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Lecture Business finance (9/e) - Chapter 4: Applying the time value of money to security valuation

Chapter 4 - Applying the time value of money to security valuation. Use the tools of financial mathematics to value debt and equity securities, apply the dividend growth model to value ordinary shares, explain the main differences between the valuation of ordinary shares based on dividends and earnings,. | Chapter 4 Applying the Time Value of Money to Security Valuation 2 2 2 2 2 2 2 2 2 Learning Objectives Use the tools of financial mathematics to value debt and equity securities. Apply the dividend growth model to value ordinary shares. Explain the main differences between the valuation of ordinary shares based on dividends and earnings. 2 2 2 2 2 2 2 2 2 Learning Objectives (cont.) Explain the nature of interest rate risk. Understand the theories that are used to explain the term structure of interest rates. Apply the concept of duration to immunise a bond investment. 3 3 3 3 3 3 3 3 2 Valuing a Financial Asset Financial assets are valued under certainty by discounting the known future cash flows at the market interest rate and adding the resultant present values. In the case of shares, the future cash flows are dividends while, in the case of bonds, the future cash flows will be coupon / interest payments. 4 4 4 4 4 4 4 4 3 Note coupon should be singular Valuation of Shares | Chapter 4 Applying the Time Value of Money to Security Valuation 2 2 2 2 2 2 2 2 2 Learning Objectives Use the tools of financial mathematics to value debt and equity securities. Apply the dividend growth model to value ordinary shares. Explain the main differences between the valuation of ordinary shares based on dividends and earnings. 2 2 2 2 2 2 2 2 2 Learning Objectives (cont.) Explain the nature of interest rate risk. Understand the theories that are used to explain the term structure of interest rates. Apply the concept of duration to immunise a bond investment. 3 3 3 3 3 3 3 3 2 Valuing a Financial Asset Financial assets are valued under certainty by discounting the known future cash flows at the market interest rate and adding the resultant present values. In the case of shares, the future cash flows are dividends while, in the case of bonds, the future cash flows will be coupon / interest payments. 4 4 4 4 4 4 4 4 3 Note coupon should be singular Valuation of Shares Assuming Certainty The periodic cash flows from an investment in shares are dividends. Assuming the dividends continue indefinitely, the value of the share (P0) is: 5 6 6 6 6 6 6 6 5 Valuing Shares The previous equation does not ignore the capital gain component of returns, as the price a share is sold for at time n should represent the discounted value of dividends beyond time n. 6 7 7 7 7 7 7 7 6 Note time n – n should be in italics Valuing Shares (cont.) The previous valuation equation can be expressed in the following way to illustrate the point: 7 8 8 8 8 8 8 8 7 Introducing Uncertainty The presence of uncertainty results in investors requiring compensation in the form of a higher promised rate of return (ke): 8 9 9 9 9 9 9 9 8 The Required Rate of Return on Shares The required rate of return (ke) is determined using the concept of the opportunity cost of capital. For a risky security, the opportunity cost is at least the return on the risk-free security (i). The amount by .