03A

FIN211 Financial Management Lecture Notes

Topic: Mathematics of finance Part II (Text reference: Ch 4)
In the previous lecture we looked at how to calculate the future
and present values of (a) single sums of money, and (b) equal
periodic cash flows.
For given amounts, those present or future values are affected by:
(1) the annual interest or discount rate; (2) the number of times
interest is compounded per year; and (3) the total length of time.
The annuity previously examined was an ordinary annuity, in
which the cash flows are assumed to occur at the end of each
period. There are two other types: an annuity due and a deferred
annuity.
In an annuity due the cash flows are assumed to occur at the start
of each period. This means that both the present and future values
of an annuity due will be increased by the time value of a single
period; i.e. 1 + i.
The PV of an annuity due is therefore: PMT
( )
1
1
]
1

+

i
i
n
1 1
(1 + i)
= PMT
( )
( )
i
i i
n 1
1 1

+ +
= PMT
( )
( )
1
1
]
1

+
+

i
i
n 1
1 1
1
See Equation (4-13) on p 88 (in which the first round bracket
should be deleted).
Similarly, the FV of an annuity due is: PMT
( )
( ) i
i
i
n
+
1
1
]
1

+
1
1 1
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= PMT
( )
1
1
]
1

+
+
i
i i
n
1 1
1
= PMT
( )

'

1
1
]
1

+
+
1
1 1
1
i
i
n
No textbook equation
In a deferred annuity the cash flow stream is deferred into the
future. This means that its PV is decreased, and its FV increased.
For example, the PV of an annuity of $10 per year for 10 years,
commencing 5 years from now, is the same as the PV of an
ordinary annuity discounted by a further 4 years (not 5 years,
because the first cash flow of an ordinary annuity is assumed to
occur at the end of the first period; in this case 5 years from now).
The PV of this deferred annuity is therefore:
PMT
( )
1
1
]
1

+

i
i
n
1 1
(1 + i)
4

If the discount rate is 8%, the PV is:
$10
( )
1
1
]
1

08 . 0
08 . 1 1
10
(1.08)
4
= $10 6.71 1.36 = $49.32
There are 4 variables in single amount calculations and 5 variables
in annuity calculations. These are: number of periods (n), interest
or discount rate per period (i), present value (PV) and future value
(FV) for single amounts, plus periodic cash flow (PMT) for
annuities.
In all cases the value of all except one variable will be known,
leaving the value of the remaining variable to be calculated. So far
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we have looked at calculating PVs and FVs. But in other
situations it may be necessary to calculate the values of other
variables, such as n, i, & PMT.
Calculating the values of n or i for single amount calculations is
fairly easy and is demonstrated in this weeks tutorial work.
Calculating the same values for annuity calculations is more
difficult and in these situations a financial calculator is
recommended.
Valuation of shares & bonds, Part 1 Text reference: Ch 10
Valuation emphasis is on financial assets (securities), rather than
physical assets.
A financial asset is typically a security representing a claim on
future cash flows. Its value therefore reflects expectations about
those cash flows: amount, timing, duration and risk.
It may be relevant to consider the manner in which future cash
flows are to be generated and the nature of human involvement in
that process. For example, cash flows required for servicing and
redeeming govt bonds are typically tax-generated. The process is
bureaucratic. No wealth needs to be created and the degree of
human enterprise is minimal.
Towards the other end of the spectrum, cash flows may depend on
wealth creation, involving high levels of enterprise and risk-taking
entrepreneurial activity.
Security valuation is an important aspect of financial
management. A company issues securities in order to raise capital.
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It needs to obtain capital at the lowest possible cost: i.e. to raise
the maximum amount of capital for given expected future cash
outflows.
It also needs to maximise the market value of existing issued
securities, thereby minimising its cost of capital. This can be
achieved by reducing the perceived riskiness of future cash flows;
e.g. by signing long-term sales contracts.
Cost of capital is used in making capital budgeting decisions.
Lower capital costs provide a firm with a competitive advantage;
allowing greater flexibility in investing in wealth-creating
activities, thereby facilitating the accumulation of physical assets
and adding further to the value of securities with claims on that
wealth.
Cost of capital is a matter of public, as well as private,
significance. Countries with lower capital costs have a
competitive advantage over countries with higher capital costs.
This partly explains, for example, Australias abolition of stamp
duty on share transactions and the introduction of dividend
imputation.
Definitions of value
Book value is the value derived from reported balance sheets in
which a range of conventions may be applied to asset valuation,
including amortised historical cost, current cost, recoverable
amount, etc. There is a legal expectation that reported asset values
will not be overstated or liabilities understated: i.e. that assets and
liabilities will be respectively reported at neither more nor less
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than their fair values.
Fair value is a purpose or intention-led concept. For example, if
an asset is intended to be sold today, its fair value is its current
liquidation or disposal value, which may be regarded as
establishing a minimum or floor value.
Should expected transaction costs be included in measures of
fair value?
International financial reporting standards (IFRSs) generally use
fair value as the prescribed basis for valuing assets and liabilities.
For marketable securities fair value is equated with market value
(MV), rather than net market value (NMV, defined for assets as
market value less liquidation costs and for liabilities as market
value plus liquidation costs).
Prior to the introduction of IFRSs in Australia, NMV was a
commonly prescribed basis of valuation. For example, NMV was
mandated as a basis for valuing assets and liabilities by AAS 25
Financial Reporting by Superannuation Plans (which became
operative for reporting periods ending on or after 30 June 1993)
and AASB 1023 Financial Reporting of General Insurance
Activities (which became operative for reporting periods ending
on or after 30 June 1992).
Where financial assets and liabilities are marked to market, the
following arguments can be advanced for using MV, as opposed
to NMV, as a measure of fair value.
1. Logically, all financial assets and liabilities should sum to
zero. The summing of net market values produces a net
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liability, representing transaction costs forecast to be incurred
upon the future liquidation of assets and liabilities, and a
corresponding notional asset, representing future transaction
revenues to be earned by third parties. It can be argued that
such contingent costs and revenues should be accounted for in
the same manner: neither should be anticipated and each
should be recognised only when respectively incurred and
earned.
2. Transaction costs cannot always be accurately forecast.
Government levies can change without notice and commission
fees such as brokerage vary according to transaction amount -
ranging from a high of about 10% on a transaction of $1,000
(fee = $100) to a minimum of less than 0.1% on transactions
exceeding $1 million.
3. Recognition of transaction costs only in the period in which
they are incurred produces a more reliable measure of
performance.
4. Relative movements in market values are unaffected by the
use of gross instead of net values.
5. The use of NMVs focuses on the consequences of liquidating
assets and liabilities rather than adding to them. NMV
understates the cost of acquiring additional assets and
overstates the value obtainable from acquiring additional
liabilities.
6. Profit measurement should use the one best value for each
input item. In the case of financial liabilities not intended to be
held until maturity the one best measure is fair value - defined
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as gross market value. This is a compromise between the net
proceeds and gross outlays associated with liquidating or
acquiring assets and between the gross outlays and net
proceeds of extinguishing or acquiring liabilities. There is no
logical justification for recognising net proceeds in relation to
assets and gross outlays in relation to liabilities. In the
interests of reliable and unbiased measurement each should be
recognised on the same basis.
7. Alternative values for financial assets and liabilities may be
disclosed by way of supplementary notation.
Shareholders funds
Note that a balance sheet makes no attempt to record share-
holders funds at fair value. The book value of shareholders
funds is the amount remaining after deducting the book value of
all liabilities from the book value of all assets. Even if all assets
and liabilities are recorded at fair value, the book value of
shareholders funds remains a residual or balancing item with no
necessary connection to more realistic measures of value.
Book values may be out-of-date and unrealistic, but have the
advantage of being comparatively stable and therefore convenient
reference-points over extended periods of time. Even though the
book value of shareholders funds is typically lower than market
value, it is sometimes assumed that the ratio between the two
values is fairly constant. Such an assumption may itself be
unrealistic, but is nevertheless implied when using book values for
forecasting growth rates a topic addressed later in these notes.
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Shares may be valued in terms of net tangible asset backing per
share or net asset backing per share. The former is the book
value of shareholders funds, less intangibles, divided by the
number of shares on issue. The latter is the same as book value
per share i.e. the book value of shareholders funds divided by
the number of shares on issue.
Typically a shares book value is below its market value. A
possible reason is that market value includes the present value of
growth expectations; something that is excluded from book value.
Figure 1 summarises the market to net tangible assets value gap
for companies comprising the All Ordinaries Index on the
Australian Securities Exchange (ASX).
Value
index
%
Value
index
%
Value
index
%
Debt 65.5 39.6 65.5 28.1 65.5 18.8
Equity 100.0 60.4 167.9 71.9 282.0 81.2
Debt +
Equity
165.5 100.0 233.3 100.0 347.5 100.0
Data
input:
Price/
NTA
2.82
Price/
Book
1.68
Debt/
Equity
39%
Tangible
assets
Book Market
Recognised
intangibles
Unrecognised
intangibles
V a l u e b a s i s
Value recognition Accounting conservatism
Figure 1. The market to net tangible assets value gap (Source: ASX, Comsec)
< > < >
PV of growth expectations (equity-driven market value added)
Figure 1 suggests that the gap (or at least a large part of it)
between the market value of equity and the book value of the
underlying tangible assets represents the present value of growth
expectations. [Note: expectations rather than the conventional
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attribution of opportunities.] We can assume that those
expectations are equity-driven on the grounds that shareholders
and shareholder-aligned managers are the principal beneficiaries
of the consequent market value added.
Market values are established by market forces, the strength of
which may depend on the nature of the market. For heavily-traded
shares, market values will fluctuate almost continuously. Such
volatility can reduce the attractiveness of using market values as a
basis for establishing a shares intrinsic value.
Note that the current market price of a security is its last sale price
or lower subsequent offer or higher subsequent bid. Traders bid to
buy and offer to sell. The liquidation value of a security is its
current bid price.
Intrinsic value is the PV of expected future cash flows. It can be
highly subjective and may therefore vary between individuals.
Basic trading rules
The general aim is to buy low, sell high. That is, buy an asset
when it is regarded as underpriced and sell it when it is regarded
as overpriced.
Underpriced means market value < intrinsic value; buy
Overpriced means market value > intrinsic value; sell.
Note that for a transaction to occur, buyer and seller must have
different perceptions of intrinsic values. Where intrinsic values do
not depend on personal utility preferences, there may be winners
and losers in a transaction. For example, the buyer of a share may
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have got it right and thereby makes a profit; while the seller has
got it wrong and thereby makes a loss.
This is typically the case when trading in derivatives. [The present
value of a derivatives contract is typically zero, but positive for
any intermediary arranging the contract. The outcome could be a
loss for both parties, or a profit for one and a loss for the other.
But it is impossible for both parties to win.]
An overview of the valuation process (textbook pp 275-6)
Note that when evaluating an asset, one should consider (a) the
manner in which future cash flows will be generated and (b)
security. Is the process of cash flow generation bureaucratic (low
risk) or entrepreneurial (high risk)? Is the security a govt
guarantee (low risk), a registered first mortgage (low risk), or is
there no security at all (high risk)?
Required rate of return
This will reflect the investors assessment of the riskiness of
future cash flows. The higher the risk, the higher the required rate
of return. Note that where risk is measured in terms of standard
deviation, the required rate of return may be a direct linear
function of risk.
Valuing securities
Bonds
A bond has a:
par value = face value = redemption value = nominal value;
10
return of rate required r
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coupon rate of interest applied to its par value;
maturity date.
Bond interest is typically paid twice-yearly.
PV of a bond = PV of the interest payments (an annuity) + PV of
the par value (future value).
See textbook, pages 277-81.
Note that the price of a bond is inversely related to its yield or
discount rate; i.e. the higher the yield on a bond, the lower will be
its price, and vice-versa. When the yield on a bond is lower than
its coupon rate, its price will be higher than its par value. When
the yield on a bond is higher than its coupon rate, its price will be
lower than its par value.
Preference shares
PV = annual dividend required rate of return.
Ordinary shares
PV =
g r
D

1
Where D
1
= expected dividend per share one year from now
r = required rate of return
g = expected growth rate. Can be defined in terms of
growth in the book value (BV) of shareholders
funds
= BV
1
/ BV
0
1
= return on equity (ROE) profit retention ratio.
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Expected rates of return
r = expected rate of return
Shares
r = dividend yield + g
= D
1
/ P
0
+ g
Bonds
Expected return = internal rate of return (IRR: interest symbol i
on the calculator).
The IRR is the discount rate that equates the PV of a bonds future
cash flows with its current market price. This rate can be
identified either through a process of iteration or by using an
electronic device such as a financial calculator or Excel
spreadsheet.
Note that if the price of a bond is below its par value, its yield will
be higher than its coupon rate, and vice-versa.
Preference shares
Expected return = D / P
0
All marketable securities
In an equilibrium situation: (1) expected return = required return,
and (2) market price = intrinsic value.
* * * *
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