FINANCIAL MANAGEMENT

CHAPTER 4

VALUATION

Learning Objectives
After reading this unit, you will be able to:
Discuss the concept of present value of money
Explain the concept of future value of money
State the meaning of annuity and its present and future value
Use these concepts in business application

Structure
4.1 Introduction
4.2 Time Value of Money
4.3 Future Value Concept
4.4 Present Value Concept
4.5 Annuity Concept
4.6 Business Applications Of Time Value Of Money (T.M.V.)
4.7 Valuation of Financial Assets
4.8 Summary

4.1 Introduction

Ÿ Decision-making is the important management function. Any decision

involves incurring cost today and benefit tomorrow
Ÿ Time value of money is useful to bring costs and benefits at same point of
time so that decisions can be taken if costs are more than benefits.
Ÿ Many times business wants to make provisions for liabilities going to
occur in future. To make exact assessment of provision time value of
money is useful.

4.2 Time Value Of Money

i. Value of unit of money is different in different times. Sum of money

received today has more value than sum of money received after some
time.

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ii. Time value of money is also referred to as time preference for money.
iii. There are three reasons for time preference for money :
a) Risk and uncertainty: Individual is not certain about future receipts.
b) Preference for consumption: money is means by which individuals
acquires goods and services. Most of them prefer present
consumption to future consumption because due to illness, death or
inflation they may not be able to enjoy future consumption.
c) Investment opportunities: With present available cash. They are in a
position to avail investment opportunities to earn additional cash.
iv) Time preference is generally expressed by an interest rate. This rate is
available even in absence of risk and it is called risk free rate. However,
in real life situation, risk is always involved. It is therefore necessary to
add risk premium. Thus,
Required rate of return = Risk free rate + Risk Premium
It is also called as opportunity cost of capital of comparable risk, as
investors could invest money in assets or securities of equivalent risk.
v) Basic objective of financial management is wealth maximization, which
is future oriented. Therefore, time value of money has great importance in
financial decision-making. In order to evaluate decisions costs and benefits
are to be compared at same point of time. Costs are incurred today and
benefits are derived in future, which must be brought to level of today. This is
done with the help of present value of money.

4.3 Future Value Concept

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This factor is given in compounded value tables, which are readily available.
In case r is in fraction and / or n is also in fraction then these tables are not
useful and one has to use computer for calculating future value.
Illustration 1:

Rs. 20,000 deposited in bank for 3 years. Rate of interest is 10%. What will
be maturity value of deposit, if compounding is done yearly?

Illustration 2:

In problem 1, if rate of interest is 12% and compounding is done 6 monthly,

what is maturity value?

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Illustration 3:
Anil wants to deposit Rs. 1,00,000. Interest rate is 12% and compounding is
done quarterly. What will be the maturity value?

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Illustration 4
Asmita received scholarship of Rs. 2,00,000. This amount she will use for
payment of MBA fees after 12 months. Till such time, she has deposited
amount in bank. Rate of interest is 12% and compounding is done monthly.
How much amount will be available to her?

Illustration 5:
Company wants to pay off liability Rs. 5,00,000 after 6 months. How much
amount should be kept aside today?

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Illustration 6:
Rate of interest is 12% P.A. What is effective rate of interest if
(a) Compounding is done twice a year (b) 4 times a year (c) 12 times a
year

4.4 Present Value Concept

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Illustration 1:
What is the P.V. of amount Rs. 3,00,00 which is to be received after 3 years
Compounding is done yearly and Rate of interest is 12%.

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Illustration 2:
Company is considering the buying of a machine for Rs. 70,00,000. It
will give benefits for 5 years as follows :
Year Benefit
1 10,00,000
2 15,00,000
3 20,00,000
4 25,00,000
5 30,00,000
Rate of interest applicable is 12%.

Should company buy the machine?

Illustration 3:
Company has been offered a contract which has following terms:
An immediate cash outlay of Rs. 15,000 followed by cash inflow of Rs. 17,900
after 3 years. What is company's rate of return on this contract.

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4.5 Annuity Concept

Annuity is a finite series of equal cash flows made at regular intervals. In

business many payments are made or received at regular interval. Finding
present and future value of annuity becomes essential for many business
decisions or investment decisions by investors.

[PVAF]r,n is a present value annuity factor. This factor is given in annuity

tables for particulars r and n. If r is in fraction one has to use computer to
calculate (P.V.) annuity.

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Illustration 1:
A 4 year annuity of Rs. 3,000 P.A. is deposited in bank account which pays
9% interest compounded annually. What is future value of annuity?
[Given: ( CVAF) = 4.573 ]

Illustration 2:
Recurring deposit is opened in bank for 12 months. Amount deposited every
month is Rs. 5,000. If rate of interest is 12% how much amount would be
available on maturity of recurring deposit.

Illustration 3:
Interest is to be received at the end of each year for the next 5 years Rs.
10,000. What is the present value of this amount if rate of interest is 10%
p.a.[PVAF)10%,5 = 3.7907]

Solution:

This is an annuity of Rs. 10,00n0

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Illustration 4:
Find P.V. of investment which is expected to give a return of Rs. 2,500 P.A. and
Rs. 2,500 P.M. perpetually. Rate of interest is 12%.

4.6 Business Applications Of Time Value Of Money (t.m.v.)

a) Finding out Implicit Rate of Interest:

Financial institutes issue deep discount bond where investor is required to pay
a specific amount at the time of issue and receives larger amount at the end of
specified period. TMV is useful to find out rate of interest.
Illustration 1:
Deep Discount Bond is issued for Rs. 5,000 today and will mature after 5
years for Rs. 10,000 what is rate of interest Offered.

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Illustration 2:
A company offers a scheme under which a deposit of Rs. 15,000 will entitle the
depositor to receive Rs. 4,000 per year at the end of each of next 5 years.
Should the scheme be accepted ? (PVAF)r,5 = 3.75 for 10.57%.

Investor should accept scheme if normal rate of interest is less than

this.

b) Calculating no. of periods for repaying certain amount

Many times, equal installment including principal and interest is to be paid to
bank or other lender. Management is interested to know how many payments
would be required to clear off the loan.

Illustration 1:
A loan of Rs. 50,000 is to be repaid in equal annual installments of Rs. 14,000.
The loan carries 6% interest rate. How many payments are required to repay
this loan?

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c) Sinking Fund:
A finance manager may be interested to accumulate a target amount in order
to replace an asset or in order to repay liability at the end of a specified period.

Illustration: 1
An amount of Rs. 1,00,000 is required after 5 years to repay a liability. How
much amount should be accumulated every year.

d) Capital Recovery:
Sometimes one may be interested to find out equal annual amount paid in
order to repay a loan of specified amount over a specified period together
with interest.
Illustration 1
Amount borrowed = Rs. 1,00,000
Repayment = 5 Equal yearly installments
Rate of Interest = 10% P.A. and PVAF = 3.791

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e) Deferred Payments:
Sometimes repayment of loan may not start immediately. In such case
management is interested to know installment amount which would include
principal and interest.

Illustration 1:
Loan of Rs. 1,00,000 is taken on which interest is payable @ 10%. Repayment
is to start at the end of third year from now. What should be annual payment if
total loan and interest is to be repaid in 6 installments PVA F 10%, 6 =
4.355
Ĭ ŎÕÞPÒŎŌÈ
ĂHÅ Find amount due at end of 2nd year i.e. At he beginning of 3rd year, from now
F.V. = PV ( 1 + r)n
= 1,00,000 ( 1 + 0.1)2
= 1,21,000

(II) 1,21,000 is the PV of annuity of 6 years. @ 10%.

PV = (Annuity Amount) x PVAF 10%, 6
1,21,000 = Annuity x 4.355
Annuity = 1,21,000
4.355
= Rs. 27,784

4.7 Valuation Of Financial Assets

(a) Concept of Valuation:

· Financial assets refer to the financial claims such as Bonds,
Preference Shares, Equity Shares etc.
· Every financial manager and investor must understand how to
value: financial assets, to judge whether they are good to buy or not.
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· Book Value (BV) of an asset:

- Accounting concept
- Based on historical data given in balance sheet
- Book value of debenture is the face value itself and is stated in balance
sheet.
- Book value of Equity Shares = Net worth of co.____
No. of equity shares
Ÿ Market Value (MV) of an assets:
- Price at which asset can be sold
- Market value of financial asset is the price of financial asset prevailing in
stock exchange
Ÿ Liquidating Value (LV):
- Refers to net difference between the realizable value of all assets and the
sum of all liabilities.
- This net difference is available to the owners.

Ÿ Capitalized Value (CV):

- Sum of present value of cash flows expected to be received in future
- For finding PV required rate of return is the discounting rate.
- In valuation of financial assets, the capitalized value is the most relevant
concept of valuation.
(b) Required Rate of Return:
Ÿ Required rate of return may be defined as minimum rate of return
necessary to induce an investor to hold or to buy a security.
Ÿ It is a function of following :
I) The risk free rate (Rf )
ii) Risk perception of investor
iii) Risk premium i.e. compensation required for bearing risk
(Rp )

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Ħ = Rf + Rp K = Required rate of return.

Rate of
Return K

Rp

----------------------------------------------
Risk
Free Rf
Rate

Risk.
c) Basic Valuation Model:
Ÿ Assumptions:
I. Estimated future cash flows is a single figure and not a series of
expected figures.
ii. Every investor has a subjective assessment of the risk associated with
financial assets and its expected cash flows. He incorporates this risk
in valuation procedure through discount factor. Thus, no standard rate
of discount can be applied to all the investors and to all the securities.
Higher the risk greater would be the discount factor.

PV of security Vo = (CF)1 + (CF)2+ -----------(CF)n

(1+k)1 (1 +k)2 (1 + k)n

= ? n(CF)i
i=1 (1+k)i

Where Vo = Value of the security at present

(CF)i = Cash flow expected at the end of year i
k = Discount rate
n = Expected life of an asset

Example:
An investment is expected to provide an annual cash flow of Rs. 5,000 for next
5 years and discount rate is 15% then,

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(d) Bond Valuation:

Ÿ Bond or Debenture is a debt security issued by company and subscribed by
investor.
Ÿ It is used for long term financing by firm.
Ÿ When bonds are issued and subscribed by an investor following conditions
are implied:
i) Company will pay interest regularly say monthly, quarterly etc.
ii) Company will repay principal amount after certain period say 5,7,10
years.
iii) Rate of interest is specified in the terms of issue.
iv) Any other conditions are also stated.
Ÿ Following terms are important
i) Par Value :
- This is also called as face value or nominal value of a bond.
- Principal amount of bond
- Stated on face of bond
- May be Rs. 100, Rs. 1,000 etc.
- Bond can be issued at discount i.e. 100 Rs. bond issued for Rs. 95
- Bond can be issued at premium i.e. 100 Rs. bond issued for Rs. 105
ii) Coupon Rate:
- Interest rate on par value
- Generally described as %
- Applied on par value to calculate periodic interest payable on bond

iii) Maturity:
- Period from date of issue
- On maturity firm must repay bond par value to investor.

Ÿ Basic assumption in bond valuation is that first payment will become due
for payment after one year from date of issue.

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Illustration:
A bond of Rs. 1,000 having coupon rate 12% is redeemable at par in 10 years
find out the value of bond if
a) Required rate of return is 12%, 10%, 14%.

Conclusion:
i) Coupon rate = Required rate
Bond should be purchased at its face value (Rs. 1,000)
ii) Coupon rate < Required rate
Bond should be purchased at price.
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Situation Decision
i) Required Rate = Coupon Rate Purchase bond at its face value( Rs. 1,000)
ii) Required Rate >Coupon Rate Purchase bond at price below face value
(Rs.895.92)
iii)Required Rate < Coupon Rate Purchase bond at price above face value
(Rs.1123.40)

Illustration 2:
A bond of Rs. 10,000 bearing coupon rate 12%andredeemable in 8 years at
par is being traded at Rs. 10,600. Find out YTM of bond.

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Illustration:
DDB has maturity 10 years. Par value 25,000 required rate 15%

Solution:
Bo (DDB) = 25,000 (PVF 15%, 10 years.)
= 25,000 x 0.247
= Rs. 6,175

Ñ) Valuation of Preference shares

Valuation of redeemable preference shares is similar to bond valuation
Po = ?n Di + Rv .

i=1
(1 + kp)I ( 1 + kp )n
Po = Value of Preference Shares
Di = Annual Fixed Dividend
Rv = Redemption Value
n = Life of Preference Shares.
Kp = Required Rate of Return by Preference Shareholders.

f) Valuation of Equity Shares:

I) Based on Accounting Information
A) Book Value:
·Value of firm's ownership based on balance sheet values for each equity
share.
·BV = Equity Share Capital + Reserves
No. of Equity Shares
· Assumption is that all assets are expected to realize an amount which is
stated in balance sheet.
· Easy to calculate.
· Ignores profitability of firm.
· Considers historical Figures and therefore fails to give realistic valuation of
equity shares.

B) Liquidation Value:
Ÿ All the assets of company are sold.
Ÿ All the liabilities including preference shares are paid.
Ÿ Remaining amount is distributed to equity shareholders.
Ÿ Based on current realizable values.
Ignores profitability of firm.
Ÿ
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II) Based on Dividends

A) Constant Dividend
Ÿ Dividend amount remains constant over years.
Ÿ Dividend stream is therefore a long term annuity or perpetuity.
Ÿ Po = D Po = Value of equity shares
Ke D = Constant dividend
Ke = Rate of return expected by equity
shareholder.
Ÿ Model requires no. estimation of future dividends and only
dividend expected at the end of year 1 is required.
Ÿ Constant dividend is unrealistic assumption.
Illustration:
Firm pays a dividend of 20% on equity shares of face value of Rs. 100.
Dividend is expected to remain constant and rate of return of investor is 15%.
Solution:
Po = D
Ke
= 20
15%
= Rs. 133.33

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III) Valuation Based on Earnings

A) Gordon Model:
Ÿ As per this approach, earnings of the firm are assumed to be either
distributed to shareholders or reinvested in business.
Ÿ Growth in dividend in future would depend upon the profits retained 7
rate of return on these retained profits.
Ÿ Model is based on following assumptions :
- Retention ratio is constant
- Rate of return on reinvested profits is constant
Ÿ As per model
Po = EPS1 ( 1 – b) Po = Price of a share
Ke - br (EPS)1 = EPS at year end 1
b = Retention ratio
ke = Reqd. Rate of return.
r = I.R.R.

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Thus difference of Rs. 48 (108 – 60) is one which investor is ready to pay for
growth opportunities or investors are willing to forgo present dividends for
higher future earnings and dividends.

Further is r = 10% which is less than required rate i.e. 15% then firm is
considered as no growth firm and investor will not be ready to pay a higher
price even if firm retains. The earning and value of equity share is

Po = 9 ( 1 - 0.4 )___
0.15 - 0.4 x 0.1
= Rs. 49.10

B) Based on P /E Ratio:
Ÿ P/E ratio is the ratio between the price of a share and its EPS
Ÿ Value = EPS x P/E
Ÿ For forecasting P/E ratio
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Following factors are to be considered.

- Find P/E of similar companies or industry
- Risk involved in business is to be assessed
- Evaluate growth prospectus of a company
- Stability of earnings
- Quality of management
- Dividend payout ratio
- Accounting policies
- EBIT of company
- Interest burden
- I / Tax rate
- Pref. capital and dividend
- Capital structure of firm
Illustration:
EBIT of company is Rs. 60 Crore. Interest paid Rs. 10 Crore. Tax rate 40%.
Company has Rs. 20 Crore equity capital (Rs. 10 each) and preference capital
(10%) Rs. 5 Crore. P/E ratio is 8. What is the value of company's share.
Solution:
E.B.I.T. = 60 Cr.
-Interest = 10 Cr.
= E.B.T. = 50 Cr.
- Tax(40%) = 20 Cr.
= E.A.T. = 30 Cr.
E.P.S. = E.A.T. - Preference Dividend
No. of Equity Shares
= [30 - 0.5] Cr. = Rs. 14.75
2 Cr.
Value = EPS x P/E
= 14.75 x 8 = Rs. 118

4.8 Summary

Ÿ In business decisions, knowing present and future value of any cash

outlay is essential.
Ÿ Present value gives value of benefits today, which are going to be
received in future. Management can compare today's cost and benefits
of today and them it is possible to take appropriate decision.
Ÿ Future value is useful to know amount to be kept aside today so that
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Ÿ desired amount at future point of time can be made available.

Ÿ Annuity is series of receipts or payments made at regular interval. This is
useful to collect desired level of funds for future liabilities to be paid.
Ÿ Time value of money is useful to business for taking many vital
decisions, such as finding implicit rate of interest, no. of periods
necessary to pay certain amount, amount to be transferred to particular
fund for paying future liability or replacing an asset, capital recovery and
so on.
Ÿ Financial assets have different types of value. Book value is one, which
is shown by books of accounts. Market value is price at which asset is
sold or bought in financial market.
Ÿ Capitalized value is the present value of future cash flows and this value
is important in finding value of financial assets.
Ÿ Different methods are used to find out the value of financial assets i.e.
equity shares, preference shares and debentures.

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