4. 4
A rupee today is worth more than
a rupee tomorrow.
Definition
5. 5
Simple interest
. Simple interest incurs only on the principal.
While calculating simple interest we keep the
interest and principal separately, i.e., the
interest incurred in one year is not added to
the principal while calculating interest of the
next period.
7. 7
Example: Simple Interest?
Assume that you have Rs 100 today and you
want to invest the amount with a bank for five
years. The bank is offering an interest rate of
7 percent.
8. 8
Simple Interest
We can obtain the simple interest on the investment using
the formula
n
iPVFV )1( +×=
9. 9
Here FV is the simple interest accrued for the
term of the investment
PV is the amount invested, i.e., Rs 100 in our
example
i stands for the interest rate offered by the
bank, i.e., 7 % = 0.07
n is the term of the investment, which is
assumed to be 5 years
Simple Interest
10. 10
Putting these values in the formula, we get
• FV = 100 + (100 x 0.07 x 5)
• FV = 100 + (7 x 5)
• FV = 100 + (35)
• FV = Rs 135
15. 15
yearly compounding
F V = PV x (1 + (i / m) m x n
Such a compounding would be calculated using
the following formula.
Compound interest
16. 16
Here ‘m’ refers to the compounding gap during the
term of the investment. In order to calculate monthly
compounding, the value of ‘m’ would be 12;
however, for quarterly compounding calculation m
would be equal to 4.
Compound interest
17. 17
Assume that the investor in our previous example
is offered a compound return (interest) on his same
investment, at the same interest rate and term. The
future value of the investment is given as under
Example
0 1 2 3 4
18. 18
Putting these values in the formula, we get
F V = PV x (1 + i) n
FV = 100 x (1+0.07)5
FV = 100 x (1.07)5
FV = 100 x (1.40255)
FV = 140.255
21. 21
Here e is a constant the derived value of which is
2.718
Continuous Compound Interest
After putting the values
F V = PV x e i x n
FV = 100 x 2.718(0.07x5)
FV = 100 x 1.419
FV = 141.9
Formula can be rearranged to compute required return, if price and dividend known:
Equity Valuation
As will be discussed in chapter 5, the required return on common stock is based on its beta, derived from the CAPM
Valuing CS is the most difficult, both practically & theoretically
Preferred stock valuation is much easier (the easiest of all)
Whenever investors feel the expected return, rˆ, is not equal to the required return, r, prices will react:
If exp return declines or reqd return rises, stock price will fall
If exp return rises or reqd return declines, stock price will rise
Asset prices can change for reasons besides their own risk
Changes in asset’s liquidity, tax status can change price
Changes in market risk premium can change all asset values
Most dramatic change in market risk: Russian default Fall 98
Caused required return on all risky assets to rise, price to fall
