arbitrage
opportunity.
Traders will react quickly to an arbitrage
opportunity, and prices will adjust.
Assets must be priced in financial markets to
rule out arbitrage (the Law of One Price).
Market Prices and Arbitrage
The market price of an asset must equal its present
value.
Example: Suppose you can borrow or lend at 10%.
Assume the market price of a one-year bond with a
FV of $110 is $98.

The price of this bond is less than its present value.
There is an arbitrage opportunity.
110
$100
(1 .10)
PV = =
+
Example (cont.)
To arbitrage this opportunity, we
1.) buy the bond
2.) borrow $100 for one year.

Example (cont.)
To arbitrage this opportunity, we
1.) buy the bond
2.) borrow $100 for one year.
The cash flows from this strategy today and at the
end of one year are:
Today One Year
Buy the bond -98 +110
Borrow $100 (1 yr) +100 -110
Net cash flow +2 0
Market Value
The only price for a bond which rules out
arbitrage is $100.
$100 is also the present value of the payoff of the
bond.
RULE: Assets must be priced in the market to rule
out arbitrage (i.e., no arbitrage)
Therefore, the present value of an asset is its market
price.

Perpetuities and Annuities
We frequently deal with projects whose cash
flows follow a special pattern:
Equal payments over a number of years.
A stream with a finite life is called an Annuity.
An infinitely lived stream is called a Perpetuity.
There are some shortcuts for evaluating the
present value of these streams of cash flows.
Perpetuities
Consider a bond that pays a fixed amount of interest
every year, forever. The principal will never be repaid.
This type of security is a Perpetuity and has been
issued by the British government.
The present value of a perpetuity is

r
C
r
C
r
C
r
C
PV
1
3
1
2
1 1
...
) 1 ( ) 1 ( ) 1 (
= +
+
+
+
+
+
=
Perpetuities
For example, the present value (today) of $100 a
year forever (starting in 1 year) when r = 10% is

Note: This formula assumes the cash flow and
interest rate are constant forever.
Also Note: This formula computes the value in one
period of cash flows that start in the next period. Be
careful with the timing.

000 , 1
10 .
100
= = PV
Perpetuities
Example: You will receive $100 per year, starting
3 years from today and lasting forever (r=8%).

To compute the present value today:

Note that the exponent is 2, not 3.

250 , 1
08 .
100
) 2 ( = = year PV
67 . 071 , 1
) 08 . 1 (
250 , 1
) (
2
=
+
= today PV
Growing Perpetuities
Suppose the perpetual cash flows are growing at a rate
of g% per year.
The present value is

Note: What is the reasonable range of growth rates
for this calculation?

g r
C
PV
=
1
Annuities
An Annuity is an asset that pays a fixed sum each
year, for a specified number of years.
Example: Consider an annuity that will pay $100 a
year for 10 years, starting 1 year from today.
We may think of this annuity as
a perpetuity paying $100 a year forever, starting in
1 year, minus
a perpetuity paying $100 a year forever, starting in
11 years.
Annuities
The value today of the first perpetuity is

The value of the second perpetuity in Year 10 is also
$1000.
The value today of the second perpetuity is

So, the PV of the annuity is 1000-385.543=614.457

1000
10 .
100
= = PV
54 . 385
) 10 . 1 (
1000
10
=
+
= PV
Annuities
To compute the present value of an annuity
that makes (constant) payments from year 1 to
n:

Financial calculators and spreadsheet programs
frequently refer to annuities as PMT
(payment).

1 1 (1 )
1
(1 )
n
n
PMT r
PV PMT
r r r
| | | | +
= =
| |
+
\ . \ .
Example
You are the winner of a $30 million state lottery. You
can take your prize as either
30 payments of $1 million (starting in 1 year) or
$15 million paid today.
If the interest rate is 8% per year, which should you
choose?
To compute the present value of the annuity:

Choose the $15 million today, because the present
value is higher.
30
1 (1 .08)
$1 $11.26
.08
PV million million
| | +
= =
|
\ .
Annuities
Sometimes, we may know the present value and may
want to compute an annuity amount.
Solve the last equation for PMT.
The reciprocal of the annuity present value factor is

1 (1 )
n
r
PMT PV
r

| |
=
|
+
\ .
Example
Suppose you would like to borrow $7,000 at an
interest rate of 6% per year.
The loan plus interest are to be repaid in equal
monthly payments over 3 years.
Using r = .06/12 = .005 per month and n = 12(3)=36
months, payments are

95 . 212 $
) 005 . 1 ( 1
005 .
000 , 7 $
36
=
|
|
.
|
\
|
+

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Time Value of Money Rules

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