Download - TVM, Valuation, Risk and Return
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Financial management
Time value of money, Risk
and return, Valuation
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Objectives of Financial
management• Profit maximisation/EP – !mbiguity, "uality of benefits/risk, timing of benefits
• #ealt$ maximisation
– Value, ie%, &ort$ to t$e o&ners
– 'a(italisation/discount rate t$at reflects risk and time (references
– Economic value added )EV!*
•
!fter tax o(erational (rofits of a firm less t$e cost of funds used tofinance investments
– Focus on stake$olders
• Em(loyees, customers, su((liers, creditors, o&ners and ot$ers
&$o $ave direct link &it$ t$e firm•
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Time value of money
+ &ill gladly (ay you Tuesday for a $amburger
can eat today- . Wimpie, from the Popeye cartoon
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earning Objectives
0 Ex(lain t$e meaning of t$e time value of money and t$eim(ortance of t$e timing of cas$ flo&s in making financial
decisions
0 'alculate t$e future value and (resent value of cas$ flo&s for
one (eriod and multi(le (eriods
0 olve for t$e interest rate im(lied by a given set of (resent
value and future value cas$ flo&s
0 !((ly time value of money tec$ni"ues to solve basic (roblems
facing financial managers
0 1se a calculator/excel s$eet to solve time value of money
(roblems
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'entral conce(ts in finance
0 Risk-return tradeoff . nvestors &ill take on additional
risk only if t$ey antici(ate $ig$er return%
0 Time value of money 2 value of a unit of money is
different in different time (eriods
! ru(ee available today is &ort$ more t$an a ru(ee
available at a future date%
T$is is because a ru(ee today can be invested to earn a
return%
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Tec$ni"ues•
Future value or 'om(ounding – 'om(ound interest is t$e interest earned on a
given de(osit/(rinci(al t$at $as become a (art of
t$e (rinci(al at t$e end of a s(ecified (eriod
– Princi(al refers to t$e amount of money on &$ic$
interest is received
•
Present value or 3iscounting – Present value is t$e current value of a future
amount
–
3iscounting is determining t$e (resent value of afuture amount
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R4 and RET1R5
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Risk and return of a single asset
• Return 2 actual income received (lus any
c$ange in t$e market (rice of an asset /
investment
• 'alculation of ex(ected return 2 single (eriod
• Risk 2 variability of actual return from t$e
ex(ected return associated &it$ a given asset
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6easurement of risk
• 7e$avioural (oint of vie&
– ensitivity analysis
–
Probability distribution• 8uantitative/statistical (oint of vie&
– tandard deviation
– 'o.efficient of variation
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Risk and return of a (ortfolio
• Portfolio 2 combination of t&o or more
securities/assets
•
Portfolio ex(ected return• Portfolio risk
• 'orrelation/covariance
• 3iversification
• Risk return trade off
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Risk return trade off
•
ystematic risk – 'aused by factors t$at affect t$e overall market/all
securities
–
5on diversifiable/unavoidable• 1nsystematic risk
– 1ni"ue to (articular com(any/industry/security
– 3iversifiable/ avoidable
• '!P6
–
Provides a frame&ork for basic risk return trade
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'a(ital !sset Pricing model• 6odel t$at describes t$e relations$i(/tradeoff
bet&een risk and ex(ected/re"uired rate of return
• Ex(lains t$e be$aviour of security (rices and
(rovides a mec$anism to assess t$e im(act of
(ro(osed security investment on investors9 overall(ortfolio risk and return
• Provides a frame&ork for basic risk return trade off in
(ortfolio management
• Enables dra&ing certain im(lications about t$e risk
and si:e of risk (remium necessary to com(ensate
for bearing risk
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!ssum(tions• Efficiency of market
–
nvestors &ell informed
– Transaction costs are lo&
– 5egligible restrictions on investments
–
5o investor is large enoug$ to influence – nvestors in general agreement about likely (erformance
– Ex(ectations are based on one year $olding (eriod
•
nvestor (references – Prefer to invest in securities &it$ t$e $ig$est return for a given
level of risk or lo&est risk for a given level of return
– Return a risk measured in terms of ex(ected value and standard
deviation res(ectively
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6easure of risk• 7eta coefficient is an index of t$e degree of
res(onsiveness/comovement of security return &it$market return
• Risk free return
• Ex(ected return less risk free return ; excess return
• 7eta coefficient re(resents t$e c$ange in excess
return on t$e individual security over c$anges in
excess return on market (ortfolio• 7eta of market (ortfolio is e"ual to <
• ndex of systematic risk of individual security relative
to t$at of market (ortfolio
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7eta of a security and '!P6
formula
T$e '!P6 formula is= ra ; rrf > 7a )rm.rrf*Required Return = Risk free rate + (Market return – Risk free rate) *
Beta
Portfoio Beta = (the sum of) !"ei#ht of security $ Beta of security%
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Valuation of long term securities
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Valuation of bonds/debentures
• 7ond 2 long term debt instrument used by
government, government agencies and
business enter(rises to raise a large sum of
money
• Par value 2 value on t$e face of t$e bond
•
'ou(on rate 2 s(ecified interest rate availableon security
• 6aturity (eriod 2 number of years after &$ic$
t$e (ar/s(ecified value is (ayable to t$e
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llustration
• ! firm $as issued a
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7asic bond valuation
•
Present value of contractual (ayments its issuer )cor(orate* isobliged to make from t$e beginning till maturity
• !((ro(riate discount rate &ould be t$e re"uired return
commensurate risk and (revailing interest rate
• #$en t$e re"uired return is e"ual to t$e cou(on rate, t$e
bond value e"uals t$e (ar value
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m(act of re"uired return on bond
values• '$ange in t$e basic cost of long term funds• '$ange in t$e basic risk of t$e firm
•
f RRC'R t$en bond value D (ar value= 3iscount )6.7*
• f RRD'R t$en bond value C (ar value= Premium)7.6*
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m(act of maturity on bond value• Time to maturity
• RR
• 7ond value
–
'onstant RR – '$anging RR
• 'onstant re"uired returns
•
'$anging re"uired returns
• T$e s$orter t$e time to maturity, t$e smaller t$e
im(act on bond value caused by a given c$ange in
t$e re"uired return
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ield to maturity
• Rate of return investors earn if t$ey buy a
bond at a s(ecific (rice and $old it till maturity
•
llustration
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Valuation of (reference s$ares
• Ex(ected return is t$e return t$at is ex(ected
to be earned on a given security over an
infinite time $ori:on
• ero gro&t$ model
• 'onstant gro&t$/Gordon model
•
Variable gro&t$ model