As Per Updated Syllabus

UGC - NET
MANAGEMENT
UNIT - 5
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Unit-5
Management - V

1. VALUE AND RETURNS

1.1 Time Preference for Money
• "Time value of money" means the sum of money received in future is less
valuable than it is today. The present worth of rupee that is to be received after
some time will be less than a rupee received today.
• The reason for time preference of money is that we have the reinvestment
opportunities for funds which are received early. The funds so invested will
earn a rate of return; this would not be possible if the funds are received in
future time.
• Thus, time value money is expressed in terms of a rate of return or more
popularly as a discount rate.
• There are two techniques used for calculating future incomes in terms of the
present value.
• Compounding Technique
• Discounting Technique

Compounding Technique
Interest is compounded when the amount earned on an initial principal amount
becomes part of the principal at the end of first compounding period. Thus, interest
earned is added to initial amount to arrive at new principal for second compounding
and so on.
Suppose,
Principal amount P = Rs 1000
Rate of Interest r = 5%
Number of years n = 3
Compounding of interest can be calculated as
A = P (1 + r)"
Where, A, is the compounded amount after n years

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Amount at end of
1st year, A, = 1000(1 + 0.05)' = Rs 1050.00
2nd year, A, = 1050(1 + 0.05)' = Rs 1102.50
3rd year, A, = 110250(1 + 0.05)' = Rs 1157.625
or Az = 1000(1 + 0.05)3 = Rs 1157.625 Future Value Interest Factor FVIF = (1 +
r)"
• Amount after n years or future value can be calculated as FV = P * FVIF

Semi-Annual Compounding
It means that there are two compounding periods within a year. Interest is paid after
every six months at a rate of one-half of the annual rate of interest.
FV =P(1+12
where, FV = future value
Thus, rate of interest is halved, and n = 2 (2 half years)

Quarterly Compounding
It means that there are four compounding periods of 3 months each in a year. Instead
of paying full interest once a year, one-fourth of the interest is paid in four equal
installments every quarter (4 quarters)
The greater is the number of times compounding is done in a year, higher will be the
future value or the yield or return. Discounting Technique
Discounting is an attempt to calculate the present value of a cash flow falling due on
a future date. It is the reverse of compounding technique which tries to calculate the
present value of future cash flows.
Where, A is the sum to be received in future after n years, the r is the current rate of
interest. Present Value of Series of Cash Flows
In capital budgeting decisions, the present value of all the cash flows received by a
firm every year can be determined as

Illustration. Mr. X wishes to determine the present value of future cash flows of next
five years which are Rs. 1000, Rs. 2000, Rs. 3000, Rs.4000 and Rs. 5000 for every
year, respectively. Assume that individual cash flows are discounted at 10% every
year.

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Year Cash Flow PVF PV

1 Rs. 1000 0.909 Rs. 909.00
2 Rs. 2000 0.826 Rs.1652.00
3 Rs.3000 0.751 Rs. 2253.00
4 Rs. 4000 0.683 Rs. 2732.00
5 Rs.5000 0.621 Rs. 3105.00
Rs.15000 Rs. 10651.00

The present value of Rs 15000 which a person can receive in different cash values
in next five years is Rs 10651 discounted at rate of 10% for next 5 yr.

Present Value of Annuity

An annuity is a series of equal cash flows of an amount each year. Bond, equity or
any other investment that offers an investor a regular cash inflow each year can be
valued in current period with the help of present value of annuity.

where, C = Annual cash flow remains same = Annuity

PVF, = Present value discounting factor for ith year Shortcut Method of Calculating
PV of Annuity
Discounted at the rate of interest 'r' for 'n' years with annuity of value C.

1.2 Valuation of Bonds and Shares

Valuation of Long-term Securities

The price, an investor or a buyer is willing to pay to purchase a specific asset or
security would be the value of that asset or security. The valuation process links risk
and returns expected by the investor from its assets to determine the worth at a given
point of time.
The key factors in valuation process are
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(i) Expected returns in terms of cash flows together with their timing.
(ii) Risk in terms of required return. Risk denotes the chance that an expected
return/cash flow would not be realized.
The greater the risk, lower the value and vice versa.

Valuation of Tangible Assets

The assets of permanent nature, which are held for the purpose of running a business
are termed as tangible assets. These can be:
• Plant
• Machinery
• Land
• Building
• Furniture and fixtures
• Vehicles like car, truck, etc.
Raw material and finished goods Tangible assets are to be valued at a cost price less
depreciation in their value by constant use.

Valuation of Intangible Assets

The assets which cannot be seen or touched but are valuable to the company are
known as Intangible assets.
These are goodwill, copyrights, trademarks, formula, patents, licenses, slogan,
prestige.
Intangible values are also valued at the cost price i.e, expenditure incurred for
acquiring them.

Concepts of Values
Book Value : It is an accounting concept. The book value is the value of an asset as
recorded at historical cost and they are depreciated over years. Book value may
include intangible assets at acquisition cost minus amortized value. The difference
between the book value of assets and liabilities is equal to shareholder's funds or net
worth.
Market Value : It is the current price in the market at which the asset or security can
be sold or bought

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Liquidation Value : It is also called as Realization Value; it is the amount that a

company could realize if it sold assets on binding of the business. It is generally a
minimum value which a company might accept if it sells its business,
Replacement Value : It is the price to be paid in order to purchase a similar but new
asset with old asset.
Going Concern Value : It is the amount that a company could realize if it sold its
business as a running one. Its value would always be higher than the liquidation due
to the usefulness of assets and value of intangibles.
Salvage Value : The value at which an asset might be sold as a scrap when it has to
be discarded.
Value of Goodwill : This value can be arrived at by multiplying the super profit with
the company's year of purchases.
Intrinsic Value : It is also called as economic value. It is the present value of the
future cash flows associated with the assets.

Bonds (Debentures)
Bonds are also termed as debentures. They are negotiable promissory notes that can
be used by corporates, institutes or government agencies to raise funds from
investors. It has the following features.
1) It is an acknowledgment of debt.
2) It is convertible into equity at a larger stage.
3) Redeemable at the time of maturity.
4) Secured instrument for raising debt against collaterals.
5) Issuer can be the corporates or/and the government agencies.

Terms Related to Bonds.

1) Face Value : Also termed as par value, it is the value on the face of the bond.
It represents the amount of money; the person borrows and promises to repay
at the time of maturity. A bond may be issued at par, at premium (more than
face value) or at discount (less than par value).
2) Coupon Rate : It is the specified interest rate, payable to the bondholder on
the par value irrespective of the price of issue.
3) Maturity Period : It is the number of years after which the par value is payable
to the bond holders. Thus, bond holder will receive redemption value at the
time of maturity.

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4) Market Value : a bond may be traded in a stock exchange. Market value is the
price at which the bond is usually sold or purchased in the market.

Methods of Valuation of Bonds

Basic Bond Valuation Model : The value of bond is the present value of the payments
its issuer will make to the bonds issue from time of purchase till its maturity. The
discounting rate to arrive at present value depends on risk and prevailing interest
rate. It is also the required rate of return on the bond. Payments to bond holder are :
Interest earned every year in form of annuity.
Par value at time of maturity i.e., redemption value.

Illustration. A bond whose par value is Rs 1000 bears a coupon rate of 12% and has
a maturity period of 3 yr. The required rate of return on bond is 10%. What is the
intrinsic value of the bond? Sol.
Interest 1 = 12% of (R) = Rs 120 Redemption value R = Rs 1000 Required rate r =
10%, n = 3 Vo = 120 x PVIFA,109, 3) + 1000 * PVIF 109, 3) = 120 * 2.487 + 100
* 0.751 = Rs 1049.44 (Note when,
r = 1, bond sells at par value r< I,
bond sells at premium
r> I, bond sells at discount)
This implies that the bond of Rs 1000 worth is worth Rs 1049.44 today it required
rate of return is 10%. Thus, investor is willing to pay more than the par value for the
bond today.

Q. The value of a bond with a given maturity period is

(UGC-NET JUNE 2014 P-2)
a) Present value of maturity value of the bond
b) Present value of annual interest plus present value of maturity value
c) Total amount of interest plus the maturity value received
d) Maturity value received
Ans. (b)

Q. Consider the following two statements :

(UGC-NET DEC. 2014 P-2)

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Statement I: Bond value would decline when the market rate of interest rises.
Statement II : There is a positive relationship between the value of a bond and the
interest rate. Select the correct code :

Codes :
a) Statement i and Statement II both are correct.
b) Statement I is correct, but Statement II is incorrect.
c) Statement II is correct, but Statement I is incorrect.
d) Statement I and Statement Il both are incorrect.
Ans. (B)

Bond Value with Semi-annual Interest : Some of the bonds carry interest payment
semiannually. Annual interest payment is halved, number of years to maturity will
be doubled to get the number of half-yearly periods. Discount rate must be divided
by two to get the discount rate for half-yearly period.
Thus, bond value (V.) can be calculated as

The valuation of bond is simpler than an equity, as the investor is certain about the
expected cash flows.

Zero Coupon Bonds: Bonds which do not make periodic interest payments are zero
coupon bond. Their coupon rate is zero. The return to the investor consists of the
difference between the redemption value of the bond on maturity date and the 'below
face value' at which he purchases it. Its valuation can be done as
Vo = R(PVIF,izn )
where, R is redemption value/face value
r = Required rate of return, and
n = Years of maturity

Illustration. Suppose, a firm issues a zero-coupon bond having a 5 years maturity

and face value of
Rs 1000. If the investor's required rate of return is 8 %. Find the value of bond. Sol.
Vo = 1000 (PVIF 0.04,10)

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In other words, an investor buying zero coupon bond Rs 681 today can get Rs 1000
after 5 years and his investment of Rs 681 will earn him a 8% compound annual rate
of return. Since, there is a significant difference between the issue price and maturity
value of such bonds, they are also called as Deep Discount Bonds.

Yield to Maturity
Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held
until it matures. It is expressed as an annual rate. In other words, it is the internal
rate of return (IRR) of an investment in a bond if the investor holds the bond until
maturity, with all payments made as scheduled and reinvested at the same rate.
Yield to maturity (YTM) = [(Face value / Present value)'/Time period,

Yield to Call
Yield to call is the yield of a bond if the bond is bought and hold until the call date.
But this yield is valid only if the security is called prior to maturity. The calculation
of yield to call is based on the coupon rate, the length of time to the call date and the
market price. Many bonds are callable, especially those issued by corporations. This
means that the issuer of the bond can redeem the bond on what is known as the call
date, at a price known as the call price. The call date of a bond is always before the
maturity date.

C = the annual coupon payment, CP = the call price, YTC = the yield to call on the
bond, and
CD = the number of years remaining until the call date. Illustration. Find the yield
to call on a semiannual coupon bond with a face value of $1000, a 10% coupon rate,
15 years remaining until maturity given that the bond price is $1175 and it can be
called 5 years from now at a call price of $1100.

Characteristics of Warrants
• Detached warrants can be traded as independent securities, but they have a
predetermined life and expire at a certain date. They may also be perpetual
warrants, which never expire.
• Warrants are distributed to shareholders in lieu of cash or stock dividend or
can be sold directly as a new security issue.
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• A warrant holder has no right unlike a shareholder. He never receives any

dividend and has no voting right. Usually 1:1 is the rate of share to warrants.
The exercise price of the warrant is what the holder must pay to purchase the
stated number of shares.
• The existence of the positive premium on a warrant means that it will be more
beneficial for the warrant holder to sell his warrant when he exercises it. The
premium associated with a warrant shrink as the expiry date approaches.

Valuation of Warrants
when, S. = Spot price of the share or current market price
X = Exercise price
N = Number of shares in a warrant
then, Vo = (S. - X) N Illustration. A warrant is issued along with a debenture issue.
The holder of the warrant has a right to get 5 shares at the rate of 250. If the current
market price of the share is Rs 300,
calculate the value of warrant ? Sol. N = 5, SO = 300, X = 250
Vo = (300 - 250) * 5 = Rs 250

1.3 Risk and Returns Return

The rate of return on an asset/investment for a given period is the annual income
received plus any change in market price, usually expressed as a per cent of the
opening market price.
R-D, +(P, -PA)
P-1 where D, = Dividend/ annual income at the end of year
P, = Market price at close of year (closing price)
PH = Market price at close of year (opening price) Returns can be drawn from an
asset in two ways. () Current yield called as revenue earnings by usage of asset.
(ii) Capital/gain/loss by liquidating the asset at profit/loss. illustration. Mr. ABC
bought some shares of company 'X' for Rs 500 each. At the end of a year, he got Rs
5 per share as dividend and sold the shares at Rs 550 each.

What will be his returns on investment?

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