Transcript Chapter 5- Valuation Concepts

Chapter 5
Valuation Concepts
Basic Valuation
From “The Time Value of Money”
we realize that the value of
anything is based on the present
value of the cash flows the asset
is expected to produce in the
future.
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Basic Valuation
 The Value of the Asset
 = the sum of the discounted cash flows the asset is expected to
generate over time
 Required return = the rate you use to discount the cash
flows back.
 = the rate of return investors consider appropriate for holding such
an asset
 = based on riskiness and economic conditions
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Key Terms for Bonds
 Principal Amount = Face Value = Maturity Value,= Par Value:
The amount of money borrowed
 Coupon Payment: The specified number of dollars of interest
paid each period, generally each six months, on a bond.
 Coupon Interest Rate: The stated annual rate of interest paid
on a bond.
 Maturity Date: A specified date on which the par value of a
bond must be repaid.
 Original Maturity: The number of years to maturity at the time
the bond is issued.
 Call Provision: Gives the issuer the right to pay off bonds prior
to maturity.
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Task: Find the present Value of
Genesco’s 15%, 15-year, $1,000
bonds valued at 15% required
rate of return
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Task: Find the present Value of
Genesco’s 15%, 15-year, $1,000
bonds valued at 15% required
rate of return
Financial calculator solution:
INPUTS
OUTPUT
15
N
15
I/YR
?
150
PV
PMT
-1000
1000
FV
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Changes in Bond Values Over Time
 Par Value Bond
 Discount Bond
 Premium Bond
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Par Value Bonds
 Par Value Bond:
When the going interest rate = the bond’s
coupon interest rate
The market value of a bond will always
approach its par value as its maturity date
approaches, provided the firm does not
go bankrupt.
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Discount Bonds
 An increase in interest rates in the
economy causes the price to fall
Discount Bond
= when a bond sells below its par value
 occurs whenever the going rate of interest
rises above the coupon rate
The bond value decreases so that the rate
of return investors earn equates to the
higher kd.
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Premium Bonds
 A decrease in interest rates in the
economy causes the bond price to rise
Premium
= when a bond sells above its par value
occurs whenever the going rate of interest
falls below the coupon rate
The bond value increases so that the rate
of return investors earn equates to the
lower kd.
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Calculating a Bond’s Current Yield
Current yield = the annual interest
payment on a bond divided by its
current market value
Current
yield
INT

Vd
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Time path of value of a
15% Coupon,
$1000 par value bond
when interest rates are
10%, 15%, and 20%
Year
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
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k d = 10%
$1,380.30
$1,368.33
$1,355.17
$1,340.68
$1,324.75
$1,307.23
$1,287.95
$1,266.75
$1,243.42
$1,217.76
$1,189.54
$1,158.49
$1,124.34
$1,086.78
$1,045.45
$1,000.00
k d = 15% k d = 20%
$1,000.00
$766.23
$1,000.00
$769.47
$1,000.00
$773.37
$1,000.00
$778.04
$1,000.00
$783.65
$1,000.00
$790.38
$1,000.00
$798.45
$1,000.00
$808.14
$1,000.00
$819.77
$1,000.00
$833.72
$1,000.00
$850.47
$1,000.00
$870.56
$1,000.00
$894.68
$1,000.00
$923.61
$1,000.00
$958.33
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$1,000.00 $1,000.00
Changes in Bond Values Over Time
 Time path of value of a 15% Coupon, $1000 par value
bond when interest rates are 10%, 15%, and 20%
Bond Value
$1,500
kd < Coupon Rate
$1,250
kd = Coupon Rate
$1,000
$750
kd > Coupon Rate
$500
$250
$0
1
3
5
7
9
11
13
15
Years
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Finding the Interest Rate on a
Bond: Yield to Maturity
YTM is the average rate of return earned on a bond
if it is held to maturity.
Financial calculator solution:
INPUTS
OUTPUT
15
N
?
-950
I/YR PV
15.89
150
PMT
1000
FV
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Interest Rate Risk on a Bond
 Interest Rate Price Risk: the risk of changes
in bond prices to which investors are
exposed due to changing interest rates.
 Interest Rate Reinvestment Rate Risk: the
risk that income from a bond portfolio will
vary because cash flows have to be
reinvested at current (presumably lower)
market rates.
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Value of Long and Short-Term
15% Annual Coupon Rate Bonds
Value of
Current Market
1-Year Bond 14-Year Bond
Interest Rate, k d
5%
10%
15%
20%
25%
$
$
$
$
$
1,095.24
1,045.45
1,000.00
958.33
920.00
$
$
$
$
$
1,989.86
1,368.33
1,000.00
769.47
617.59
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Valuation of Financial Assets Equity (Stock)
 Common Stock
 Preferred Stock: hybrid
similar to bonds with fixed dividend amounts
similar to common stock as dividends are not
required and have no fixed maturity date
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Stock Valuation Models
Term: Expected Dividends
D̂ t  dividendthe stockholder expects to
receive at the end of Year t
D 0 is the most recent dividendalready paid
D̂1 is the next dividendexpected to be paid,
and it willbe paid at the end of this year
D̂ 2 is the dividendexpected at the end of two years
All future dividendsare expected values, so the
estimates may differ among investors.
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Stock Valuation Models
Term: Market Price
P0  the price at which a stock
sells in the market tod ay.
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Stock Valuation Models
Term: Intrinsic Value
P̂0  the value of an asset that , in the
mind of an investor, is justified
by the facts; may differ
from the asset' s current market
price, its book value , or both.
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Stock Valuation Models
Term: Expected Price
P̂t  the expected price of the stock
at the end of each Year t.
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Stock Valuation Models
Term: Growth Rate
g  the expected rate of change
in dividendsper share
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Stock Valuation Models
Term: Required Rate of Return
k s  the minimum rate of return on a
common stock that stockholde rs
consider acceptable given its
riskiness and returns available on
other investment s.
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Stock Valuation Models
Term: Dividend Yield
D̂1
 the expected dividend divided
P0
by the current price of a share
of stock
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Stock Valuation Models
Term: Capital Gain Yield
P1  P0
 the change in price (capital gain)
P0
during a given year divided by its
price at the beginning of the year
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Stock Valuation Models
Term: Expected Rate of Return
= Expected dividend yield + capital gains
yield
k̂ s  the rate of return on a common
stock that an individual investor
expects to receive
D̂1 P1  P0


P0
P0
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Stock Valuation Models
Term: Actual Rate of Return
ks  the rate of return on a common
stock that an individual investor
actually receives, after the fact;
equal to the dividend yield plus
the capital gains yield.
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Expected Dividends as
the Basis for Stock Values
If you hold a stock forever, all you
receive is the dividend payments.
The value of the stock today is the
present value of the future dividend
payments.
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Stock Values with Zero Growth
A Zero Growth Stock is a common stock
whose future dividends are not expected
to grow at all = A PERPETUITY
g  0, and D̂ 1  D̂ 2  D̂   D 0
D
P̂0 
ks
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Normal, or Constant, Growth
Normal Growth is growth that is expected
to continue into the foreseeable future at
about the same rate as that of the
economy as a whole.
g = a constant
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Normal, or Constant, Growth
(Gordon Growth Model)
A Constant Growth Stock is a common stock whose
future dividends are expected to grow at a constant
rate = A GROWING PERPETUITY
P̂0 
Div1
ks  g
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Expected Rate of Return on a
Constant Growth Stock
Rearrange the formula for the price to
get Dividend Yield
k̂ s
D̂1

 g
P0
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Valuing Stocks with
Nonconstant Growth
 Nonconstant Growth: The part of
the life cycle of a firm in which its
growth is either much faster or much
slower than that of the economy as a
whole.
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Valuing Stocks with
Nonconstant Growth
1. Compute the value of the dividends that
experience nonconstant growth, and then
find the PV of these dividends.
2. Find the price of the stock at the end of the
nonconstant growth period, at which time it
has become a constant growth stock, and
discount this price back to the present.
3. Add these two components to find the
intrinsic value of the stock P0.
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Stock Market Equilibrium
1. The expected rate of return as seen by the
marginal investor must equal the required
^ =k .
rate of return, k
x
x
2. The actual market price of the stock must
equal its intrinsic value as estimated by the
marginal investor, P ^
P
0 =
0.
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Changes in Stock Prices
 Investors change the rates of return
required to invest in stocks.
 Expectations change about the cash
flows associated with particular stocks.
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The Efficient Markets
Hypothesis
 The weak form of the EMH states that all
information contained in the past price
movements is fully reflected in current
market prices.
 The semistrong form states that current
market prices reflect all publicly available
information.
 The strong form states that current market
prices reflect all pertinent information,
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whether publicly available or privately held.
Valuation of Real
(Tangible) Assets
 A company proposes to buy a machine so it
can manufacture a new product. After five
years the machine will be worthless, but
during the five years it is used, the company
will be able to increase its net cash flows by
the following amounts:
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Valuation of Real
(Tangible) Assets
Year
1
2
3
4
5
^
Expected Cash Flow, CF
$120,000
$100,000
$150,000
$80,000
$50,000
To earn a 14% return on investments like this,
what is the value of this machine?
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Calculator Solution:
In “CF” register:
Type: 2nd, CE/C to clear information stored
CF0 = 0
C01 = 120,000
F01 = 1
C02 = 100,000
F02 = 1
C03 = 120,000
F03 = 1
C04 = 80,000
F04 = 1
C05 = 50,000
F05 = 1
In “NPV” Register:
Type: I = 14, enter, down arrow
See: NPV = (varies)
Type: CPT
See: NPV = 356,790.50
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For Next Class
Review Chapter 5 materials
Do Chapter 5 homework
Prepare for Quiz on Chapter 5
Read Chapter 6 (Capital Budgeting)
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