valuation relationship & its application
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Valuation Relationship and
Applications
Cash Flows, Time Value, Sensitivity Analysis of TimeValue, Applications, Spreadsheets and Compounding
by
Ajay mohan
Department of Management Studies
Pondicherry University
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Cash Flows
Characteristics
- size or amount of cash flow
-direction of cash flow
-timing of cash flow
Types of cash flows are
- Operational cash flows,
- Investment cash flows and- Financing cash flows
Cash flow stream or payment stream
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Time Value
Time has a value and considered when evaluating
cash flows
The money at the present time is worth more thanthe same amount in the future
Discounting
Compounding (present value of a cash flow)PV = CFt/(1+kt)
t OR PV = CF(t) * (1+kt) t
CFt = Cash flow received at time t
Kt = discount rate to be applied to the cash flow
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Sensitivity Analysis
Its an consideration of the sensitivity of financial
outcomes to changes in underlying assumptions.
Sensitivity of NPVs to the Discount Rate
Time amount PV(10%) PV(25%)
A 01 500 454.55 400.00 B 01 900 818.18 720.00
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Spread Sheet
Boon to financial analysis and financial
engineering.
-Lotus 1-2-3 (Lotus Development Corporation)-Excel (Microsoft)
It ease the examination of complex cash flow
patterns
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Applications of Valuation Arithmetic
Used to price
all forms of financial securities
Common stock
Preferred stock
Bonds
Mortgages and real estate deals
Tables to interpolation
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PVA = CF * 1- (1+ k) n / k
FVA = CF * (1 + r )n -1 / r
PV = CF1 / k g
PV = CF / k
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Compounding
When the cash flows are received more frequently than the period on which
the interest rate or the discount rate is defined.
A rate of interest of 10%, paid once a year at the end of the year.
Here 10% = nominal rate (NR) and effective annual rate (ER) or simple rate of
interest
If interest is paid semiannually (sa). Then NR= 10%
ER = (1+NR/m)m
- 1 (i.e., ER= 10.25% )
Where m = number of compounding. The more frequent the compounding, the
greater will be the effective rate.
Effective rate of interest increases as m gets larger.
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Effective rate of interest & compounding
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When the number of compounding increases,the effective rate of interest will be constant.
Under continuous compounding, this constant
is the Effective rate of interest.
In continuous compounding m= infinity,
ER = exp(NR) -1
Exp(.) denotes the exponential function (e
x
)Its the value e raisedto power NR
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Absolute valuation & Relative valuation
Valuation Arithmetic determines theabsolute value of investment
It describes the value of an
investment opportunity
Relative value comes to playwhen we consider Arbitrage
It considers the value of an
investment opportunity relative
to other investment opportunityAn asset may have a high Absolute value and simultaneously have a low relative
value or vice versa.
for example, a bond is being traded at a premium (108% of par value), this
might be the highest price at which this bond is ever traded and it will be
considered to have a high absolute value. But if other bonds of equivalent riskand maturity to this bond are trading at even higher prices, then the bond has a
low relative value. Here, the overvalued bonds can be sold out and can purchase
undervalued bond.
Several financing options may be nearly equivalent in terms of the cash flow
streams they entail. But one financing alternative may have a lower cost than
others and ,therefore, have greater relative value to the firm.
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Thank you
by
Ajay mohan
Department of Management Studies
Pondicherry University