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Valuation
Learning Outcomes
cost-benefit
analysis
valuation principle
time value of money
future value and compounding
present value and discounting
cash flow streams
annuities and perpetuities
compounding frequency
interest rate quotes
Topic 2 Time Value of Money and Valuation
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Learning Outcomes
application:
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Cost-Benefit Analysis
a
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Cost-Benefit Analysis
when
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in
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Valuation Principle
The
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decision:
.
.
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if
sooner
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why?
1.
2.
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Effect of Inflation
inflation
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Effect of Inflation
inflation
consumer
inflation
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real
from
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equation
(1 + nominal rate) = (1 + real rate)*(1 +
inflation rate)
nominal rate real rate + inflation rate
Irving
Fisher
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real
real
interest rate 5% - 3% = 2%
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Inflation
inflation rate
= 10%
source: hongkong.coach.com
now
Topic 2 Time Value of Money and Valuation
source: hongkong.coach.com
in a years time
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Deferred Consumption
given
other
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Deferred Consumption
that
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Deferred Consumption
inflation rate
= 0%
for a whole
year!
source: hongkong.coach.com
receive $4,400
now
Topic 2 Time Value of Money and Valuation
source: hongkong.coach.com
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what
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future
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discounting
present
value
compounding
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future
value
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rule
rule
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now
period
N-2
N-1
$5
$5
$105
cash
-$100
flow
$5
cash
outflow
$5
cash
inflows
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where
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$10,200
cash flow
$10,300
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example:
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initial investment =
$10,000; annual
interest rate = 5%;
annual compounding
$114,674
$70,400
$43,219
$40,000
$26,533
$20,000 $16,289
$0
0
10
20
30
40
investment horizon (years)
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FVN
FVN = PV * (1 + r ) or PV =
N
(1 + r )
N
where
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$500,000
PV =
= $306,956.63
10
(1 + 5%)
year
10
$500,000
$306,957
Topic 2 Time Value of Money and Valuation
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$109,273
$100,000
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example:
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example:
N = 23.79 years
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Ct
PV =
t
t =1 (1 + r )
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FVN = C t * (1 + r )
N t
t =1
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$25,000
PV =
= $376,157.42
t
t =1 (1 + 6%)
year
38
40
39
$25,000
$376,157
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source: www.realityblurred.com
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= $13,121.6
year
$1,000
$1,000
$11,000
$13,122
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perpetuity:
growing
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Annuity
5-year
year
$100
$100
$100
$100
$100
1
1
PV = C * * 1
r
(1 + r )N
1
FVN = C * * [(1 + r )N 1]
r
where FVN = future value at N; PV = present value;
r = interest rate; N = number of years; C =
constant cash flow in each year
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source: HSBC
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PV = $100 *
* 1
= $432.95
5
5%
(1 + 5%)
1
5
FV5 = $100 *
* [(1 + 5%) 1] = $552.56
5%
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$100,000 = C *
* 1
5
12%
(1 + 12%)
C = $27,740.97
C
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1
1
$10,000 = $200 *
* 1
1.5%
(1 + 1.5%)N
N = 93.11 months or 7.76 years
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1
1
$70,000 = $10,000 * * 1
10
r
(1 + r )
r = 7.07%
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Growing Annuity
5-year
year
1
$100
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Growing Annuity
N
1
1+g
PV = C1 *
* 1
r-g
1 +r
1
FVN = C1 *
* [(1 + r )N (1 + g )N ]
r-g
where
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1 + 3%
1
PV = $100 *
* 1
= $458.39
5% - 3% 1 + 5%
1
FV5 = $100 *
* [(1 + 5%) 5 (1 + 3*) 5 ] = $585.04
5% - 3%
5
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Perpetuity
non-growing
of $100
year
$100
$100
$100
$100
growing
0
1
2
3
4
year
$100
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Perpetuity
C1
non - growing perpetuity : PV =
r
C1
growing perpetuity : PV =
r-g
where
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Perpetual Bond
source: Cbonds
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PV
= $100/5% = $2,000
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PV
= $100/(5%-3%) = $5,000
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usually
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interest
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.
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r*
D
F*
Topic 2 Time Value of Money and Valuation
F
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business
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S0
S1
i1
i0
i1
D
F0 F1
D1
i0
D0
F0 F1
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the US
APR:
also
monthly
12%
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Hong Kong
APR:
similar
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source: DBS
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Compounding Frequency
the
rules
the
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Compounding Frequency
APR
FVN = PV * 1 +
FVN
PV =
mN
(1 + APR / m)
mN
where
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show
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compounding
FV1 = $10,000*(1+6%/4)4*1 = $10,613.64
quarterly flat rate = 6%/4 = 1.25%
EAR = (1+6%/4)4 1 = 6.14%
monthly compounding
FV1 = $10,000*(1+6%/12)12*1 = $10,616.78
monthly flat rate = 6%/12 = 0.5%
EAR = (1+6%/12)12 - 1 = 6.17%
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compounding
FV1 = $10,000*(1+6%/365)365*1 =
$10,618.31
daily flat rate = 6%/365 = 0.02%
EAR = (1+6%/365)365 1 = 6.18%
continuous
compounding
FV1 = $10,000*e6%*1 = $10,618.36
EAR = e6%*1 - 1 = 6.18%
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equivalent
when
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equivalent
10.25%
equivalent
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loan
balance
-C
-C
-C
year
N-1
-C
-C
usually,
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Tax Loan
source: DBS
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the
1
1
$50,000 = C *
* 1
24
1%
(1 + 1%)
C = $2,353.67
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month
beginning
loan balance
monthly
payment
1
2
3
4
5
6
7
8
9
10
11
12
$50,000.00
$48,146.33
$46,274.12
$44,383.18
$42,473.34
$40,544.40
$38,596.17
$36,628.46
$34,641.07
$32,633.81
$30,606.47
$28,558.86
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
interest payment =
beginning loan balance *
monthly interest rate
$500.00
$481.46
$462.74
$443.83
$424.73
$405.44
$385.96
$366.28
$346.41
$326.34
$306.06
$285.59
principal repayment =
monthly payment interest payment
$1,853.67
$1,872.21
$1,890.93
$1,909.84
$1,928.94
$1,948.23
$1,967.71
$1,987.39
$2,007.26
$2,027.34
$2,047.61
$2,068.08
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beginning
loan balance
monthly
payment
13
14
15
16
17
18
19
20
21
22
23
24
$26,490.78
$24,402.01
$22,292.36
$20,161.61
$18,009.55
$15,835.97
$13,640.66
$11,423.39
$9,183.95
$6,922.12
$4,637.67
$2,330.37
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
$2,353.67
interest payment =
beginning loan balance *
monthly interest rate
$264.91
$244.02
$222.92
$201.62
$180.10
$158.36
$136.41
$114.23
$91.84
$69.22
$46.38
$23.30
principal repayment =
monthly payment interest payment
$2,088.77
$2,109.65
$2,130.75
$2,152.06
$2,173.58
$2,195.31
$2,217.27
$2,239.44
$2,261.83
$2,284.45
$2,307.30
$2,330.37
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$2,500
principal repayment
$2,000
$1,500
$1,000
$500
$0
1
2 3 4
5 6 7
8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
months
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better
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better
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Notice
so
in
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Challenging Questions
1. In financial principle, how important are our
personal preferences in valuing an investment
decision?
2. Given that the exchange rate is CNY 10 for HKD
11.50. If the stock of Company XYZ sells at CNY
10 in the A share market in Mainland China and
sells at HKD 11.86 in Hong Kong. What do you
do to take advantage of the arbitrage
opportunity?
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Challenging Questions
4. Give two reasons why arbitrage may not work in
real life.
A.
B.
5. The value of a dollar today relative to the value
of a dollar in a years time tends to increase if
weight on current
people put a
consumption relative to future consumption and
the inflation rate is
.
6. If the observed interest rate of a security is 5%
and the expected inflation rate is 3%, what is
the nominal interest rate of the security? Explain.
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Challenging Questions
6. Nominal interest rate tends to
with the
expected inflation rate. Who will benefit from a
higher inflation rate, the borrower or lender of a
loan?
7. When the interest rate rises, the interest rate
factor is
, the discount factor is
and the
present value is
.
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Challenging Questions
8. If a depositor puts $10,000 in a three-year time
deposit account and the annual compound
interest rate is 3%, what are the conditions
under which the depositor can really earn the
3% annual compound interest rate?
A.
B.
9. The present value of a future cash flow is higher
if the interest rate is
and the investment
.
horizon is
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Challenging Questions
10.If a companys earnings per share grew from $1
to $2 over a 10-year period, the total growth
would be 100%, but the annual growth rate
would be less than 10%. True or false? Explain.
11.Other things being equal, a borrower would like
to pay a
interest rate on a loan while an
lender would like to receive a
interest rate
from an investment. A borrower wants the
compounding frequency to be
and a lender
wants the compounding frequency to be
.
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Challenging Questions
12.Which of the following financial instrument
should offer the highest interest rate?
A. the maturity is 10 years and the risk is low
B. the maturity is 5 years and the risk is low
C. the maturity is 10 years and the risk is
high
D. the maturity is 5 years and the risk is high
13.Other things being equal, which is higher, APR
or EAR? Explain why. Which is more relevant for
financial decisions?
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Challenging Questions
14.In view of a recessionary economy, a central
bank may use an expansionary monetary policy
to stimulate it. It usually
the money supply
the general interest rate level. In
so as to
such an interest rate environment, consumption
and investment tend to
.
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Challenging Questions
15.An investment is expected to generate a rate of
return of 16%. There are three alternative
investments with the same risk and the subject
investment with an expected rate of return of
14%, 12% and 10% respectively in the market.
What is the opportunity cost of capital of the
subject investment?
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