TVM, RISK AND RETURN

TIME VALUE OF MONEY

According to corporatefinanceinstitute.com, the time value of money is a basic financial concept that

This is true because the money that you have right now can be invested and earn a return, thus creating
a larger amount of money in the future. (Also, with future money, there is the additional risk that the
money may never actually be received, for one reason or another.) The time value of money is
sometimes referred to as the net present value (NPV) of money.

The time value of money is an important concept not just for individuals, but also for making business
decisions. Companies consider the time value of money in making decisions about investing in new
product development, acquiring new business equipment or facilities, and establishing credit terms for
the sale of their products or services

RISK AND RETURN

Why do we have to study risk and return? 

According to Lasher (2014), the reason for studying risk and return is to be able to understand the
concepts of risk and return to capture the high average returns of equity investing while limiting the
associated risk as much as possible.

In investing, risk and return are highly correlated. Increased potential returns on investment usually go
hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific
risk, competitive risk, international risk, and market risk. Return refers to either gains and losses made
from trading a security [online].

The return on investment is expressed as a percentage and considered a random variable that takes any
value within a given range. Several factors influence the type of returns that investors can expect from
trading in the markets.

Diversification allows investors to reduce the overall risk associated with their portfolio but may limit
potential returns. Making investments in only one market sector may, if that sector significantly
outperforms the overall market, generates superior returns, but should the sector decline then you may
experience lower returns than could have been achieved with a broadly diversified portfolio [online].

Synthesis:

This topic discussed how TVM works, and its importance in financial management decision. TVM
concepts are essential in making decisions about investing in new product development, acquiring new
business equipment or facilities, and establishing credit terms for the sale of the company's products or
services. This topic also discussed the importance of studying risk and return, return on investment, and
the CAPM.

T 1.1. TVM - Future Value

FV = PV [FVFk,n ] To get the FVFk,n = (1 + i)^t

FV = PV x (1 +i)^t

Future Value-Amount to which an investment will grow after earning interest.

Compound Interest-Interest earned on interest.

Simple Interest-Interest earned only on the original investment.

Example -Simple Interest

Interest earned at a rate of 6% for five years on a principal balance of $100.

Interest Earned Per Year = 100 x .06 = $ 6

Example -Simple Interest

Interest earned at a rate of 6% for five years on a principal balance of $100.TodayFuture

Example -Compound Interest

Interest earned at a rate of 6% for five years on the previous year’s balance.

Interest Earned Per Year =Prior Year Balance x .06

Example -Compound InterestInterest earned at a rate of 6% for five years on the previous
year’s balance.TodayFuture Years12345Interest EarnedValue100Value at the end of Year 5 =
$133.8261066.36112.366.74119.107.15126.257.57133.82

100x1.06=106

106x1.06=112.36

112.26x1.06=119.10

Future Value of $100 = FVFVrt=$100(1+r)^t

What is the future value of $100 if interest is compounded annually at a rate of 6% for five
years?

Fv=100(1.06)^5=133.82

Example: Manhattan Island Sale

Peter Minuit bought Manhattan Island for $24 in 1626. Was this a good deal?To answer,
determine $24 is worth in the year 2006, compounded at 8%.

=fv= 24(1+.08)^380=120.57 trillion

2006-1626=360

FYI -The value of Manhattan Island land is well below this figure.

T 1.2. TVM - Present Value

PV = FV [PVFk,n]  To get the PVFk,n =   1/(1+i)^t

PV = FV ( 1/(1+i)^t)

3 terms that you need to remember when you are calculating the present values

Present Value –Value today of a future cash flow

Discount Factor –Present value of a $1 future payment

Discount rate-Interest rate used to compute values of future cash flows

PV=Future Value after t periods (1+r)t

Time value of money

The PV formula has many applications. Given any variables in the equation, you can solve for
the remaining variable.

Pv=fv(1/(1+r)^t)

•Value of Free Credit

•Implied Interest Rates

•Time necessary to accumulate funds

Example

Your auto dealer gives you the choice to pay $15,500 cash now or make three payments:
$8,000 now and $4,000 at the end of the following two years. If your cost of money is 8%,
which do you prefer?

Imidiate payment 8000

Pv1 4000(1/(1+.08)^1)= 3703.70

Pv2 4000(1/(1+.08)^2)=3429.36

Total pv= 15 133.06

PVs can be added together to evaluate multiple cash flows.

PV = c1 ( 1/(1+i)^t)+ c2( 1/(1+i)^t)+….

VALUATION AND CHARACTERISTICS OF BONDS

According to CFI Education Inc., corporate bond valuation is the process of determining a corporate
bond’s fair value based on the present value of the bond’s coupon payments and the repayment of the
principal. Corporate bond valuation also accounts for the probability of the bond defaulting and not
paying back the principal in full.

Lasher (2014) states that Valuation is a systematic process through which we establish the price at which
security should sell. We can call that price the security’s intrinsic value.

Corporate bonds are bonds issued by corporations to finance various activities, including operations,
expansion, or merger and acquisition. Corporate bonds generally offer higher yields than government
bonds because they usually come with a higher probability of default, making them riskier. Additionally,
there are different types of corporate bonds that range in levels of risk and yield.

Valuation and Characteristics of Bonds - Part 1

Valuation and Characteristics of Bonds - Part 2

Valuation and Characteristics of Bonds - Part 3

Valuation and Characteristics of Bonds - Part 4

Important Notes to Remember - Valuation of Bonds

VALUATION OF BONDS

Valuation is a systematic process through which we determine the price at which a security should sell. 
Since the value of securities is based on the future cash flows that come from owning them, valuation
involves determining the present value of those flows.  Securities don't always trade for
the intrinsic values we calculate for them.  This means valuation is a method of identifying potential
bargains.

Real assets are tangible things like cars and houses that provide services like transportation and
shelter.  The value of real assets is based on the services they provide.  Financial assets are pieces of
paper that provide no services in themselves.  However, they give their owners claims to cash flows
expected in the future.  The value of financial assets is based on receiving those future cash flows.

A security's value is based on an estimate of its future cash flows.  That, in turn, is largely based
on an estimate of the issuing company's future financial performance.  It is a fact of human nature that
people form different opinions of the future based on the same knowledge of the past and present. In
other words, different people interpret the same events differently.  This leads to differing valuations
even when the same information is available to everyone.

A bond represents a debt relationship between the investor (lender) and the issuing company
(borrower).  In contrast, stock represents ownership of a share of the issuing company. 

A bond issue is a device through which one organization simultaneously borrows from many lenders
under one agreement. Each bond represents a share of the loan.  An investor is said to "buy" a bond
even though he or she is actually lending money. 

The amount of the loan represented by a bond is denominated (printed) on its face. This principal
amount, known as the bond's "face value," is repaid on a designated "maturity" date at the end of
the bond's "term."  Until maturity, the investor receives only interest, usually paid twice a year at the
bond's "coupon rate" which is also printed on the face of the bond.  Since no principal is repaid until
maturity, bonds are said to be "non-amortized" debt. 

The payment of interest and principal to bondholders has a higher legal priority than the payment of
dividends to stockholders. Therefore, bonds are said to be less risky than stocks of the same company. 

Conflicts between stock and bondholders exist because the rewards of risky ventures accrue to
stockholders, but the penalties for failure can also hurt bondholders. Hence stockholders are more
inclined to support risk-taking than bondholders.
A call provision is a clause in a bond contract that allows the issuing company to pay the debt off
early.  Calls are usually exercised when interest rates have fallen substantially and the bond's debt can
be reissued at a lower rate.  They also allow companies to escape indentures that may have become
restrictive.

Call provisions generally require that bondholders receive an additional payment if the call is exercised
to compensate for the loss of the original high-interest rate. The payment is known as the call
premium (to the bondholder) or penalty (to the issuer).   There's also generally a protected period
at the beginning of the bond's life when it can't be called. 

The coupon rate is the rate at which the bond pays interest on its face value.  It is used to calculate the
dollar amount of interest payments. 

The bond's yield is the current market rate offered by bonds of similar risk and term. It is used to take
the present value of the bond's future interest and principal payments. 

The current yield is the annual interest payment divided by the current price of the bond.

The interest actually paid by a bond is constant from year to year, but the return on an investment in
the bond as seen by a new buyer varies as its price changes.  The prices of old bonds adjust continually
to keep their yields competitive with newly issued bonds.  They can therefore be traded during their
entire lives, but not at face value.

Bonds are generally less risky investments than the stock of the same company.   However, a
bond can become riskier if the issuing company is run recklessly or takes on riskier projects.  Indentures
are contractual conditions required by lenders (bond buyers) that control the way management can run
the company in an effort to limit risk.

A bond's price is the present value of its future cash flows, including periodic interest
payments and a single payment returning principal at maturity.  The interest payments
constitute an annuity since they are constant in amount and regular in timing.  Therefore, the present
value of a bond's cash flows is conveniently separable into an annuity problem to handle the interest
payments and an amount problem to handle the return of principal.

Bond prices and interest rates vary inversely with one another (but not in direct proportion).  The
relationship arises because investors often need to sell old bonds in the secondary market where
interest rates change regularly.  To stay competitive with newly issued bonds, an old bond has to offer a
market yield to a new buyer.  The only way it can do that is through a price change, since bond interest
payments are fixed.

We can roughly estimate a bond's price by looking at the difference between the current interest rate
and the bond's coupon rate. If that difference is large, and the bond has a long time until maturity, we
can guess that the percentage price change will be in the neighborhood of the percentage interest rate
change.
Bond prices vary inversely with interest rates.  If an investor buys a bond and interest rates rise, its
market price falls.  Therefore, an investor who has to sell the bond while rates remain high suffers a loss
due to a price change induced by an interest rate change.  The possibility of such a loss is called interest
rate or price risk. 

The phenomenon also depends on the maturity of the bond, because the prices of long-term bonds
change more in response to interest rate changes than the prices of short-term bonds. This connection
leads to the term maturity risk.

A bond's future cash flows are discounted to their present values by dividing by (1+k) i where i varies
from 1 to the bond's term of n periods.  The sensitivity of (1+k)i  to changes in k depends on the value of
i.  The larger is i, the more (1+k)i changes due to a given change in k.

In a long-term bond, many of the cash flows are discounted by factors with large exponents. In a short-
term bond, the exponents are all small.  Therefore, a change in k affects a long-term bond relatively
more than a short-term bond.

To describe the process of finding a bond’s yield at a given selling price, we begin by making an educated
guess at the yield based on the relation between the bond's selling price and its face value.  Then we
evaluate the price implied by that yield and compare it to the actual selling price.  If the two are
different we make another guess at the yield and repeat the process.  We continue until a yield is found
that results in a price that's very close to the selling price.  Successive guesses are not random but are
based on the inverse relationship between prices and yields.

A bond issued at a high coupon rate is likely to be called if interest rates drop substantially.  If the drop
occurs during the call-protected period, the call is likely at the end of that period.  Under these
conditions, the call limits price increases induced by interest rate declines, because it makes above-
market interest payments unlikely after the call-protected period.

The principal repayment required when a bond issue matures is typically many times the annual interest
paid during the issue's life.  That means a borrowing company that has easily funded interest payments
can be unable to come up with enough cash to repay the principal when it's due.  In extreme cases, this
can cause the borrower to fail and never repay the full amount of principal. 

A sinking fund usually prevents this from happening by forcing the borrower to put aside money for
principal repayment over an extended period so that it is available at the bond's maturity.

VALUATION AND CHARACTERISTICS OF STOCKS

Every investor who wants to beat the market must master the skill of stock valuation. Essentially, stock
valuation is a method of determining the intrinsic value (or theoretical value) of a stock. The importance
of valuing stocks evolves from the fact that the intrinsic value of a stock is not attached to its current
price. By knowing a stock’s intrinsic value, an investor may determine whether the stock is over- or
under-valued at its current market price [online].
Valuing stocks is an extremely complicated process that can be generally viewed as a combination of
both art and science. Investors may be overwhelmed by the amount of available information that can be
potentially used in valuing stocks (company’s financials, newspapers, economic reports, stock reports,
etc.) [online]

Therefore, an investor needs to be able to filter the relevant information from the unnecessary noise.
Additionally, an investor should know about major stock valuation methods and the scenarios in which
such methods are applicable [online].

According to Lasher (2014), corporations are owned by the holders of their common stock. Stockholders
choose directors, who in turn appoint managers to run the company. In theory, this means that
stockholders have a voice in running the company through the board of directors.

However, most large companies are widely held, meaning that stock ownership is spread among a large
number of people with no individuals or groups controlling more than a few percent. Under those
conditions, stockholders have little power to influence corporate decisions, and stock ownership is
simply an investment.

Lasher (2014) states that in stock investment, income comes in two forms. Investors receive dividends
and realize a gain or loss on the difference between the price they pay for stock and the price at which
they eventually sell it. This last part is called a capital gain or loss.

Important Notes to Remember - Valuation of Stocks

VALUATION OF STOCKS

The return on a stock investment comes from dividends and price appreciation.  Although neither is
guaranteed, both have the potential for growth in the future.  This is in distinct contrast to investments
in debt vehicles that guarantee future payments but offer little or no possibility of a return that's higher
than promised. 

Although stock implies ownership, few equity investors expect to play a role in running the companies
whose shares they buy. Such firms are widely held, and few stockholders have large enough blocks of
stock to influence management decisions. 

In small businesses, of course, owners usually run their companies.

The cash flows associated with both stocks and bonds consist of a stream of relatively small amounts
followed by a final larger payment.  The streams are dividends for stocks and interest payments for
bonds, while the final payments are the selling price of stock and the return of a bond's principal. 

A stock's value to an investor is best represented by the present value of the dividends
paid while the share is held plus the present value of the price received upon sale.  However, that final
selling price can be replaced by a similar model of value in the mind of the investor who buys the share. 
Thus at the end of the first investor's holding period, another stream of dividends begins, followed by an
eventual selling price.  In effect, the valuation model has been transformed into a longer stream of
dividends and a selling price by the consideration of two sequential investors.  This mental construct can
be applied as many times as we like and the eventual selling price pushed indefinitely far into the future
where its present value is zero.  We're left with just the present value of an infinitely long series of
dividends.

Forecasting the future of a business and the price of its stock is a difficult and imprecise task especially
for outsiders who don't have access to the company's detailed plans and records.  However, an overall
evaluation is often formed based on a variety of imprecise observations and feelings about the
company.  That subjective feeling can be nicely summed up in a projected growth rate.  Growth rate
models allow us to estimate stock prices based on this summary information which although incomplete
is often all we have.

Normal growth implies a forecast dividend growth rate that is less than the return required on an
investment in the stock.  Supernormal growth implies the reverse, a growth rate greater than the
required return.  Supernormal growth exists but is generally assumed to be temporary.  It is usually
modeled to last no more than a few years.  Normal growth can last indefinitely. 

The two-stage growth model separates the future into two periods.  The first is a finite number of
years during which the growth rate can have any value but is usually assumed to be super normal.  The
second period is infinitely long and is characterized by normal growth.  The procedure projects the firm's
dividends from the present until just after normal growth begins.  The Gordon Model is then used to
determine the value of the stock at the beginning of the period of normal growth.  The value of the
stock today is the sum of the present values of the Gordon Model amount and all the calculated
dividends up until that time.  

Stock valuation is considerably less precise than the bond valuation for two reasons.  First,
there's a big difference in the predictability of the future cash flows associated with the two
instruments.  Bond payments are contractually specified and generally quite reliable.  Dividends and the
eventual selling price of stocks, on the other hand, are uncertain even for stable companies.  Second,
the appropriate discount rate for taking present values is an estimate based on perceived risk for stock,
while it is a more readily known market return for bonds.

Stocks that don't pay dividends have value because they are expected to pay dividends at some time in
the future.  This is true even if management states its intent never to pay out its earnings as dividends. 
The absence of dividends at some time during the firm's life implies that stockholders would never
receive any value for their investments.

Company executives working with investment bankers estimate a range of prices for the stock to be
issued.    They then go on a roadshow making promotional presentations to potential investors.  During
the trip they ask investors, mostly institutional clients of the investment bank, to estimate the number
of shares they will be willing to buy.  This process is called “book” building.  These estimates are not firm
orders, but collectively represent likely investor demand for the stock.  Based on the book the team
decides on a price along with a volume number that will raise the amount of money the company is
looking for. 

The IPO price may be a reasonable estimate of intrinsic value since it is developed by analyzing the firm’s
business and estimates of demand from knowledgeable professionals.  It may, however, be intentionally
somewhat underpriced.

Preferred stock pays a constant dividend that is specified in amount but not
guaranteed.  However, the cumulative feature generally requires that preferred dividends be caught
up before common dividends can be paid.  The value of a preferred share is the present value of the
perpetuity of its dividends.   

Preferred stock is legally equity but in some ways behaves more like debt. It is viewed as a hybrid
because its characteristics are like those of common stock on some issues, like those of bonds on other
issues, and lie somewhere in between on still others.  The main issues are as follows.

  (1) Preferred dividends are constant, as are interest payments.  They are unlike common stock
dividends, which are usually expected to grow. 

  (2) Bonds have maturity dates on which the principal is returned.  Preferred, like common stock, has no
maturity, and never returns principal. 

  (3) Interest must be paid, common dividends can be passed indefinitely.  Preferred dividends are
between in that they can be passed, but are subject to a cumulative feature. 

  (4) In bankruptcy, the priority of preferred is between that of bonds and common stocks.

  (5) Like bondholders, preferred stockholders have no voting rights. 

  (6) Interest is tax-deductible to the paying company while dividends, common or preferred, are not. 

The features of bonds, preferred, and common stocks create an ordering of risk. Bonds are the safest,
because their payments are the most assured.  Common is the most risky, because its payments are the
least certain.  Preferred is in the middle.  The compensation for bearing the risk of common stock is that
the return can be very high if the company does well.  That possibility doesn't exist with bonds or
preferred.

Fundamental Analysis involves doing research to discover as much as possible about a company's

Technical Analysis is based on the belief that market forces dictate prices and price movements, and
that movement patterns repeat themselves. Therefore, technicians believe that recognizable patterns
can predict stock price changes. 
The efficient market hypothesis says that financial markets are efficient in that new information is
disseminated very rapidly.  This means that at any time, all available information is reflected in stock
prices, and studying historical patterns of price movement can't consistently help an investor in earning
above-average returns. 

It also implies that fundamental analysis won't help individual investors much, because professionals are
doing it all the time.  They discover and disseminate anything an individual can figure out long before he
or she does.