Time Value of Money

Time Line
Cash Flows at-the-end of period
• Cash Flows of Rs 1000/- each at Year-end for 4 years
1000 1000 1000 1000

0 Period 1 1 Period 2 2 Period 3 3 Period 4 4

Cash Flows at-the-beginning of period

• Cash Flows of Rs 1000/- each at Year-beginning for 4 years
1000 1000 1000 1000

0 Period 1 1 Period 2 2 Period 3 3 Period 4 4

2
 Time Value of Money
• Time Value of Money (TVM): Money (Cash flows) today
is more valuable than the same quantity of money in
the future.
• Why TVM?
✓ Inflation: Rs. 100/- today will buy more goods than a year
from now. - value of currency decreases over time.
✓ Preference of present consumption over future
consumption: to induce people to postpone the
consumption, you have to offer them more in the future.
✓ Uncertainty : higher uncertainty (risk) means less
valuable the future cash flow.
• Thus, the cash flows occurring in different time periods have
to be made comparable.
3
 Time Value of Money
• To take today’s cash flows into the future : Future
Value
0 1 2 3 4 5

P FV
@ r%

• To bring future cash flows to today’s value: Present

Value
0 1 2 3 4 5

P FV
@ r%
4
 Future Value
• Future Value of an investment is what the investment will
be worth after earning interest for one or more time
periods.
• Suppose you deposit Rs. 100/- in a bank deposit that pays
10% pa, how much will you have in one year/ two years?
• FV1 = Principal + Interest earned
= 100 + 10% of 100
= 100 + 0.10*100 = 100*(1.10) = Rs. 110
FV1 = P0 + P0*r = P0 (1+ r)
FV2 = Principal (FV1) + Interest earned (FV1)
= 110 + 0.10*110 = 110*(1.10) = Rs. 121
= 100*(1.10) *(1.10) = 100*(1.10)2 = Rs. 121
FV2 = P0 (1+ r)2 5
 Future Value
• Future Value of amount P0 , after ‘n’ years would be:
FVn = P0*(1+r)n
Future Value Interest Factor
[FVIF (n,r)]

• Values of FVIF for various combinations of ‘r’ and ‘n’ are

given in Future Value Interest Factor tables.

FVIF (5 yrs,6%)

6
 Future Value
If you invest Rs.80,000/- @ 14%p.a., how much would it amount
to in 3 years?
✓ Future Value of Rs. 80,000/- @14% after 3 years
would be: 80,000*(1+0.14)3 or 80,000*FVIF (3
years,14%)
= 80,000*1.48154 = Rs 1,18,523.52

80,000 1,18,523.52

0 1 2 3

7
Future Value

8
 Future Value
Suppose you plan to invest Rs 25,000/- in a bank fixed
deposit for a period of 15 years. The rate of interest on
the fixed deposit is 6.50% pa. How much amount you
would have in your bank account at the end of 15 years?

PV = Rs. 25,000/- ; r = 6.50% ; n = 15 years ; FV = ?

FV = PV(1+r)n = 25000(1.065)15
= 25000(2.57184) = Rs. 64,296.03

10
 Future value

Higher the interest rate, faster the savings grow

5900
5400
18%
4900
Future Value

4400
3900 15%

3400
12%
2900
10%
2400
8%
1900
5%
1400
900
1 2 3 4 5 6 7 8 9 10

Years

11
 Compounding more than once a year
• Interest may be paid more than once a year.
• If you invest Rs.80,000/- @ 14%p.a., how much would it
amount to in 5 years, if interest is compounded semi-annually?

80000*(1+0.14/2)(5*2)
= 80000*1.96715
= 157,372.11

12
 Compounding more than once a year
• Future Value is : r n*m
FVn = P*(1+ )
m
where ‘m’ is no. of times interest is paid.
➢ If you invest Rs.80,000/- @ 14%p.a., how much would it amount
to in 5 years, if interest is compounded quarterly, monthly, or
daily?
Frequency m Future Value
Quarterly 4 80000*(1+0.14/4)(5*4)
= 80000*1.98979 = 1,59,183.11
Monthly 12 80000*(1+0.14/12)(5*12)
= 80000*2.00561 = 1,60,448.78
Daily 365 80000*(1+0.14/365)(5*365)
= 80000*2.01348 = 1,61,078.60
13
 Compounding more than once a year
• As ‘m’ approaches infinity, the term (1+r/m)n*m approaches
er*n, where ‘e’ is approx. 2.71828 and is defined as
1 m
e=limit(1+ )
m→ m
• Future Value on continuous compounding basis is:
FVn = P*er n

If you invest Rs.80,000/- @ 14%p.a., how much would it amount

to in 5 years, if interest is continuously compounded?

✓ Future Value on continuous compounding would be:

80000*e0.14*5 = 80000*2.01375 = 1,61,100.22

14
 Nominal vs. Effective Interest Rate
Nominal Future Effective
Frequency (m) Rate Value Interest Rate
Annual 1 10% 1100.00 (1.10)-1 10.0000%
Semi-annual 2 10% 1102.50 (1+ 0.10/2)2 - 1 10.2500%
Quarterly 4 10% 1103.81 (1+ 0.10/4)4 - 1 10.3813%
Monthly 12 10% 1104.71 (1+ 0.10/12)12 - 1 10.4713%
Daily 365 10% 1105.15 (1+ 0.10/365)365 - 1 10.5156%
Continuous 10% 1105.17 exp (0.10) - 1 10.5171%

Daily Compounding is same as Continuous Compounding

m
 Stated Annual Interest rate 
EIR = 1+  -1
 m  15
 Effective Interest rate
iBank charges 7.95% pa interest compounded monthly,
on its car loans while uBank charges interest @ 8% pa
compounded half yearly. Which car loan is cheaper?
12
 0.0795 
EIR (iBank) = 1+ - 1 = 0.08246 = 8.246% pa
 12 

2
 0.08 
EIR (uBank) = 1+  - 1 = 0.08160 = 8.16% pa
 2 

Although uBank is charging higher Nominal Interest rate, the

Effective Interest Rate is lower (EIR), hence preferred.
16
 Where to Invest ?
Atul wants to invest Rs. 10 Lac for a period of 10 years.
He can invest in Government bonds which mature in 6
years and earn interest @ 8% pa. The expected 4 year
fixed deposit rate (effective 6 years hence), given by a
local bank is 3.5% pa, with half yearly compounding.
Meanwhile, Yep Bank has offered an investment proposal
offering 6.5% pa with quarterly compounding for 10
years. Which proposal is better for Atul?

17
 Where to Invest ?
Option 1: Invest in Government Bonds @ 8% pa for 6 years & @
3.5% pa (half yearly compounding) in bank fixed deposit for next 4
years thereafter.
• 10,00,000 * (1.08)6 = Rs. 15,86,874.32
• 15,86,874.32 * (1.0175)8 = Rs. 15,86,874.32 *1.14888 = Rs. 18,23,131/-

Option 2: Invest in Yep Bank 10-year Fixed deposit @ 6.5% pa

(quarterly compounding) for 10 years.

• 10,00,000 * (1.01625)40 = 10,00,000* 1.90556 = Rs. 19,05,560/-

Better to deposit with Yep Bank.

18
 Growth Rate
Due to advertising campaign, the sales of a firm have
increased from Rs 20 Mn to Rs 35 Mn in three years.
What is the average annual growth rate?

PV = Rs 20 Mn ; FV = Rs 35 Mn ; time period = 3 years, g=?

FV = PV*(1+g)n
35 = 20*(1+g)3
g = (35/20)1/3 -1 = 0.2050711 = 20.51%

Sales grew at a Compounded Annual Growth Rate (CAGR) of 20.51%

19
 Present Value
• The process of calculating the present value of a
future Cash Flow is called discounting and the
interest rate used for discounting is called the
discount rate.

• From our understanding of Future Value, we know that

FVn = P (1+r)n, hence,

Present Value Interest

1 Factor [PVIF(n,r)]
P=FVn *
(1+r)n

= FVn* PVIF (n, r)

20
 Present Value Interest Factor (PVIF)

• Values of PVIF for various combinations of “r” and “n” are given
in Present Value tables.

PVIF
(5 yrs,5%)

21
 Present Value
What is the worth of Rs.10,000/- received at the end of 5 years
from now, if the discount rate is 6% p.a.?

10,000

0 1 2 3 4 5

??

✓Present Value of Rs. 10,000 (Future Value) would be :

10,000=P*(1.06)5
10,000
PV= 5
=10,000*0.74726 = Rs.7,472.60
(1.06)

22
 Present Value
1100
1000
900
800
Present Value

700 5%
600
500
400
300
200 18%
100
1 2 3 4 5 6 7 8 9 10

Years

Higher the discount rate, lower the Present Value

25
 Time Value of Money Functions in MS Excel

Solving for Formula

PV =PV(RATE, NPER, PMT, FV)
FV =FV(RATE, NPER, PMT, PV)
Discount Rate =RATE (NPER, PMT, PV, FV)
Payment =PMT(RATE, NPER, PV, FV)
No. of Periods =NPER(RATE, PMT, PV, FV)

26
 Annuity
Annuity is a stream of ‘n’ equal cash flows (inflows or
outflows) at regular intervals for a fixed period of time.
➢ If each investment is made at the END of each period,
the annuity is called Regular / Ordinary Annuity or
Annuity in arrears
0 1 2 3 n

A A A A

➢ If each investment is made at the BEGINNING of each

period, the annuity is called Annuity Due.
0 1 2 3 n-1
A A A A A
27
 Future Value of Annuity (Regular Annuity)
• Future Value of a 5-year Regular Annuity of Rs 1000/- @ 10%:

0 1 2 3 4 5

1000 1000 1000 1000 1000

1000(1.10)0 =1000
1000(1.10)1 =1100
1000(1.10)2 =1210
1000(1.10)3 =1331
1000(1.10)4 =1464
=6105

 (1+r)n -1   (1.10)5 -1 
FVA RA = A   = 1000  
 r   0.10 
= 1000*6.10510=6105.10
28
 Future Value of Annuity (Regular Annuity)
• Future Value of n-year Regular Annuity of A @ r%:
0 1 2 3 n-2 n-1 n
A A A A A A
A(1+r)n-1
A(1+r)n-2
A(1+r)n-3

A(1+r)2
A(1+r)1

FVARA = A(1+r)n-1 + A(1+r)n-2 + A(1+r)n-3 +........+ A(1+r)2 +A(1+r)1 + A

 (1+r)n -1  Future Value Interest Factor Annuity

FVARA = A   [FVIFA(n,r)]
 r 

29
Future Value of Annuity (Regular Annuity)

30
 Future Value of Annuity (Annuity Due)
• Future Value of 5-year Annuity Due of Rs.1000 @ 10%:
0 1 2 3 4 5

1000 1000 1000 1000 1000

1000(1.10)1 =1100
1000(1.10)2 =1210
1000(1.10)3 =1331
1000(1.10)4 =1464
1000(1.10)5 =1610
=6715
 (1+r)n -1   (1.10)5 -1 
FVA AD = A   (1+r) = 1000   (1.10)
 r   0.10 
=1000*6.71561=6715.61
31
 Future Value of an Annuity (Annuity Due)
• Future Value of Annuity Due:
0 1 2 3 n-2 n-1 n

A A A A A
A(1+r)n
A(1+r)n-1
A(1+r)n-2

A(1+r)2
A(1+r)1

FVA AD = A(1+r)n + A(1+r)n-1 + A(1+r)n-2 +........+ A(1+r)2 + A(1+r)1

 (1+r)n -1 
FVA AD = A   (1+r)
 r 
32
Future Value of an Annuity (Annuity Due)

33
 Future Value of an Annuity
Sairam deposits Rs.50,000/- every year in a 5-year recurring
deposit earning interest @8%p.a. How much money would
get accumulated in the recurring deposit account, by the end
of 5 years?
??
0 1 2 3 4 5
Case-1 Regular Annuity:
50,000 50,000 50,000 50,000 50,000
 (1.08)5 -1 
FVA RA = 50,000   = 50,000*5.8666= Rs.2,93,330/-
 0.08  ??
0 1 2 3 4 5
Case-2 Annuity Due:
50,000 50,000 50,000 50,000 50,000
 (1.08)5 -1 
FVA AD = 50,000   (1.08)
 0.08 
= 50,000*6.3359= Rs.3,16,796/-
34
 Present Value of an Annuity
• Present Value of Regular Annuity:
1 2 3 n-2 n-1 n
0 1 2 3 n-2 n-1 n
A A A A A A
A/(1+r)1
A/(1+r)2
A/(1+r)3

A/(1+r)n-2
A/(1+r)n-1
A/(1+r)n

A A A A A A
PVARA = 1
+ 2
+ 3
+.........+ n-2
+ n-1
+
(1+r) (1+r) (1+r) (1+r) (1+r) (1+r)n

1 1  Present Value Interest

PVARA =A  - n 
Factor Annuity
 r r(1+r)  [PVIFA (n,r)]
35
 Present Value of an Annuity
• Present Value of Annuity Due:

1 2 3 4 n-1 n
0 1 2 3 n-2 n-1 n
A A A A A A
A/(1+r)1
A/(1+r)2
A/(1+r)3

A/(1+r)n-2
A/(1+r)n-1

A A A A A
PVA AD = A+ 1
+ 2
+ 3
+.........+ n-2
+
(1+r) (1+r) (1+r) (1+r) (1+r)n-1

1 1 
PVA AD =A  - n 
(1+r)
 r r(1+r)  36
Present Value of an Annuity (Annuity Regular)

37
Present Value of an Annuity (Annuity Due)

38
Present Value of an Annuity
=PV(Interest Rate, Time,
-Annuity,,0(or1))

Discounting Rate (r)

Time Period n)

-Annuity

= ‘0’ End of period

= ‘1’ Start of period

Returns the Present Value of

the Annuity

39
 Present Value of an Annuity
Aditya is planning to buy a Single premium pension plan
which would give him an annual pension of Rs 50,000/-
for the next 30 years. What should be the maximum
premium that he should pay now for the pension plan,
assuming interest @9%?

• Single premium (to be paid now) = Present value of the

annuities to be received over the life of the pension plan.

 1 1 
= 50000  - 30 
 0.09 0.09(1.09) 

= 50000*10.2737 = Rs.5,13,683/-
40
 Equated Monthly or Yearly Installments
Suppose you take a loan of Rs 2,50,000/- @8% pa to be
repaid in 5 yearly equal installments. Find the amount
of each installment?

41
Equated Monthly or Yearly Installments
1 1 
PVA RA =A  - n 
 r r(1+r) 
 1 1 
2,50,000 = A  - 5 
 0.08 0.08(1.08) 

2,50,000
A= = 62,614/-
3.9927

42
 Equated Yearly Installments

Opening Annual Interest Principal Closing

Year Balance Instalment Repayment Balance
(1) (2) (3) = (1)*8% (4) = (2)-(3) (5) = (1)-(4)

1 250,000 62,614 20,000 42,614 207,386

2 207,386 62,614 16,591 46,023 161,363
3 161,363 62,614 12,909 49,705 111,658
4 111,658 62,614 8,933 53,682 57,976
5 57,976 62,614 4,637 57,977 0
3,13,070 63,070 2,50,000

43
 Equated Monthly Installments
Ajay has approached HDFC Bank for the loan of Rs.
1,00,000/-. The bank shall charge interest @8% pa and the
loan has to be repaid over 3 years in equal monthly
installments. How much would be the amount of each
installment?
1 1 
PVA RA =A  - n 
 r r(1+r) 
 1 1 
1,00,000 = A  - 3*12 
 0.08/12 0.08/12 (1+0.08/12) 

1,00,000 = A (150.00 - 118.08819 )

1,00,000
A= = Rs. 3,133.64
31.91181 44
Equated Monthly Installments

45
 Saving for College Education

Sunil wants to send his daughter to a 4-year college, 18 years

from now. Tuition fees is Rs. 50,000 per year now which is
expected to rise @ 5% pa over the next 18 years. If Sunil’s
saving can earn @ 8% pa, (a) how much he should invest
(lumpsum) now to meet the expenditure, or (b) how much he
should invest each year for the same.

47
Saving for College Education

48
 Refinancing a Housing Loan

Mudit had taken a 30-year loan for Rs. 2,00,000/-, 3 years

ago @ 9%pa. The interest rate has fallen now to 7.50%pa.
He is thinking of refinancing the loan. Cost of refinancing is
2.50% of the loan. Assuming the discount rate as 6%, should
the loan be refinanced?

49
Refinancing Housing Loan

50
Refinancing Housing Loan

51
 Growing Annuity
Growing Annuity is a stream of ‘n’ cash flows growing @
‘g’, paid at regular intervals.
• Growing Regular Annuity:
0 1 2 3 n
A A(1+g) A(1+g)2 A(1+g)n-1

• Growing Annuity Due:

0 1 2 3 n-1 n
A A(1+g) A(1+g)2 A(1+g)3 A(1+g)n-1

52
 Present Value of a Growing Annuity
• Present Value of Growing Regular Annuity :
0 1 2 3 n-1 n
A A(1+g) A(1+g)2 A(1+g)n-2 A(1+g)n-1
A
(1+r)1
A(1+g)1
(1+r)2
A(1+g)2
(1+r)3

A(1+g)n-2
(1+r)n-1
A(1+g)n-1
(1+r)n A A(1+g) A(1+g)2 A(1+g)n-1
PVGARA = 1
+ 2
+ 3
+......+
(1+r) (1+r) (1+r) (1+r)n

A   1+g  
n

PVGARA =  1-   
r-g   1+r   For r > g
53
 Present Value of a Growing Annuity
• Present Value of Growing Annuity Due:
0 1 2 3 n-1 n
A A(1+g) A(1+g)2 A(1+g)3 A(1+g)n-1
A(1+g)
(1+r)1
A(1+g)2
(1+r)2
A(1+g)3
(1+r)3

A(1+g)n-1
(1+r)n-1

A A(1+g)1 A(1+g)2 A(1+g)n-1

PVGA AD = 0
+ 1
+ 2
+......+
(1+r) (1+r) (1+r) (1+r)n-1

A   1+g  
n

PVGA AD =  1-   (1+r) For r > g

r-g   1+r   54
 Value of a Business
Indicoffee, a popular coffee shop located in a busy
shopping mall, is expected to generate net cash flows of
Rs 3 Lacs a year. If the cash flows increase @ 2.5% pa for
the next 50 years, what is the worth of the coffee shop?
(assume discount rate of 15%)
Case-1 Growing Regular Annuity:

3,00,000   1.025  
50

PVGARA =  1-    = Rs.23,92,380/-

0.15 - 0.025   1.15  

Case-2 Growing Annuity Due:

3,00,000   1.025  
50

PVGARA =  1-    (1.15) = Rs.27,51,245/-

0.15 - 0.025   1.15  

55
 Present Value of a Growing Annuity
The annual (year-end) lease payment of a building increase
by 10% for the next 5 years. If 8% is the appropriate
discount rate and first years’ payment is Rs. 10,000/-, what
is the maximum amount that an investor pay to be the
recipient of these lease payments?

Growing Regular Annuity:

10,000   1.10  
5

PVGARA =  1-    = Rs.48,042/-
0.08 - 0.10   1.08  

If Growing Annuity Due:

10,000   1.10  
5

PVGA AD =  1-    (1.08) = Rs.51,886/-

0.08 - 0.10   1..08  
56
 Future Value of a Growing Annuity
• Future Value of Growing Regular Annuity :
0 1 2 3 n-1 n
A A(1+g) A(1+g)2 A(1+g)n-2 A(1+g)n-1
A
(1+r)1
A(1+g)1
(1+r)2
A(1+g)2
(1+r)3

A(1+g)n-2
(1+r)n-1
A(1+g)n-1
(1+r)n

A   1+g  
n

  
n n
FVGARA = PVGARA *(1+r) = 1-  *(1+r)
r-g   1+r  

57
 Future Value of a Growing Annuity
• Future Value of Growing Annuity Due:
0 1 2 3 n-1 n
A A(1+g) A(1+g)2 A(1+g)3 A(1+g)n-1
A(1+g)
(1+r)1
A(1+g)2
(1+r)2
A(1+g)3
(1+r)3

A(1+g)n-1
(1+r)n-1

n
FVGAAD = PVGA AD *(1+r)
A(1+r)   1+g  
n

 1-  
n
FVGA AD = *(1+r)
r-g   1+r  
58
 Future Value of a Growing Annuity
Mr. Sairam is 35 years old now and wants to save each
year until he is 65. If he saves Rs 10,000/- every year and
the savings grow@ 5% pa (after the first year),how much
will he have saved by age 65 if the interest rate is 10% pa?

35 36 37 38 65
0 1 2 3 30
10,000 10,000(1.05) 10,000(1.05)2 10,000(1.05)29
Step-1 : Calculate PVGA:
10,000   1.05  
30

PVGA =  1-    = Rs. 1,50,464/-

0.10 - 0.05   1.10  
Step-2 : Calculate FVGA using PVGA:
FVGA = PVGA*(1+r)n = 1,50,464*(1.10)30 = Rs. 2.625 Mn
59
 Perpetuity
Perpetuity is a stream of equal cash flows at regular
intervals which lasts forever.

0 1 2 3
∞
A A A
• Present Value of a Perpetuity:
A A A
PVP= 1
+ 2
+ 3
+......
(1+r) (1+r) (1+r)

A
PVP=
r

60
 Perpetuity
You want to endow an annual MBA graduation party at
your alma amter. The event would cost Rs.50,000/- each
year forever. If the business school earns @ 8%p.a. on its
investments and the first party is in one year’s time, how
much will you need to donate to endow the party?

50,000 50,000 50,000

PVGP= 1
+ 2
+ 3
+......
(1.08) (1.08) (1.08)

50,000
PVGP= =Rs.6,25,000/-
0.08
61
 Growing Perpetuity
Growing Perpetuity is a stream of cash flows at regular
intervals and grows at a constant rate forever.
0 1 2 3 4 ∞

A A(1+g) A(1+g)2 A(1+g)3

• Present Value of a Growing Perpetuity:

A A(1+g) A(1+g)2 A(1+g)3

PVGP= 1
+ 2
+ 3
+ 4
......
(1+r) (1+r) (1+r) (1+r)

A
PVGP=
r-g
62
 Growing Perpetuity
But then you are informed that the cost of the party would
increase by 4% per year, (after the first year).How much
will you now need to donate to endow the party?

50,000 50,000(1.04) 50,000(1.04)2

PV= 1
+ 2
+ 3
+......
(1.08) (1.08) (1.08)

50,000
PV= =Rs.12,50,000/-
0.08 - 0.04
You need to double the amount of your gift !!!

63
 Summary
Present Value Future Value
Single Cash Flow 1
C C(1+r)n
(1+r)n
Annuity 1 1   (1+r)n -1 
A - n  A
(Regular Annuity)  r r(1+r)  
 r 
Annuity 1 1   (1+r)n -1 
(Annuity Due) A - n
(1+r) A  (1+r)
 r r(1+r)   r 
Growing Annuity
A   1+g   A   1+g  
n n
(Regular Annuity)  1-   1-   (1+r)
n

r-g   1+r   r-g   1+r 



A   1+g  
n
Growing Annuity A(1+r)   1+g  
n
 1-  (1+r)
r-g   1+r    1-   (1+r)
n
(Annuity Due) 
r-g   1+r  
Perpetuity A
r
Growing Perpetuity A
r - g
64
The MBA Decision

65
Valuation of Securities
 Valuing a Coupon Bond
NTPC issues 14% bonds of Rs.10,000/- face value,
redeemable after 5 years. Assuming the required rate of
return is 10%, what should be the price of the bond today?
0 1 2 3 4 5
A A A A A+F
A/(1+r)1

A/(1+r)2
A/(1+r)3

A/(1+r)4

A+F/(1+r)5
n
Coupon Interest Face Value of Bond
Value of Coupon Bond =  t
+ n
t=1 (1+r) (1+r)
A A A A Fn
V0 = 1
+ 2
+ 3
+.....+ +
(1+r) (1+r) (1+r) (1+r) (1+r)n
n
67
 Valuing a Coupon Bond
Face Value = Rs.10,000 ; Coupon rate = 14% pa;
Tenure = 5 Years; Required rate of return = 10%;
Price of Bond= ??
5
At F
V0 = t
+ 5
t=1 (1+r) (1+r)
5
1,400 10,000
= t
+ 5
t=1 (1.10) (1.10)

=1,400*PVIFA(5yrs, 10%) + 10,000*PVIF(5 yrs, 10%)

=1,400*3.79079 + 10,000*0.62092
= 5,307.10 + 6,209.21 = Rs.11,516.31
68
 Valuing a Coupon Bond
NTPC issues 14% bonds of Rs.10,000/- face value,
redeemable after 5 years. The market price of the bond
now is Rs. 10720.96. What is the Yield to Maturity (YTM) of
the bond ?
0 1 2 3 4 5
A A A A A+F
1400/(1+r)1
1400/(1+r)2
1400/(1+r)3
1400/(1+r)4
1400+10000/(1+r)5
10720.96

1,400*PVIFA(5yrs, x%) + 10,000*PVIF(5 yrs, x%) = 10,720.96

x% = 12% 69
 Valuing a Zero-coupon Bond
Consider a Zero-coupon Bond with face value of Rs.
5,000/- payable at the end of 3 years. What should be
the price of the bond today, if the required rate of return
is 5%?
5,000

0 1 2 3
??

Fn
Value of ZCB =
(1+r)n
5,000
V0 = 3
= Rs.4,319.19
(1.05) 70
Valuing Equity : Dividend Discount Model (DDM)
• Value of an equity share is the present value of the
stream of expected future dividends discounted at an
appropriate discount rate.

Value of a stock = PV(expected future dividends)

D1 D2 D3 D
Value = + + +..........+
1 2
(1+r) (1+r) (1+r) 3
(1+r)


Dt
Value =  t
General Form of DDM
t=1 (1+r)

71
 Dividend Discount Model (DDM)
ABC Co. is expected to pay a dividend of Rs.3/- forever.
What should be the Value of the equity share, if an
investor has a required rate of return as 13%?

D1 3.00
Value = = = Rs.23/-
r 0.13

72
 DDM - Constant Growth
• If the dividends are expected to grow at a constant
rate ‘g’, and r > g, then,
D1 D1 (1+g)1 D1 (1+g)2 D1 (1+g)3
V0 = 1
+ 2
+ 3
+ 4
+..........+
(1+r) (1+r) (1+r) (1+r)
D1
V0 =
(r - g)
Assumptions:
• D1 > 0
• Dividends grow at a constant growth rate “g” =ROE*b (b= retention ratio)
• Dividend Payout ratio (1-b) is constant

73
 DDM - Constant Growth
ABC Co. is expected to pay a dividend of Rs.3/- which is
expected to grow @ 7% forever. What should be the Value
of the equity share, if an investor has a required rate of
return as 13%?

D1 3.00
Value = = = Rs.50/-
(r - g) (0.13 - 0.07)

74
 DDM - Multiple Growth Rate
• A firm may pass through different growth phases and hence
dividends may also grow at different rates.

D1 D1 (1+g1 )1 D2 (1+g 2 ) D2 (1+g 2 )2

V0 = 1
+ 2
+ 3
+ 4
+..........+
(1+r) (1+r) (1+r) (1+r)
n
D t-1 (1+g t ) Vn Dn+1
V0 = t
+ n
where Vn =
t=1 (1+r) (1+r) r - gn
n
Dt-1 (1+g t ) 1  Dn+1 
V0 = t
+ n 
× 
t=1 (1+r) (1+r)  r - gn 
75
 DDM - Multiple Growth Rate

D0 = 3.50; g1-3=15% g 4-6=12% g7+=8% ; r = 12% ;

D1 = 4.03; D2 = 4.63; D3 = 5.32; D4 = 5.96; D5 = 6.68; D6 = 7.48; D7 = 8.08

 4.03 4.63 5.32 5.96 6.68 7.48   8.08 1 

V0 =  1
+ 2
+ 3
+ 4
+ 5
+ 6 
+ × 6
 (1.12) (1.12) (1.12) (1.12) (1.12) (1.12)   (0.12 - 0.08) (1.12) 

P0 = 124.78 Rs. 125/-

76