valuation relationship & its application

8/7/2019 valuation relationship & its application

1/13

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


2/13

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


3/13

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


4/13

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


5/13


6/13

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


7/13

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


8/13

PVA = CF * 1- (1+ k) n / k

FVA = CF * (1 + r )n -1 / r

PV = CF1 / k g

PV = CF / k


9/13

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.


10/13

Effective rate of interest & compounding


11/13

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


12/13

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.


13/13

Thank you

by

Ajay mohan

Department of Management Studies

Pondicherry University

valuation relationship & its application

Documents

Transcript of valuation relationship & its application