1 Finance School of Management FINANCE Review of Questions and Problems Part III: Chapter 7-9

2 Finance School of Management  Three analytical “pillars” to finance: Optimization over Time （ intertemporal trade- offs ） : Part II Asset Valuation: Part III—Principals of Asset Valuation & Valuation of Bond and Stock Risk Management （ portfolio theory & derivatives ） : Part IV & V

3 Finance School of Management Chapter 7: Principles of Asset Valuation Fundamental Value Well-informed investors Free and competitive market Law of One Price Competitive market  Equivalent asset  Comparable asset  Valuation models Efficient Market Hypothesis Strong efficient Semi-strong efficient Weak efficient Arbitrage Interest rate Exchange rate Historical information Public information All information Price and Other Information

4 Finance School of Management  Problems of homework: 7.2 – In a competitive market, the Law of One Price states that the market prices of equivalent assets are the same.  In the question, we should consider sale tax on liquor correctly: 25+25*16%=29  Residents should pay 25 if they bought liquor in Taxfree and pay 29 （ 25 for ‘real price’ and 4 for tax ） if in Taxachusetts.

5 Finance School of Management 7.8 – it is a application of Law of One Price- using valuation models to estimate assetvalue.  to estimate leverage （ leverage is factor affecting the earnings per share: midway between two groups ）  to predict earnings per share （ approaches in Chapter 3 ） 7.11 – to refer to content and give the correct answers.

6 Finance School of Management Chapter 8: Valuation of Known Cash Flow: Bonds  Main Contents: The discount rate and the frequency of discounting are the key inputs to value known cash flows using DCF （ Present Value Formulas ） Bond is a kind of Income-fixed securities and Pure Discount Bonds are the basic building blocks to estimate values of Coupon Bonds Current Yield/Yield to Maturity/Rate of Return Some effects on bond price or yields Several risks about bond

7 Finance School of Management  Key Components: to determinate the inputs （ i, n and PMT ） to value known cash flows using PV formulas. to calculate coupon yield/yield to maturity/rate of return correctly. Bond Valuation with a Flat Term Structure-8.2

8 Finance School of Management  8.2.a & b--Solutions:  Step 1: prices of zero or 4% coupon bond 6 months ago: discount rate=market interest rate=yield to maturity （ annualized yield ） =4%  Step 2: determinate the cash flows of coupon bond on each date(1*4% of coupon bond is not a Normal Annuity) and then calculate the prices today using discount rate 5% niPVFVPMT Result 304%? %?11*4%1

9 Finance School of Management cash flows: 0.5, 1.5, 2.5, 3.5,…,  Step 3: rate of return: it is yield to maturity, but not current yield. niPVFVPMT Result 305%? %?11*4% (0.8672) 0 t the zero-coupon bond is more sensitive to yield changes than the 4% coupon bond

10 Finance School of Management  Key Components: Give the cash flows or payments on corresponding date or year (you needn’t discount the cash flows). Coupon Stripping is a process to unbundle the cash flows (coupon) from Coupon Bond (coupon stripping is used to create Pure Discount Bonds or Treasury Strips).  8.4.b--Solutions: subtracting 0.93*70 from , you can obtain the break-even price of Treasury Strip. Coupon Stripping-8.4

11 Finance School of Management  Key Components: The effect of callable, convertible, ‘put back’ and tax-exempt on the market price of bonds.P :  The callable bond would have a lower price than the non- callable bond to compensate the bondholders for granting the issuer the right to call the bonds.  The convertible bond would have a higher price because it gives the bondholders the right to convert their bonds into shares of stock. Bond Features and Bond Valuation-8.6

12 Finance School of Management  The puttable bond would have a higher price because it gives the bondholders the right to sell their bonds back to the issuer at par.  The bond with the tax-exempt coupon has a higher price because the bondholder is exempted from paying taxes on the coupons. (Coupons are usually considered and taxed as personal income). The options or rights are valuable!

13 Finance School of Management Chapter 9: Valuation of Common Stocks The discount cash flow （ DCF ） formula for the present value of a stock is just the same as it is for the present value of any other asset. We just discount the cash flows by the return （ market capitalized rate/opportunity cost of capital/market required risk-adjusted rate/required return ） that can be earned in the capital market on security of comparable risk. In well-functioning capital market, all securities in an equivalent risk class are priced to offer the same expected return because of existing of arbitrage. Dividends or cash flows resulting from investment of retained earnings.

14 Finance School of Management  Main Contents: Discounted Dividend Model （ DDM ）  constant growth rate of dividend  earnings and investment opportunities  Price/Earnings & Firm’s Value Effects of dividend policy on the stock price and on the wealth of shareholders  cash dividend, share repurchases and stock dividend in M&M’s frictionless environment  dividend policy in the real world

15 Finance School of Management Discounted Dividend Model （ DDM ） -9.4 Constant Growth (income stocks) Solving for K Capital gain yield Why the expected growth rate of dividends g is less than the market capitalization rate k?

16 Finance School of Management Earnings and Investment Opportunities (growth stocks) Accounting equation Components of firm’s value NPV of new investment ？ What adds value is the opportunity to invest in projects that can earn rates of return in excess of the required rate, k! Firms with consistently high P/E ratio can be interpreted to have relatively low capitalization rate or relatively high present value of value-added investments

17 Finance School of Management Dividend Policy-9.10 Dividend policy Effect on stock price Effect on shareholder’s wealth Real world Cash dividend fall (DDM) unchangedPersonal tax on cash dividend Share repurchases unchanged Personal tax on capital gain Stock dividend (stock split) fall (more shares) unchangedRegulation Cost of external financing M&M’ s frictionless environment No taxes and no transaction cost Shareholders can achieve the effect of corporate dividend policy by reinvesting dividends or selling shares on their own Dividend policy has no effect on the wealth of shareholders