MODULE ll

CONCEPTS OF
VALUE AND
RETURN

PRESENTED BY;
ANJITHA PK, JYOTHISH, UVAIS
PART I
TIME PREFERENCE FOR MONEY
 Time preference for money is an individual’s preference for possession
of a given amount of money now, rather than the same amount at some
future time.
 Three reasons may be attributed to the individual’s time preference for
money ;
Rise.
Preference for consumption.
Investment opportunities.
REQUIRED RATE OF RETURN:
 The time preference for money is generally expressed by an interest
rate. This rate will be positive even in the absence of any risk. It may be
therefore called the rise -free rate.
 An investor requires compensation for assuming risk, which is called risk
premium.
 The investor’s required rate of return is;
Risk- free rate + risk premium.
 Would an investor want Rs.100 today or after one year?
 Cash flows occurring in different time periods are not comparable. It is
necessary to adjust cash flows for their differences in timing and risk.
Example:
If preference rate =10%
 An investor can invest if ₹100 if he is offered ₹110 after one year.
 ₹110 is the future value of ₹100 today at 10% interest rate.
 Also ₹100 today is the present value of ₹110 after a year at 10% interest
rate.
 If the investor gets less than ₹110 then he will not invest. Anything
above ₹110 is favourable.
 TIME VALUE ADJUSTMENT:
 Two most common methods of adjusting cash flows for time value of
money ;
Compounding – the process of calculating future values of cash flows
Discounting -the process of calculating present values of cash flows.
FUTURE VALUE:
Compounding is the process of finding the future values of cash flows by
applying the concept of compound interest.
Compound interest is the interest that is received on the original amount
(principal) as well as on any interest earned but not withdrawn during earlier
periods.
Simple interest is the interest that is calculated only on the original amount
(principal), and thus, no compounding of interest takes place.
Example of compound interest:
Calculate the value of compound interest for an amount of ₹100 for the rate of
interest is 4.5% for 3 years.
Ans:
A= p( 1+r/100)^n
=100(1+4.5/100)^3
=114.116
I=A-P
=114.116-100
=14.116
When the compounding is done quarterly, monthly, half yearly etc.we can use
the formula ;
A=P( 1+r/m)^nm
Eg: Calculate the compound interest for the ₹700 with an interest rate of 4.5%
which is compounded quarterly for one year.
Ans:
A=700(1+0.04/4)^4 m=4
=732.03
I=A-P
=732.03-700
=32.03
Example of simple interest :
Calculate the value of simple interest for an amount of ₹700 with the rate of
interest is 4.5% for 3 years.
Ans:
I= pnr p= principal
n = no.of years
r = rate of interest
I= 700×3×0.045
=94.5
FUTURE VALUE (CALCULATION):
 The general form of equation for calculating the future value of a lump
sum after ‘n’ periods may, therefore, be written as follows;
FV = P (1+r) ^n
P=Principal
r = interest rate
n = number of years
 The term (1+r)^n is the compound value factor ( CVF) of a lump sum of
Re 1, and it always has a value greater than 1 for positive ‘r’, including
that (CVF) increases as ‘r’ and ‘ n’ increases.
FV = P (CVF)
Future value example:
If a person deposited ₹ 55650 in a bank, which was paying a 15% rate of
interest rate on a 10 years time deposit, how much would the deposit grow at
the end of 10 years?
Ans:
We have FV = P( 1+r)^n
=55650×4.04 P= 55650
=224826 r= 15%
n =10
FUTURE VALUE OF AN ANNUITY :
Annuity is a fixed payment (or receipt) each year for a specified number of
years.
FV= C [ ( (1+r)^n-1)/r] C = periodic payment/ cash flow
r = rate per period
The term within the brackets is the compound value factor for an annuity of
Rupees 1, which we shall refer as CVFA.
FV(A)= C×CVFA
EXAMPLE:
Suppose that a firm deposits rupees 5000 at the end of each year for 4 years at
6% rate of interest. How much would this annuity accumulate at the end of the
fourth year?
Ans:
FV(A)= C×[( (1+r)n-1)]/r
= 5000×4.3746
=21873
SINKING FUND:
Sinking fund is a fund, which is created out of fixed payments each period to
accumulate to a future sum after a specified period. For example companies
generally create sinking funds to retire bonds (debentures) on maturity.
PRESENT VALUE :
 Present value of a future cash flow ( inflow or out flow) is the amount of
current cash that is of equivalent value to the decision- maker.
 Discounting is the process of determining present value of a series of
future cash flows.
  The interest rate used for discounting cash flows is also called the
discount rate.
PRESENT VALUE OF A SINGLE CASH FLOW:
 Formula to calculate the present value of a lump sum to be received
after some future periods;
P = FV/(1+r)^n
 The term (1+r)^n is the discount factor or present value factor ( PVF)
and it is always less than 1.0 for positive ‘r’, indicating that a future
amount has a smaller present value.
 If cash flow is not same in all years we can use the formula;
o PV= [C1/(1+r)] + [C2/(1+r)^2] + [C3/(1+r)^3] +...... + [Cn/(1+r)^n]

Example:
Suppose that an investor wants to find out the present value of rupees 50000
to be received after 15 years. His interest rate is 9%. Find out the present
value?
Ans:
P= Fv/(1+r)^n
= 50000/(1.09)^15
=13726.9
PRESENT VALUE OF AN ANNUITY :
The computation of the present value of an annuity can be written in the
following general form;
PV(A) = A [ ( 1-(1+r)^-n)/r]
Example:
A loan of 15,000 has been paid to customer for an interest rate of 4.5 % for 3
years. Find out the equal monthly instalments he has to pay.?
Ans:
PV(A)= A [ ( 1-(1+r)^-n)/r]
i.e A=P/ [ ( 1-(1+r)^-n)/r]
= (P×r)/ ( 1-(1+r)^-n
=(15000×0.00375)/(1-(1+0.00375)^-36)
=56.25/ 0.1260
=446.20
PART II

Annuity Derivation vs. Perpetuity Derivation:

What's the Difference;

Annuity Derivation Vs. Perpetuity Derivation: An Overview

The difference between an annuity derivation and a perpetuity derivation is
related to their distinct time periods. An annuity uses a compounding
interest rate to calculate its present value or future value, while a perpetuity uses
only the stated interest rate, or discount rate. However, several different kinds of
annuities exist, and some seek to replicate the features of a perpetuity.

KEY TAKEAWAYS

 When calculating the time value of money, the difference in an annuity

derivation and perpetuity derivation is related to their distinct time
periods. 
 An annuity is a set payment received for a set period of time. Perpetuities
are set payments received forever—or into perpetuity. 
 Valuing an annuity requires compounding the stated interest rate.
 Perpetuities are valued using the actual interest rate

Annuity Derivation
An annuity is an equal and annual series of payments made over a
predetermined time period. Annuities can be used for a variety of purposes, but
the most common one is providing a steady income for retirees. 

In the case of retirees, a lump sum of money or assets is exchanged for a series
of smaller payments in the future. This payment is often guaranteed for the life
of the beneficiary, meaning that, for a fee, the seller of an annuity assumes the
longevity risk, or the risk that the beneficiary will outlive the amount paid. 

Annuities are generally sold by insurance companies. From the business

standpoint, the lump sum gained by an insurance company upfront, followed by
small payments made years later, can be a good complement for other insurance
products, which generally take in small annual payments in the form of
premiums, followed by large, unpredictable, payouts.

The value of an annuity is derived as follows:

Perpetuity Derivation
A perpetuity is an infinite series of periodic payments of equal face value.
Therefore, a perpetuity's owner will receive constant payments forever.

A perpetuity can be thought of as a kind of annuity that never ceases, though in

the case of a perpetuity, interest is not used to calculate the value. 

The concept of a perpetuity is used in numerous financial models. The British

government issues a perpetuity in the form of a bond called a consol. Upon
purchase, a consol pays a small coupon forever.

A perpetuity calculation in finance is used in valuation methodologies to find

the present value of a company's cash flows. This is done by discounting back at
a certain rate.

While the actual face value of a perpetuity is indeterminable because of its

indefinite time period, its present value can be derived. The present value is
equal to the sum of the discounted value of each periodic payment.
The value of a perpetuity is derived as follows:

COMPOUND INTEREST VERSUS SIMPLE INTEREST

Interest is the cost of borrowing money, where the borrower pays a fee to the
lender for using the latter's money. The interest, typically expressed as a
percentage, can be either simple or compounded. Simple interest is based on the
principal amount of a loan or deposit, while compound interest is based on the
principal amount and the interest that accumulates on it in every period. Since
simple interest is calculated only on the principal amount of a loan or deposit,
it's easier to determine than compound interest.
The Difference between Compounding Interest and Simple Interest
Generally, simple interest paid or received over a certain period is a fixed
percentage of the principal amount that was borrowed or lent.

Real-Life Simple Interest Loans

Two good examples of simple interest loans are auto loans and the interest
owed on lines of credit such as credit cards. A person could take out a simple
interest car loan, for example. If the car cost a total of $100, to finance it the
buyer would need to take out a loan with a $100 principal, and the stipulation
could be that the loan has an annual interest rate of 5% and must be paid back in
one year.
Compound Interest
Compound interest accrues and is added to the accumulated interest of previous
periods; it includes interest on interest,

CAPITAL RECOVERY

Capital recovery is a term that has several related meanings in the

world of business. It is, primarily, the earning back of the initial funds
put into an investment. When an investment is first made in an asset
or a company, the investor initially sees a negative return, until the
initial investment is recouped. The return of that initial investment is
known as capital recovery. Capital recovery must occur before a
company can earn a profit on its investment.
Capital recovery also happens when a company recoups the money it
has invested in machinery and equipment through asset disposition
and liquidation. The concept of capital recovery can be helpful to a
business as it decides what fixed assets it should purchase.
Separately, capital recovery can be a euphemism for debt collection.
Capital recovery companies obtain overdue payments from
individuals and businesses that have not paid their bills. Upon
obtaining payment and remitting it to the company to which it is
owed, the capital recovery company earns a fee for its services.
 LOAN AMORTIZATION

What Is an Amortized Loan?

An amortized loan is a loan with scheduled periodic payments that are
applied to both principal and interest. An amortized loan payment first
pays off the relevant interest expense for the period, after which the
remainder of the payment reduces the principal. Common amortized
loans include auto loans, home loans, and personal loans from a bank
for small projects or debt consolidation.
PART III
RISK MANAGEMNET

Definition; in finance, risk refers to the degree of uncertainty and/or potential

financial loss inherent in an investment decision. In general, as investment risks
rise, investors seek higher returns to compensate themselves for taking such
risks.
Investment risk is defined as the possibility that what is actually earned as
return could be different from what is expected to be earned. All
investments are subject to risk, a key component of the risk management
process is risk assessment.

TYPES OF RISK;
 Systematic risk
 Unsystematic risk

SYSTEMATIC RISK
Systematic risk is refers to Total risk consists of two parts of risk that affect the
entire system is known as systematic risk. It also called undiversifiable risk.
 Inflation risk
 Interest rate risk

Inflation risk
Inflation risk also known as purchasing power risk represents the risk that the
money received on an investment may be worthless when adjusted with
inflation. It is highest in fixed return instruments such as bonds, debentures, and
deposit inflation risk has a particularly adverse impact on retired persons.
Interest rate risk
Interest rate risk refers to the risk that bond prices will fall in response to raising
interest rates, and rise in response to declining interest rates.Bond prices and
interest rate have an inverse relationship.

UNSYSTEMATIC RISK
Unsystematic risk refers to the risk specified to individual securities or a small
class of investments, it also called diversifiable risk.
 Credit risk
 Liquidity risk
 Business risk

Credit risk
Credit risk also known default risk refers to the probability that borrowers
will not be able to meet their commitments paying interest and principal as
scheduled. Credit risk is most simply defined as the potential that a bank
borrower or counterparty will fail to meet its obligations in accordance with
agreed terms. The goal of credit risk management is to maximise a bank's risk-
adjusted rate of return by maintaining credit risk exposure within acceptable
parameters.

Liquidity risk
Liquidity risk or market ability refers to the ease with which an investment
can be bought or sold in the market, Liquidity risk an absence liquidity an
investment. Liquidity risk is the risk that a company or bank may be unable to
meet short term financial demands. This usually occurs due to the inability to
convert a security or hard asset to cash without a loss of capital and/or income
in the process.
Business risk
Business risk also known as operating risk, it is risk caused by factors that
affect the operation of the company. Business risk refers to the company's
ability to generate sufficient revenue to cover its operational expenses. ... With
business risk, the concern is that the company will be unable to function as a
profitable enterprise

MEASUREMENT OF RISK;
Risk measures can be used individually or together to perform a risk
assessment. When comparing two potential investments, it is wise to compare
like for like to determine which investment holds the most risk, the five
measures are;

 alpha,
 beta,
 R-squared,
 standard deviation, and
 Sharpe ratio.

BETA
In finance, the beta (β or beta coefficient) of an investment is a measure of the
risk arising from exposure to general market movements as opposed to
idiosyncratic factors.

Measurement of risk;
The market portfolio of all investable assets has a beta of exactly 1. A beta
below 1 can indicate either an investment with lower volatility than the market,
or a volatile investment whose price movements are not highly correlated with
the market. A beta greater than 1 generally means that the asset both is volatile
and tends to move up and down with the market.

β<1 = stock is less risky

β>1 = stock is more risky

Computation of beta

Application
The beta (β) of an investment security (i.e. a stock) is a measurement of
its volatility of returns relative to the entire market. It is used as a measure
of risk and is an integral part of the Capital Asset Pricing Model (CAPM.)

Importance
Beta is important because it measures the risk of an investment that cannot be
reduced by diversification. It does not measure the risk of an investment held on
a stand-alone basis, but the amount of risk the investment adds to an already-
diversified portfolio. In the capital asset pricing model (CAPM), beta risk is the
only kind of risk for which investors should receive an expected return higher
than the risk-free rate of interest.