Value of Bonds and Common Stocks Principles of Corporate Finance Eighth Edition Chapter 4 Value of Bonds and Common Stocks Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered Using PV Formulas to Value Bonds How Common Stocks are Traded How Common Stocks are Valued Estimating the Cost of Equity Capital Stock Prices and EPS

Bonds By selling debt securities, bonds, companies can borrow money from the public Usually interest-only loan: principal is paid at the end Coupon = the stated interest (paid regularly) Par value = Face value = the principal amount repaid Coupon rate = the annual coupon divided by face value Maturity = the number of years until par value is repaid Current yield = coupon payment divided by bond’s market price Yield (to maturity) = interest rate required by the market

Valuing a Bond Cash Flows Example If today is September 2008, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. Cash Flows

Valuing a Bond Example continued If today is September 2008, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. The price at a 3.8% YTM is as follows

Valuing a Bond Example continued PV = PV(coupons) + PV(face amount) = 28.36 + 79,95

Valuing a Bond Example continued If today is September 2008, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. The price at a 2.0% YTM is as follows

Bond Prices and Yields Price Yield

Interest rate risk The interest rate risk refers to changes in bond prices arising from fluctuating interest rates The risk increases, when The time to maturity increases The coupon rate decreases

Stocks & Stock Market Common Stock - Ownership shares in a publicly held corporation. Secondary Market - market in which already issued securities are traded by investors. Dividend - Periodic cash distribution from the firm to the shareholders. P/E Ratio - Price per share divided by earnings per share.

Stocks & Stock Market Book Value - Net worth of the firm according to the balance sheet. Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors. Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.

Valuing Common Stocks Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends. H - Time horizon for your investment.

Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

Valuing Common Stocks

Assumes all earnings are paid to shareholders. Valuing Common Stocks If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Assumes all earnings are paid to shareholders.

Valuing Common Stocks Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model). Dividend grows at a steady rate g r > g

Valuing Common Stocks Nonconstant Growth - A version of the dividend growth model in which dividends grow at a supernormal rate first and then continue at a constant rate thereafter.

Valuing Common Stocks Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.

Valuing Common Stocks Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?

Dividend Yield + Capital Appreciation Valuing Common Stocks The formula can be broken into two parts. Dividend Yield + Capital Appreciation

Valuing Common Stocks Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation.

Valuing Common Stocks Example- continued If a stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends? Answer The market is assuming the dividend will grow at 9% per year, indefinitely.

Valuing Common Stocks Return Measurements

Valuing Common Stocks If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher. Payout Ratio - Fraction of earnings paid out as dividends Plowback Ratio - Fraction of earnings retained by the firm.

Valuing Common Stocks Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations. g = return on equity X plowback ratio

Valuing Common Stocks Example Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

Valuing Common Stocks No Growth With Growth Example Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision? No Growth With Growth

Valuing Common Stocks Example - continued If the company did not plowback some earnings, the stock price would remain at $55.56. With the plowback, the price rose to $100.00. The difference between these two numbers) is called the Present Value of Growth Opportunities (PVGO).

Valuing Common Stocks Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments. Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.